Weekly Commodity Update: Commodities torn between recession and tight supply focus

Commodity markets maintain a commanding lead over asset classes, such as bonds and stocks, as we head towards the final few weeks of trading in 2022. A year that, despite several headwinds, has yielded strong returns – with the Bloomberg Commodity Total Return index trading up close to 20% on the year. Following on from a strong finish to 2021 – driven by a post-Covid surge in demand for goods fuelled by a wall of fiscal stimulus and coordinated monetary support – the year started on tear. With demand rising strongly at a time of under-investments, the attention abruptly turned to supply worries following the Russian invasion of Ukraine.

Sanctions against Russia and risk to supply of key food commodities from Ukraine led to price spikes across all commodity markets, not least energy, grains and metals. As a result of this, the Bloomberg Commodity Total Return index spiked by more than 25% during the first quarter before spending the following months slowly deflating. However, despite numerous headwinds, such as the strongest dollar rally in years, rolling Covid related lockdowns in China and central banks hiking rates in order to kill inflation at the expense of growth, the commodity sector has performed very well, as demonstrated by the near 20% year-to-date return.

Heading into 2023, four major themes will help determine the direction of the market:

1. The depth of an incoming recession currently being priced in by the market through the most inverted US yield curve since the early 1980s
2. A recession forcing the US Federal Reserve to change its focus from rate hikes to economic support, potentially before inflation has reached a satisfactory low level, thereby supporting a reversal of the dollar and Treasury yields.
3. A reopening in China leading to a stimulus fuelled recovery in demand for industrial metals and energy.
4. The duration of the war in Ukraine and its potential impact on supply of key commodities from crude oil and gas to wheat and key industrial metals.

Recession versus tight supply

The risk of an economic downturn at a time of tight supply of several major commodities will be one of the key battlegrounds that, together with the strength of a post-Covid recovery in China, will help determine the direction of commodities in 2023. Following months of aggressive rate hikes, the US Federal Reserve is now signalling a slowing pace of future rate hikes – with the eventual peak rate being determined by incoming data.

The US bond market is already telling the Fed that it may have overdone the monetary tightening, with the yield spread between the 3-month treasury bill versus the 10-year treasury note tumbling to a twenty-year low at minus 64 basis point. An inverted level of this magnitude has only been seen prior to three previous recessions. Short-term interest rates have been driven higher by the Fed’s actions to raise the overnight Fed Fund rates, while longer-dated bond yields are lower on the prospect of slower growth (or even a recession) together with anchored long-term inflation. You can read more in this fixed income update from my colleague Redmond Wong in Hong Kong.