Commodities are falling – this is it what it means for the stock market

Inflation may fall due to recession fears, but weak economies will not be good for company profits, writes Sam Benstead. 

While it may not be obvious in food, construction and petrol prices just yet, commodity prices are plummeting in financial markets.

The Invesco Bloomberg Commodity ETF, which tracks the performance of a basket of raw materials, from livestock to precious metals and oil, has fallen around 15% from highs in early June, recovering from an initial 20% drop.

Lower commodity prices, especially after more than a year of rising raw material costs in response to economic activity after the pandemic, suggest that inflation may begin to tick lower.

Inflation is measured on a year-over-year basis, so high commodity prices are close to being “lapped”, making annual comparisons look better. Lower prices are linked to fears of recession, which will lead to lower demand for basic materials.

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Aneeka Gupta, macroeconomic research director at WisdomTree, said: “The re-opening trade in 2021 has evolved into the ‘recession trade’ in 2022, owing to a tardy start to the hiking cycle by central banks in developed markets. 

“This aggressive tightening plan is slowing the global economy, raising the probability of a global recession.”

Ariel Bezalel, head of fixed income strategy at Jupiter Asset Management, adds: “Back in 2020, the first signs that the global economy was reawakening from the pandemic were found in commodity markets, the leading indicators of reflation. Today, prices in agriculture, lumber, copper, among others, are starting to roll over.”

Bezalel, fund manager of Jupiter Strategic Bond, a member of interactive investor’s Super 60 list, adds: “Energy inflation remains unpredictable given the war in eastern Europe. That said, given that oil has already risen by nearly 60% so far this year, the contribution of energy to inflation is likely to moderate.”

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Inflation could fall steeply

Inflation will start to decline, potentially steeply, he argues, as supply chain problems that drove much of higher inflation naturally work themselves out and raw material prices fall.

He says: “It’s worth highlighting how the inflation picture can change dramatically in a short space of time. In the middle of 2008, in the build-up to the global financial crisis, inflation was running at nearly 6%, yet by July of 2009 deflation had duly arrived.”

Bond investors now expect interest rates to fall next year in order to stimulate economies. Jim Leaviss, public fixed income chief investment officer at M&G Investments, said bond markets were now starting to look through the cycle, pricing in the possibility that central banks may have to start cutting rates in 2023 as recession fears grow.

Lower interest rates are typically good for stocks, particularly high growth ones, but during a recession earnings would fall. So what does this mean for markets?

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Outlook uncertain

For James Penny, chief investment officer at TAM Asset Management, this economic backdrop will be good for government bonds.

As inflation falls back, although he thinks not to central banks’ 2% target but rather around 4% or 5%, central banks may cut interest rates, he argues.

“American consumption is slowing down, therefore the Federal Reserve may hold off on rate hikes as inflation will also slow. This could trigger a relief rally in bonds and stocks as interest rates may not go as high as anticipated.

“The rally in government bonds could be supercharged as they are also a great place to invest during a recession. Yields will fall as prices rise.”

Penny adds that stocks generally don’t do well during economic downturns, and would do particularly badly if inflation stayed above 7%.

But within equities, he likes cheap “value” shares and “quality” companies that will still be thriving when the dust settles.

He said: “A sticky inflation environment is good for value stocks. We are underweight growth and small/nano-cap shares, but like high-quality stocks.

“We are heavily underweight bonds but starting to buy some now, especially long-dated ones that will rally the most if rates decline.”

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Penny also likes precious metals, which he says would do well if the dollar drops in value, as well as if yields on bonds fall too. Investors, though, need to brace themselves for inflation likely settling at a higher level than they are used to. This is the view of BlackRock’s Investment Institute, a central research hub at the investment giant. Therefore, it is overweight equities and underweight government bonds in long-term portfolios.

It said: “We expect investors to demand more compensation to hold long-term bonds in this new regime.”

Over the short term, it reckons stocks could fall further, saying: “We see a near-term risk of growth stalling and reduce equities to a tactical underweight. We prefer to take risk in credit because we see contained default risk.”

It added that stocks would suffer if interest rate hikes trigger a growth downturn, and if policymakers tolerate more inflation, bond prices would also fall.

“Either way, the macro backdrop is no longer conducive for a sustained bull market in both stocks and bonds, we believe," it said.

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Commodities could rise again

Chris Korpan, who runs the JPM Natural Resources fund, says that there could be a longer commodities supercycle due to a lack of investment in new oil wells and mines, which coupled with still growing demand would lead to higher prices over the long term.

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He told interactive investor’s Funds Fan podcast in early July that: “Over the past decade, investments in mining have fallen. They peaked in 2012-13, and for oil investment it was 2014. We have seen reduced investment in commodities.

“The industry had poor returns over 2010 to 2015. Lower investment typically means lower supply in the future, and at the same time management is focused on distributing money to shareholders via dividends and buyback.”

If this outlook comes true, then commodity prices would rise, which would be great news for mining and oil companies.