News analysis

Commodities rally: False dawn or new beginning?

End to macroeconomic uncertainty too early to call, but near-term risks are likely fading

After a turbulent start to the year, Asian equities have made a comeback. This optimism can be credited to fading risks of a sharp Chinese yuan depreciation, US recession, and weakening regional currencies. But the most surprising development in a month of reversals has been the commodities rally, which has helped drive Asian equities up about 16 per cent since its January lows.

Commodity prices have roared to life after four years in the doldrums. Gold climbed 19 per cent to reach its recent peak and outperformed all other asset classes this year. Oil prices hit a three-month high in March. Industrial metals, led by iron ore prices - up nearly 45 per cent from last December's low - have rallied as well. Some believe the storm has passed, pointing to an unexpected surge in Chinese construction activity as evidence for a sustained commodities rebound.

While sustainably higher commodity prices remain in question, Asian assets will benefit from the pricing out of a further collapse. Equities in particular should also gain from a return to moderate inflation via improved corporate earnings and dulled commodity-related credit risks.

Still, it isn't time to be complacent just yet: the commodity supply chain may be better balanced now, but most markets remain burdened by excess supply-side capacity. Accordingly, spikes in commodity volatility remain an enduring risk for equity investments.


A Palestinian woman shopping for gold on March 30. Gold prices feast on economic uncertainty, and this year's buffet of market woes fattened the yellow metal up to recent highs.
A Palestinian woman shopping for gold on March 30. Gold prices feast on economic uncertainty, and this year's buffet of market woes fattened the yellow metal up to recent highs. PHOTO: AGENCE FRANCE-PRESSE

Gold prices feast on economic uncertainty, and this year's buffet of market woes fattened the yellow metal up to recent highs. Investors turned to gold's insurance qualities in response to a murky global economic outlook, waning dollar strength and the dwindling efficacy of central banks' monetary policies. A much-talked-about US recession and the Fed's patience in hiking rates further contributed to gold's rising popularity. Speculators covering their short positions also helped to push prices higher.

But this rally will fizzle amid strengthening US employment and household balance sheets. Resilient US economic data ahead should keep the Fed's monetary policy on a normalisation path; we expect two rate hikes this year, likely in September and December. Barring renewed fears of a US recession and a reversal in the US interest rates path, we see little upside in gold from current levels. Prices are expected to range between US$1,100 and US$1,310 over the next three months and US$1,200 in 12 months.

Oversupplied oil markets cap near-term price upside. After plummeting from US$125 in early 2012 to a low of below US$28 at the start of 2016, crude oil prices have bucked the trend and swung upwards in March to around US$40. Temporary production outages, a shift in sentiment and speculative accounts covering their short futures positions have underpinned the bounce. Given oil's ubiquitous influence on general financial markets, investors have become more risk tolerant, particularly towards emerging markets.

But like for gold, we caution against extrapolating the recent upswings in energy prices. In our estimates, oil markets are still drastically oversupplied by around 1-1.5 million barrels per day (bpd). While Opec and Russia have finally expressed an interest to freeze production, Iran has communicated otherwise, given its newfound post-sanctions economic freedom. Meanwhile, the ruptured pipe in northern Iraq that caused the supply outages has been repaired. Higher prices could also limit the recent, vital declines by US shale producers that are needed to balance the market. We think the current oil price rally could soon fade with Brent prices reversing closer to US$30 sometime in the second quarter.

That said, there is light at the end of the tunnel - capital expenditure cuts are slowly becoming visible in production figures. Non-Opec production is likely to shrink by 0.7 million bpd this year, but demand should expand by 1.1-1.2 million bpd, thanks to the steadily growing energy appetites of India and China. This provides a favourable backdrop for oil supply to tighten in the later part of 2016 and reach US$55 in 12 months.


Recent widespread price advances in base metals are attributable to a seasonal demand uptick, supply cuts and positioning changes in base metal futures amid recovering oil prices. The price rally could be enshrined further if early signs of better Chinese demand materialise. A more sustainable rebound across the broader commodity complex would stem the deflationary spiral that has gripped producer prices in the region in recent years.

We think the verdict on commodities remains to be seen, given that regional end demand remains weak and the improved data around Chinese New Year should be treated with some scepticism. We note deflationary pressure is easing regionally and businesses are finally restocking inventories. While an end to macroeconomic uncertainty is too early to call, near-term risks are likely fading which should tactically benefit risk assets.

A better balanced inventory-to-sales ratio and lower China hard landing risks in particular point towards further upside in Asia ex-Japan equities. Early earnings recovery signs are also encouraging; China industrial profits, for instance, rose unexpectedly in January and February. Asian investment-grade credit, on the other hand, may see little total return upside this year due to tight valuations, in contrast to the broader Asian equity market where valuations still imply a severe risk scenario. We thus favour Asia ex-Japan equities over Asian credit.

Within equities, exposure to materials stocks is still not warranted at this stage, but the energy sector could benefit from better supply dynamics later in the year. Fading non-performing loan pressure from exposure to commodity assets should also help select Asian financials, including select Singaporean banks. By country, we are overweight on Chinese and Singaporean equities and underweight on Taiwanese and Thai stocks, which will suffer amid persisting concerns about Taiwan's tech supply chain cycle and Thailand's weak earnings trends.

• The writer is APAC regional head at the chief investment office of UBS Wealth Management.

A version of this article appeared in the print edition of The Straits Times on April 11, 2016, with the headline 'News analysis Commodities rally: False dawn or new beginning?'. Print Edition | Subscribe