Risk-Off In Stocks Could Create Bargains In Commodities

Source: CQG

The chart shows that four short months later, lumber futures fell to a low of $448 per 1,000 board feet, less than one-third the price at the May high. Lumber returned to the $1,000 level by December 2021, rose to over $1,300 in January, and corrected to below $1,000 on Feb. 2.

As the pandemic gripped markets across all asset classes in early 2020, most commodity prices fell to multi-year lows in a tsunami of risk-off selling. The fear of a pandemic-inspired global depression had far-reaching consequences that planted the seeds for future higher prices. The cure for low prices in the world of commodities is those low prices. When demand evaporates, producers curtail or suspend output, leading to shortages. The pandemic poses unique issues as lockdowns made production impossible.

The treatment for economic instability, central bank liquidity and government stimulus stabilized the financial system. The policies lit an inflationary fuse that lifted commodity prices at a time when pandemic-inspired shortages and supply-chain bottlenecks added to the bullish trajectory of many markets.

The ascent of the commodities asset class has been like a bullish relay race, with one market handing the torch to another. The first commodity that took off on the upside was gold. The yellow metal rose to $2,063 in August 2020, an all-time high. While gold corrected and digested the move in 2021, a host of other commodities took the baton. In May, lumber, copper and palladium prices rose to new all-time highs. Crude oil, natural gas, oil products, coal and ethanol reached multi-year highs, with most remaining in bullish trends in early 2022. Agricultural commodities moved to levels not seen in years along with metals and minerals prices.

Meanwhile, addressing climate change has only exacerbated the bullish commodity trends at a time when production cannot keep up with the rising demand. The latest commodities to hold the bullish torch were natural gas, frozen concentrated orange juice futures, and palladium. Palladium traded to a low of $1,549 in December, and the price was back at the $2,375 level on Feb. 2. Signs that the semiconductor shortage is easing are increasing palladium demand as car-makers begin to increase production at assembly plants. Palladium is a critical component of automobile catalytic converters.

The bottom line is the bullish relay race in the raw materials asset class continues as we move into February. 

Just as commodity prices fall to levels where productions slow, when they rise, higher prices incentivize more output as producers scramble to meet requirements and increase profits. Therefore, the higher prices rise, the more susceptible they become to sudden and brutal downside corrections. The price action in lumber is an example of that carnage. Copper corrected from nearly $4.90 per pound in May to under $4 in August. Palladium fell from more than $3,000 per ounce last May to under $1,600 in December.

With the stock market on shaky ground, interest rates set to increase and the US dollar trending higher, commodities face a triple threat of a risk-off period. The commodities that have soared tend to be the likely candidates for a significant correction. Those corrections are likely to test the fortitude of even the most committed bulls, as declines could become hideous.

I would view any significant corrections in the commodities asset class as a temporary event. I believe the asset class’s price action from 2008-2012 is a guide to what we can expect from raw material markets over the coming years. The liquidity and stimulus that stabilized conditions during the 2008 global financial crisis were far less than during the 2020 pandemic.

Remember what Albert Einstein once said: the definition of insanity is doing the same thing repeatedly and expecting a different result.

Liquidity and stimulus lit a bullish fuse in commodities starting in 2008, and they have ignited an even hotter fuse in 2020 and 2021. We may only be in the middle innings of the commodity bull market in 2022.

Even though interest rates will rise, the US dollar is moving higher, and stocks look shaky, inflation indicators are at the highest levels in four decades. The Consumer Price Index increased by 7%, and the Producer Price Index rose by nearly 10% in 2021. Core inflation, excluding food and energy, may be at 5.5%, but at the current Fed funds rate, the Fed would need to hike rates by 25 basis points 22 times to lift rates from negative territory at the current core inflation rate. Meanwhile, since food and energy costs impact all businesses and individuals, inflation is likely at far higher levels.

Meanwhile, rising oil, gas and coal prices fuel inflation, as traditional energy remains a critical input cost for most commodity production. As energy prices rise, it puts upward pressure on metals, minerals and agricultural prices. Inflation is a vicious economic condition that erodes money’s purchasing power. While the US dollar is appreciating against other world currencies, higher commodity prices mean its purchasing power is only eroding at a slower pace than other foreign exchange instruments.

Unless the Fed holds its nose and gets uber-hawkish, inflationary pressures are not going away any time soon. The shift in US energy policy to address climate change has handed pricing power in the oil market back to OPEC and Russia. The cartel would rather sell one barrel of petroleum at $100 than two at $50. Rising energy prices will make inflation a challenge to tame.  

The commodity bull continues to charge as we enter the second month of 2022. However, corrections are part of any bull market, and they could get nasty. The optimal approach to commodities over the coming months should be to buy on price weakness, leaving plenty of room to add on deeper corrections. Lightening up and taking profits on long risk positions during rallies that take prices to multi-year highs is an integral part of the strategy. JP Morgan once said he got rich by selling too early.

For those looking to participate in the commodity bull market without venturing into the futures arena, the Invesco DB Commodity Index Tracking Fund (NYSE:DBC) is a liquid product that follows commodity prices with weighing towards traditional energy markets. DBC’s most recent top holding and fund summary include: