Investors Have Several Reasons To Be Bullish On Commodities This Year (DBC)

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February 7, 2018 6:49am NYSE:DBC

From Invesco: Commodity performance has been mixed in recent years. A strong rally in 2016 was followed by more modest returns in 2017, with gains in industrial metals offsetting weakness in energy and agricultural commodities.

As we move into 2018, I believe conditions are favorable for commodities. Here are four reasons to take a closer look.

1. Global expectations move toward interest rate normalization

The US dollar slumped throughout much of 2017 before gaining modest ground in the fourth quarter. In light of the strengthening US economy, many prognosticators at this time last year expected tighter monetary policy to drive the US dollar higher. We were not among them. Instead, we maintained that global economic growth would bring international interest rates closer in line with those in the US, which, coupled with capital flows into foreign markets, would push the dollar lower in 2017.

This call proved judicious. The dollar was off nearly 10% in 2017 — its worst performance in 14 years — and remains under pressure in early 2018, down roughly 3% in the month of January.1 Over the next year, we expect the dollar to continue to push lower, further stimulating global growth and demand for commodities as the jarring effects of global central bank policy divergence fade into history.

This is not necessarily bad news. A weak dollar can be beneficial to US exporters, who may be able to sell dollar-denominated products overseas at lower prices relative to foreign currencies. A weak US dollar can also provide a tailwind to commodities. This is because most major commodities are priced in US dollars. When the dollar falls in a broad fashion against other currencies around the world, commodities tend to rise in US dollar terms. And because the borrowings of many emerging market countries are also denominated in US dollars, a weak dollar can reduce the debt burden of these economies.

US dollar remains under pressure

US dollar remains under pressure

Source: Bloomberg L.P., Jan. 1, 1973, through Dec. 31, 2017. US trade-weighted dollar is represented by the Trade Weighted US Dollar Index. Investments cannot be made directly into an index.

2. OPEC has been disciplined in restricting oil production

Commodities could also find support from current trends in the petroleum markets. When it comes to energy prices, supply is paramount. Over the past 25 years, changes in global production volumes and the resulting impact on crude oil inventories have been the major determinants of crude oil prices. Recent years have been no exception, with falling oil prices paralleling the increase (and subsequent decrease) in output by the Organization of Petroleum Exporting Countries (OPEC) — part of the seesawing market contest with US shale producers. While disagreements abound in forecasting 2018 US shale output, falling capital investment and the recent flat line in reported US drilling activity and production are putting upward pressure on the estimated crude oil price levels at which US operators may be profitable.

As a result, oil prices are trending higher, spurred largely by a historic counterseasonal drawdown in US crude oil inventories as the effect of OPEC’s late 2016 production cut agreement finally migrates to North America. West Texas Intermediate found a bottom in the summer of 2017 and closed the year above $60 per barrel — a level not seen in more than two years. Recently, OPEC agreed to extend oil production cuts through the end of 2018, which could support crude oil total returns over the coming year.

US crude oil inventories are drawing down faster than the seasonal average

US crude oil inventories are drawing down faster than the seasonal average

Source: Bloomberg L.P., March 31, 2017, through Dec. 18, 2017. For illustrative purposes only. Index returns do not reflect payment of any sales charges or fees. Average West Texas Intermediate crude oil inventory changes represented by the average of the Department of Energy Total Inventory Index between 2013 and 2016. 2017 West Texas Intermediate crude oil inventory change is represented by the Department of Energy Total Inventory Data Index between March 31, 2017, and Dec. 18, 2017. Past performance is not indicative of future results. Investments cannot be made directly into an index.

3. Price trends lend themselves to roll yield opportunities

With the current oil futures curves in backwardation, investors in commodities are already experiencing roll yield opportunities in 2018. Backwardation implies a downward-sloped price curve whereby today’s spot prices are higher than prices for futures contracts. For example, as of Feb. 5, 2017, a March 2018 West Texas Intermediate futures contract was selling for $65 per barrel, while a December 2021 contract was priced at under $52 per barrel.2 Under this scenario, as investors roll between futures contracts, they sell current contracts at a higher price and buy the ensuring futures contracts at a lower price. This creates positive “roll yield” opportunities that can add up over time.

4. Inflation remains a risk — bad for consumers, opportunity for commodities

Commodities have historically demonstrated among the highest correlations to the consumer price index (CPI) versus other asset classes, as seen in the graphic below.

The relationship between inflation and commodities

The relationship between inflation and commodities

Source: Bloomberg L.P., Dec. 31, 2002, through Dec. 31, 2017. Commodities represented by the DBIQ Optimum Yield Diversified Commodity Index Excess Return, US equities represented by the S&P 500 Index, developed markets represented by the MSCI EAFE Index, REITs represented by the MSCI US REIT Index, TIPS represented by the BofA Merrill Lynch US Inflation-Linked Treasury Index, emerging markets represented by the MSCI Emerging Markets Index, gold represented by the Gold Spot Price Index and US bonds represented by the Barclays US Aggregate Bond Index. Past performance is not indicative of future results. Investments cannot be made directly into an index.

