Will commodity stocks benefit from a wider equity sell off?

By James Moore


US stocks have had a rollercoaster ride over the past couple of months, and Tuesday’s trading session was spectacularly volatile, with a 900-odd point range in the Dow Jones Industrial average over the past 24 hours alone. It will be some relief to bulls that the main indices have since managed to reconquer their 200 Day Moving Averages – but for how long, we’ll have to wait and see. Many will have 2008 on their minds but after all the ‘QE meddling’, it is difficult to know the true status of the economy – it’s a bit messed up, and ultimately the proverbial drugs don’t work.

A lot of commentators believe equities are overvalued, and there are numerous potential headwinds that could blow the house of cards down, but will there be a mass exodus from stocks, or a partial move to safer, less overvalued sectors?

One such potential idea springs to mind; commodities.

I’m not by any means suggesting commodity stocks will be immune to a greater selloff, but generally, I think it’s fair to say the sector has only recently started to show signs of recovery after a number of years in the doldrums.

The S&P GSCI commodity index comprises of energy raw materials, industrial and precious metals and agricultural products, including livestock. Plotting this commodities index alongside the S&P500 reveals an inverse correlation between the two. What is striking is the size of the current divergence, with overheated equity markets nearly off the charts compared with recent modest gains in commodity prices.

In 2008, commodity prices spiked just as the equity markets were dipping toes in the hot bath to follow. This was primarily down to the price of oil ramping up and general disruption due to drought-induced crop failures. Speculation on commodity futures may have also contributed, but certainly, the higher oil price rise added to the costs of processing and transporting food.

The oil price rise ahead of the 2018 financial meltdown was a result of a decrease in non-OPEC production and a surge in global demand. Oil producers attempted to ramp up supply, but a lack of investment in the preceding years left them struggling to fulfil global needs.

We could well be approaching a similar scenario in the coming few years with production restricted to reduce the glut over the past two years, and severely debt-ridden companies having held off from investing in future supply with some going bust. As crude inventories now dip back to their five-year average, we might be one geopolitical incident away from another crisis and price spike. In any event, the chart implies a considerable narrowing of divergence will take place at some stage.

The usual threat to commodities in times of financial strife is lack of demand caused by such a recession, but unlike the 2008 scenario, we don’t appear to be experiencing that part of the boom-bust cycle yet – at least with our QE-tinted glasses on. Employment levels are strong, and Interest rates are starting to trickle up, and they are usually indicators of decent economic health.

Although the JP Morgan Global Manufacturing PMI (Purchasing Managers Index) has just hit a five-month low in March at 53.4, this is still comfortably above the median value of 50 and represents a slowdown of growth, not a contraction.

The United States ISM Non-Manufacturing PMI tells a much rosier story, with the index at near decade highs. Another useful index that suggests this is more likely a stock bubble than a looming recession scenario is the St. Louis Fed Financial Stress Index (STLFSI). The STLFSI measures the degree of financial stress in the markets taking into account interest rates, yield spreads, and a number of other indicators. The index began in 1993 with a value of zero, and this was taken to represent normal financial market conditions. Values above zero suggest above-average financial market stress and vice versa.

As the chart below shows, the STLFSI hit a value of five during the 2008 market crash, but appears, perhaps surprisingly, ‘unstressed’ at around minus one in 2018.

Traditionally investors have protected themselves from inflation by buying commodities as a hedge. Gold is an obvious, popular choice, particularly in times of geopolitical crisis. Perhaps with oil edging out of its low-price environment, ‘black gold’ might also be considered a haven to shelter from an incoming storm, at least in the short term anyway. As we look to the future it’s clear demand for industrial metals is set to increase rapidly. For example, Nickel and cobalt are key components to batteries that power our technology and finally now our transport. Or perhaps urgent environmental pressures for cleaner energy will spark a resurgence in nuclear energy. Uranium is currently at all-time lows, but we know that can easily change after several years without significant investment causing a supply shortfall.

When investors start to shy away from the more speculative end of the market, intrinsic sectors gain favour, and with many commodities appearing to be coming out of their cyclic lows, some might offer relative upside in the event of a general market slide.

Author: Stuart Langelaan


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Author: James Moore

This article does not provide any financial advice and is not a recommendation to deal in any securities or product. Investments may fall in value and an investor may lose some or all of their investment. Past performance is not an indicator of future performance.

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