Commodities staged a strong comeback since April with gains in all sectors and now lead major global asset markets in year-to-date returns. G10 commodity FX has further to run if commodity price rally is sustained.
Commodities are in a sweet spot for two reasons. First, the global economy is revving up, supported by policy stimulus and vaccination progress that paves the way for re-opening. Commodities, which closely track economic activity, are set to benefit from a stronger global economy, led by the US and China and increasingly, Europe.
Government spending on infrastructure and rising investment in clean energy are expected to lift copper demand. Oil demand is set to gain from stronger domestic leisure travel heading into the summer holiday season in Western countries. The pent-up leisure demand should outweigh the lack of demand from international air travel and from countries which have seen an increasing spread of Covid-19 infections such as India.
Source: Bloomberg, Bank of Singapore
Second, commodities, which closely track inflation, are also set to benefit from positioning for higher inflation. The Fed is expecting a modest and transitory pick-up in inflation. But investors likely will not take their chances and will seek protection against persistently higher inflation with the US going big on fiscal stimulus. The hunt for inflation hedges is likely to be supportive of commodities.
A sign of physical shortage in commodities is the backwardation in the oil, copper, corn and soybeans futures curve. Backwardation is when the current price of the commodity is higher than the forward or futures contract. The current downward sloping futures curve for Brent oil in the chart below is an example of backwardation. By contrast, the Brent oil curve was upward sloping or in contango a year ago when the pandemic caused a sudden plunge in oil demand and resulted in a supply glut.
Source: Bloomberg, Bank of Singapore
Gold, too, has rallied, but more on a dovish Fed than on investors buying gold as an inflation hedge. Key Fed officials have been out in force last week reiterating the Fed’s dovish view. A dovish Fed has nudged US real yields back down, and thus unwinding more than half of this year's rise.
We prefer industrial commodities to gold as inflation hedges. Industrial commodities like oil and copper offer a positive carry, which adds to their appeal as inflation hedges compared to the no-yield commodities such as gold.
Gold is a hedge against runaway inflation or inflate on that is expected to soar past 5% due to an irresponsible Fed. We expect the Fed to be dovish as it experiments with average inflation targeting (AIT), but not irresponsible. Our view on gold remains that there is some modest upside to gold prices in the next few months. However, we are wary that gold prices could face renewed headwinds by year-end as Fed tapering comes into view.
