Lower & Low

Inflation is lower, inventories are low.  What does that mean for commodities?

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The commentary provided during this podcast reflects the personal opinions, viewpoints and analyses of the participants providing such comments, and should not be regarded as a description of advisory services provided by USCF Investments or its affiliates or SummerHaven Investment Management or its affiliates or the performance returns of any fund managed by any such entities.

 The views reflected in the commentary are subject to change at any time without notice. Nothing said during this podcast constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security.

 Investments involve the risk of loss. Diversification does not eliminate the risk of experiencing investment loss. 

Commodity trading is highly speculative and involves a high degree of risk. Commodities and futures generally are volatile and are not suitable for all investors. 

Past performance is no guarantee of future results.

Ryan Katz is a Registered Representative of Alps Distributors, Inc.

ALPS Distributors, Inc. is not affiliated with USCF Investments or SummerHaven Investment Management, member FINRA.

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Transcript

Lower & Low
Season 4: Episode 5

Katz: Welcome to The Real Spiel with Ryan and Kurt. This week we're talking about diversified commodities. As we saw in ‘21 and ‘22, inflation ran up to 9%, and coincidingly, commodities had big returns those years, Kurt. As we've previously touched on, inflation's incredibly difficult to predict, but in 2023 as inflation came down somewhat, diversified commodity benchmarks were flat or slightly down for 2023, and we've seen equities rebound from a rough couple of years. What's happened and is there still runway for diversified commodity returns? 

Nelson: Yeah, hey, Ryan. Absolutely. One of the things I would say, echo one of the points you made, inflation's hard to predict. I'd also echo that we know that when inflation is rising, that tends to be a petri dish when stocks and bonds are challenged, and commodities do very well. And the converse is also true. When inflation is falling, stocks and bonds tend to do very well. It's usually an environment where interest rates are getting lower and lower, and so economic conditions are getting easier. And that tends to be a really challenging time for commodities. That's what we saw in the 2010s. And so, I do think that the moderated returns to commodities in ‘23 are somewhat predictable. And it was a good year for the S &P 500.  But I would also say that it seems that investors tend to invest for longer than just six months or one year at a time. If you're a long -term investor, you're investing for years, maybe a decade or more. If we combine the ‘22 and ‘23 returns together, you'll see that actually the S &P 500 is only up a little bit. Things like global stocks are down, real estate is down, and so traditional assets have had a tough beginning to the 2020s, and actually the best performing asset over the last two years is commodities. So, I think that it was a tough year, but I don't think that the story's over. I think for other podcasts we've shared with listeners and other recordings we've made; we’ve driven home this point that inflation is hard to predict and There is reason to believe that there's still more work to do before we wrangle Inflation back down at a persistent 2 % level, right? 

 Katz: And we've talked about this before, Kurt, commodity prices are largely or almost entirely driven by supply and demand Global inventories are still low compared to their historical levels, whether that's from supply chain disruptions through Covid or other factors which commodities are in the lowest inventory right now. I wonder if you can kind of touch on that, where we are across the board really for commodities and their inventory levels compared to where their historical averages have been.

 Nelson: I think two sectors kind of stand out to me right now. I think none of the sectors are in significant oversupply or full storage. It's an interesting time in that commodities generally are at low inventory levels globally. But one that we've talked about before is softs. Softs tend to be smaller agricultural markets. Their production is usually geographically constrained. And we don't have very significant amounts of inventory available right now in commodities like cocoa and coffee and sugar. And so with that low inventory level, we're coming into a period of tight supply with persistent, sticky demand. I think that's an interesting setup going forward. And we've already seen in ‘23 a positive price effect to those sectors. or those commodities. Another sector I think that bears watching is the broad metals category. Metals inventories reported by exchanges such as the London Metals Exchange are at historic lows. And we're coming into a period of perhaps higher sticky demand for renewable energy, for electric vehicles, and grid enhancements that are going to be financed not just by consumers and industry but by government spending like the Inflation Reduction Act which has set aside three quarters of a billion or three quarters of a trillion dollars into these areas that will be very metals intensive. So, we have low current supply, higher demand. Then, on top of all that, difficult in creating a supply response, particularly in metals, because we can plant more crops over the course of a calendar year, create more agricultural supplies. We have hydraulic fracturing, or fracking, which can access tight oil and tight gas relatively quickly compared to what we could do 10 years ago. We have no technological innovation to extract metals in a similar fashion. It takes multiple years and billions of dollars to get to new raw metal supplies underground. That's something that I think bears watching in this coming decade. 

 Katz: Right. To put it back to inflation, in the diversified commodities conversation, every commodity has a small, what, 0 .2 to 0 .3 beta to inflation. But when you put together a diversified basket of commodities, you tend to hedge away some of the idiosyncratic risks associated with each specific commodity and what you're left with is the commonality of this inflation beta, which will jump up to something like 0 .6, 0 .7. So, in terms of the market's expectations of inflation, for the decade, we just look back at the previous decade. The 2010s were really a lost decade for commodities. Inflation really wasn't on people's radars. Equities were ripping, and commodities largely did nothing. But if you look at the prior decade, equities really did nothing.  In the 2000s, and commodities were up, depending on the benchmark, 250% to 300%. Can you talk about the 2020s as far as we are now, and where we're going in the market's expectations of inflation? 

 Nelson: Yeah, absolutely. The 2010s were a long period where commodities generally underperformed. We're expecting stocks and commodities on average to return about 5 % to 7 % above the risk -free rate. In fact, in the 2010s, equities significantly, I would even argue massively outperformed their normal expectations, with interest rates close to zero for the decade and equities kind of delivering 10 to 12 % per year for a decade. That's extraordinary. Commodities had a negative return for the decade, so both very different from what we would long -term expect. If you go dial back to the 2000s, you started with a big sell -off when the internet tech bubble collapsed in early 2000, and that set up a lost decade for equity returns. As you said, commodities did quite well. One of the things that's interesting to look at related to asset class returns and inflation is something that we call, or industry calls the tips break even inflation rates. What does that mean? It's taking two things from the bond market, tips which are inflation sensitive, or inflation protected, and comparing those to just treasury bonds which are not inflation protected. When you subtract those two, you're left with markets expectations of inflation. Inflation is a bit of an expectation game. If you think inflation is going to go higher, you'll accelerate purchases today because you expect that prices will go up. If you think inflation is just going to be anemic and prices might even go lower, well, you can buy those things later and not worry about it, which means that supplies build and prices do go lower, in a sense self -fulfilling. What did we see? In the 2010s, the tips break even rate on average, say at a five-year horizon, was only like 1 .7 % for the decade. It was below the Fed's 2 % target. That was unusual. We don't have a ton of tips data, but we have a few decades since these securities were created. If you go back to the 2000s, what we find is that tips break even rates at a five -year horizon were more like 2 .4%. So, what have we seen this decade? Well, since the beginning of 2020, we've seen tips break even rates average about 2 .5%. So, we've started the decade with something that looks and rhymes more with the 2000s than with 2010s. I think that's something positive in terms of the outlook for commodities going forward this decade. 

Katz: Absolutely. This has been The Real Spiel with Ryan and Kurt. Thank you for listening in. If you have any questions, comments, feedback, please reach out to us at therealspiel@uscfinvestments.com and we'll talk to you next time.