IndexIQ: A Commodities Rebound Near?

May 11, 2016

[The following "ETF Industry Perspective" is sponsored by IndexIQ]

Everything looks up from the bottom. The problem is knowing the bottom when you see it. That's been the challenge with commodities since the start of the year. We're almost done with Q1 and we've seen some life in oil, copper, and most dramatically in iron ore. But the markets have been choppy, and the sense among investors is that these rallies are fragile and could unwind.

As the World Bank noted in a January report, emerging market (EM) economies "have been the main sources of commodity demand growth since 2000." Weaker growth there has hit demand, which is reflected in lower prices. So it's classic economics—too many sellers and not enough buyers. But markets are dynamic and changes have been underway that are starting to have an impact on the supply side of the equation.

In the U.S., for example, oil rig counts have declined precipitously, which will hit future production. Globally, there have been massive labor force reductions in the mining sector, with Anglo American alone announcing 85,000 layoffs in December of last year. Entire mines are being mothballed. Slowly, painfully, these industries are coming to grips with overexpansion and the reality of more modest global growth.

So where does that leave markets and commodity investors? As we've seen with oil, we appear to be closer to the bottom than to the top. Oil has rallied as much as 40% from its earlier lows back to nearly $40 per barrel for West Texas Intermediate.¹ But it hasn't been a straight-line recovery, and there remains a lot of skepticism as to whether it can be sustained. We expect to see something similar with other commodities. We believe capacity will be grudgingly reduced and prices will find a bottom and move up from there, most likely in fits and starts. As basic building blocks of the industrial economy, a more sustained rally will depend on better prospects for general growth.

Given the magnitude of the sell-off, many investors have been giving commodities a closer look. (It's hard not to at least notice when the price of oil falls from $100 per barrel to $30 in a relatively brief period of time.) The idea that oil will go right back up is probably mistaken, but the belief that it can't go down forever is a reasonable one. The same can be said for other commodities.

No one can pick an absolute bottom, of course, but the negativity surrounding commodities has been extreme, and the bear case is well-known to the markets. Regression to the mean can be a powerful force. Investors who find this idea compelling or who just want to hedge against the possibility of a pickup in global growth—if suitable—may want to consider staking out at least a modest position in the asset class.

1 Source: http://www.nasdaq.com/markets/crude-oil.aspx?timeframe=2y as of 3/15/16.

 

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