What Caused the 2016 Commodity Rally?

After five consecutive years of material negative returns, commodity-related investments outperformed the broader equity and fixed income markets in 2016

Fatima Khizou 20 January, 2017 | 8:00AM
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Commodities have recorded strong gains after reaching a decade low back in January 2016, prompting a renewed interest in the sector. After five consecutive years of material negative returns, commodity-related investments outperformed the broader equity and fixed income markets in 2016.

Why Did Commodities Do So Well?

The strong outperformance of commodity and resources equities was driven by several factors. Slightly reduced concerns around the Chinese economic outlook, diminishing expectations of US interest rate rises and encouraging signs on the supply and demand fronts have all contributed to a positive backdrop for the sector.

Indeed, the Chinese government’s stimulus efforts at the start of the year have resulted in improved macroeconomic data and increases in property market prices, boosting many industrial metals and bulk commodities prices. Iron-ore has gained over 30% as Chinese steel demand increased in anticipation of the construction season. Even more remarkable, the price of coking coal increased by more than 130% in 2016.

A fall in production in a sector which has been suffering from a supply glut for a number of years has also contributed to this upward move in commodities prices. The capex reduction efforts undertaken by producers in the past few years have finally resulted in muted supply growth for many commodities. Furthermore, the demand side of the equation is also encouraging, supported by fiscal spending, notably in China as part of the government five-year plan, but also from potential spending in developed markets.

It is of little surprise that against this market backdrop many commodity-related funds delivered material positive returns.

Gold Run Upset by Trump

Of the sub-sectors across the natural resources complex, gold was the star performer for the majority of 2016. The precious metal significantly soared from the levels seen in the previous three years as investor demand for the “safe-haven” asset has increased, a move driven by uncertainties around the global economy, political events, including the UK referendum on EU membership, and increased probability of US interest rates remaining unchanged as opposed to the four rate hikes priced in by the market at the start of 2016.

The impact of these events was seen on the day of the UK referendum result, with gold price increasing by 5% and trading above $1,300 per ounce.

An obvious consequence of the popularity of gold was massive inflows into exchanged-traded funds during the first half of this year. Most dedicated gold fund managers are bullish on the long-term outlook for the precious metal given the ongoing concerns around global economic growth, political unrest and the uncertainty around the outlook of the UK after the referendum on membership of the European Union.

This positive view has further been reinforced by the gold companies’ financial strength.  Measures taken by the gold industry since the 2012to 2013 period, notably better capital allocation and operational efficiency, have led to expanding free cash flow and consequently helped to rebuild investors’ trust. Furthermore, the surge in demand for gold equities as a “safe-haven” and as a diversifier can also be explained by the low or negative yields on government bonds to which investors have traditionally turned for their safe-haven qualities. Gold fund managers also highlighted that the demand from Asia and a decline in production should support the investment case for gold.

But gold bugs were in for a nasty shock following the surprise election of Donald Trump as the 45th President of the United States however. Gold fell in value in the last two months of the year to finish 2016 at $1,152, the opposite reaction to what many would have predicted in the aftermath of a political upset.

Energy Stocks Rally with Oil Price

Energy equities, which are an important part of the commodity sector, continued to dominate the headlines last year. The price of oil, which started its downward trend in June 2014, fell to multi-year lows in January 2016 before recovering on the back of the production freeze announced by OPEC in February.

Several elements on both the demand and supply fronts have contributed to the recovery of the sector this year and subsequently to the rebalancing process. The Saudi market share strategy and laissez-faire stance has led to a decline in the US rig count. US oil production has significantly declined compared to the levels seen in 2015. Similarly, the low oil price has also put pressure on the other non-OPEC producers, reflecting lower investment in projects. Moreover, supply disruptions in Canada and Nigeria have been a catalyst behind the recovery in price.

More recently, the announcement made in Algiers by OPEC to finally cut production has provided a further boost to the oil price and was a marked shift in OPEC policy. Investors have also been encouraged by demand growth, driven particularly by the US gasoline demand and Chinese imports. Many managers and commentators think the oil price will continue to be volatile going forward but will move on an upward trajectory as the global oil supply/demand balance further tightens.

Resources-related stocks have certainly enjoyed a strong rally thus far. Supply/demand fundamentals and improvements in mining companies’ financial strength have led many to believe that this positive trend is set to continue.

From an asset allocation perspective, the commodity space has been significantly underweight in the past few years and while we have seen a substantial investment demand in some segments, many investors continue to maintain a cautious stance towards the sector. Such prudence is not surprising given the sharp losses and disillusionment experienced in the past few years. Investors can access the sector through mandates that invest across all the main sub-sectors of the commodity spectrum, specifically energy, base metals, precious metals and agriculture or through offerings with narrower focus such as energy.

A version of this article appeared in International Adviser magazine

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Fatima Khizou  is an Investment Research Analyst for Morningstar