Thursday, June 23, 2022
As both consumers and the Federal Reserve battle persistent, rising inflation, one of the most prominent inflationary tailwinds has been broad based commodity price increases. But could that tailwind to inflation be turning into a headwind? Today we explore the commodity landscape and why the recent downturn may be a positive for equity investors.
The Bloomberg Commodity Index consists of four major subgroups: Precious Metals, Industrials Metals, Agriculture and Livestock, and Energy. For today’s blog, we’re going set aside precious metals, as gold prices have completely avoided participation in the commodities rally (perhaps a warning sign in hindsight) and have traded sideways for nearly two years.
However, key bellwhethers in each of the other 3 groups all experienced major gains since the March 2020 market bottom, but are now showing signs of breaking down technically.
First up, our representative from the industrial metals group: copper. Copper is often referred to as Dr. Copper for its ability to forecast the economy, and if that is true the doc hasn’t had much positive to say in a while. After rallying more than 125% from the March lows, copper prices traded sideways for much of the past year. However, a 13% loss since June 2 has pushed copper below a key support level and to its lowest level since February 2021.
For US energy investors, the most important commodity is often WTI crude oil, and while this is likely still the healthiest trend we will look at today, recent weakness has occurred at an untimely spot for bulls. After breaking up above $115/barrel., a level that has significance going back to 2011, oil prices failed to get through their March closing highs and have rolled over sharply in recent days. It is hard to bet against one of the few clear uptrends left on earth right now, but for now near-term risk seems skewed to the downside.
Last up, wheat prices. While we could have picked a number of different commodities from the agricultural complex, wheat has been one the most volatile and closely watched due to the Russia-Ukraine conflict. Wheat prices were already up more than 70% in the 2 years prior to the Russia invasion, but spiked an additional 60% in the immediate aftermath due to Ukraine and Russia previously combining to produce more than a quarter of the world’s wheat exports. While the conflict sadly remains unresolved, wheat prices are on the verge of breaking down to their lowest level since the conflict began, as shown in the chart below.
Certainly nobody who has filled up their car with gas recently needs an explanation as to the real world impact of oil and gas prices, but do these potential reversals actually matter to investors’ portfolios? “The Federal Reserve may claim to only focus on inflation ex-food and energy,” explained LPL Financial Technical Market Strategist Scott Brown. “However, market inflation expectations have been highly correlated with commodity prices, especially over the past few years. Not only are we seeing commodity prices correct, but we are seeing a significant repricing of inflation expectations over the past few months.”
To put some hard numbers to those inflation expectations, consider the 2-year breakeven rate. Breakeven rates are the difference between inflation-linked bond yields and nominal bond yields of the same maturity, essentially showing what bond investors believe the inflation rate is likely to be over the holding period. The 2-year breakeven rate was 3.2% at the start of the 2022, but spiked to nearly 5% in late March. As of today it has fallen more than 1.25% to under 3.7% as commodity prices have fallen. If bond investors are seeing things correctly, that could mean less work for the Federal Reserve to do. For now the market is pricing in 7-8 more hikes this year, but any number less than that could be a welcome surprise for equities.
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