Outlook 2019: Commodities

• Restrained supplies should support major commodities in 2019 despite demand worries
• Deep market deficits are apparent in key energy, metals and agricultural markets
• Fading US economic outperformance, inflationary pressures and a potentially weaker dollar create a strong backdrop for real assets

Commodities have been faced with a wall of worry recently. Fear of trade wars and slowing global growth have gnawed away at investor confidence. You can’t dismiss such fears lightly, but we think the outlook for commodity returns in 2019 is positive.

Looking ahead, there is an obvious contrast between tight supply and demand balances and macroeconomic worries.

For example, the global crude market looks set to draw on inventory (ie its stored product) in 2019 despite recent volatility. In metals, London Metal Exchange (LME) aluminium inventories have more than halved since early 2017 and production cuts are likely to accelerate.

Other macro factors are also supportive for commodities, in particular:

Inflation risk

Markets are focused heavily on the potentially damaging links between trade wars and global growth. Far less focus has been on the inflationary impact of trade wars and the inflationary effect of loose fiscal policy from governments in the EU and China.

The US dollar

The US dollar has been strong in 2018. However, the impact of tax cuts fading and rising interest rates affecting sensitive parts of the economy, the likelihood of a strong dollar headwind being removed from commodities in 2019 is high.

Below we take a look at our core views in each of the major commodity sub-sectors.

Energy

Energy markets have seen a rapid turnaround in positioning, as an arguably overbought market met a series of negative catalysts: the Organization of the Petroleum Exporting Countries (OPEC) and the US ramped up production faster than expected and less severe sanctions resulting in an oil surplus at a seasonally weak period for demand.

Our fundamental outlook for oil is bullish over the next 12 months, as we expect the market to retighten in 2019.

Demand numbers continues to be strong and spare capacity (apart from Iran) is at historical lows. International oil companies continue to demonstrate and express a desire to maintain discipline in their use of capital.

Looking to North America we think expectations for production growth are overblown. Pipeline constraints from key basins will only be alleviated towards the middle of the third quarter of 2019, and Canadian production has started to be shut because of weak local crude prices.

Even assuming weaker oil demand growth in 2019 and significant production growth from North America, we still think demand will be beyond what OPEC is able to produce. We believe the market will have to draw on inventories in the second and third quarter.

We expect such inventory draws to drive the oil price up, with potential price spikes if precarious producers, such as Libya, Iraq, Nigerian and Venezuela, were to suffer disruption of their supply.

Metals

As a group we don’t expect to see major outperformance from base metals in 2019. The exception is where there are obvious supply catalysts ahead. Aluminium stands out. Prices are extremely low relative to costs and a large deficit will likely drive prices higher.

Longer term we continue to see significant potential for the nickel market based on limited supply growth and strong incremental demand from Li-ion batteries.

Precious metals are currently very out of fashion. Focus on short-term issues, such as extreme short positioning and strong Indian buying, misses the most important question for gold. Namely: when will the weight of higher interest rates on a highly leveraged US economy, as well as the impact of weaker emerging markets growth, weaker equity markets and the uncertainty of an aggressive trade posture finally spill into US economic data?

If this occurs the negative impact on rates expectations and the dollar could be profound. Timing such a scenario is difficult. Patience will be required, but 2019 is likely to yield such a turning point and would be a major positive catalyst for precious metals markets.

Agriculture

Fundamentals currently differ significantly between the five agricultural sub-sectors that we cover. The political and economic uncertainty resulting from trade wars and emerging market currency volatility has weighed heavily on agricultural markets.

However, markets such as grains and feedstock stand-out as positive given our expectation that global production and stocks will continue to tighten in 2019.

Likewise, cotton markets look promising as the demand for natural fibres worldwide remains strong whilst high quality cotton is in short supply.

Conversely, we are negative on oilseeds over the next 12 months, with the soybean complex looking particularly negative.

Finally, soft commodity markets like cocoa, coffee and sugar appear to be close to ending their long-term bearish trend. Coffee and sugar prices have tumbled since 2011 and fully reflect the importance of global inventories. While a catalyst is still missing the downside is limited and they represent an interesting long term investment opportunity.