In fact, over the past 15 years, commodities have experienced a more than 0.80 correlation to changes in the CPI — higher than US and other developed-market equities, REITs and even Treasury Inflation-Protected Securities (TIPS).3 With US economic growth accelerating, global economies on the mend and interest rates still historically low, the risk that inflation exceeds the Federal Reserve’s long-term target of 2% is on the rise, as illustrated by 10-year TIPS break-even rates, which represent the difference in yield between 10-year Treasury bonds and TIPS. TIPS break-even rates provide a rough gauge of investors’ expectations for inflation.

10-year TIPS break-even points hint to inflation pressures

10-year TIPS break-even points hint to inflation pressures

Source: Bloomberg L.P., as of Jan. 24, 2018

Considered in aggregate, I believe 2018 appears to have the markings of a promising year for commodity investors.

Investors looking for a convenient and cost-effective way to invest in the commodity markets may wish to consider PowerShares’ lineup of commodity ETFs.

1 Source: Bloomberg L.P., Jan. 23, 2018

2 Source: Bloomberg L.P., Feb. 5, 2017

3 Source: Bloomberg L.P., Dec. 31, 2017

Important information

The Barclays US Aggregate Bond Index is an unmanaged index considered representative of the US investment grade, fixed-rate bond market.

The BofA Merrill Lynch US Inflation-Linked Treasury Index is an unmanaged index composed of US Treasury Inflation-Protected Securities with at least $1 billion in outstanding face value and a remaining term to final maturity of greater than one year.

The DBIQ Optimum Yield Diversified Commodity Index Excess Return is a rules-based index composed of futures contracts on 14 of the most heavily traded and important physical commodities in the world.

The Department of Energy Total Inventory Index tracks the total US crude oil inventory in barrels.

The Gold Spot Price Index is an index comprising gold spot prices per ounce quoted in US dollars.

The MSCI EAFE Index is an unmanaged index considered representative of stocks of Europe, Australasia and the Far East.

The MSCI Emerging Markets Index is an unmanaged index considered representative of stocks of developing countries.

The MSCI US REIT Index is a free-float-adjusted, market capitalization index that is composed of equity REITs.

The Trade Weighted US Dollar Index is a weighted average of the foreign exchange value of the US dollar against a subset of the broad index currencies that circulate widely outside the country of issue.

The consumer price index (CPI) measures change in consumer prices as determined by the US Bureau of Labor Statistics.

Backwardation refers to a downward-sloping forward price curve wherein the prices of futures contracts are lower than the spot price today.

Correlation is the degree to which two investments have historically moved in relation to each other.

Futures contracts are legal agreements between two parties to buy and sell an asset at a predetermined future price.

A future (forward price) curve represents the current price for a commodity in a specific location on a specified future date.

A real estate investment trust (REIT) is a closed-end investment company that owns income-producing real estate.

Roll yield is generated by rolling a maturing futures contract to a later-dated futures contract.

A spot price is the current market price at which an asset is bought or sold for immediate payment and delivery.

Treasury Inflation-Protected Securities (TIPS) are US Treasury securities that are indexed to inflation.

West Texas Intermediate (WTI) is light, sweet crude oil commonly referred to as “oil” in the Western world.

Commodities may subject an investor to greater volatility than traditional securities such as stocks and bonds and can fluctuate significantly based on weather, political, tax, and other regulatory and market developments.

The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

The dollar value of foreign investments will be affected by changes in the exchange rates between the dollar and the currencies in which those investments are traded.

Many commodity ETFs are not suitable for all investors due to the speculative nature of an investment based upon the ETF’s trading, which takes place in volatile markets. Because an investment in futures contracts is volatile, such frequency in the movement in market prices in the underlying futures contracts could cause large losses.

Commodity ETFs are speculative and involve a high degree of risk. An investor may lose all or substantially all of an investment in these ETFs.

Many commodity ETFs are not mutual funds or any other type of investment company within the meaning of the Investment Company Act of 1940, as amended, and are not subject to regulation thereunder.

The PowerShares DB Commodity Index Tracking Fund ETF (DBC) was unchanged in premarket trading Wednesday. Year-to-date, DBC has gained 0.72%, versus a 0.85% rise in the benchmark S&P 500 index during the same period.

DBC currently has an ETF Daily News SMART Grade of A (Strong Buy), and is ranked #3 of 144 ETFs in the Commodity ETFs category.

This article is brought to you courtesy of Invesco.

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