Commodity stocks: Inflation hedges can soon become recession regrets
By Jenal Mehta
Updated
Commodity investors saw an impressive rise in commodity stocks over the past year. As demand now dwindles for raw materials, there is a concern as to whether commodity-heavy portfolios will still outperform.
Commodity prices have been dropping lately, sectors such as energy (XLE) and the metals and mining (XME) have all seen a drop in their values in recent months.
This comes after the commodities saw a massive spike in prices, mostly due to supply constraints seen during 2020 and 2021, but also influenced to the ongoing Ukraine war. This has resulted massive revenue growth for companies like Chevron (CVX) and Royal Dutch Shell (RDS).
Royal Dutch Shell (RDS) Price Chart
As these pressures ease, there will be a need for a rise in demand for raw materials so that prices stay up. But demand levels currently remain under question as the economy slows down.
Before a complete recession hits, however, there is likely to be a period of stagflation, which will not allow commodity prices to drop too low. This period is also likely to see safe haven assets like gold to continue to outperform.
What is your sentiment on SHELa?
Supply side struggle
There have been many commodity supercycles in the past which is characterised as a period of time where prices of raw materials rise sharply.
The most recent supercycle was driven by supply side disruptions as a result of lockdown disruptions.
This supper cycle resulted in high revenues for upstream oil companies, which are involves in oil discovery. These companies could charge downstream firms the higher commodity price without seeing any immediate effect on demand.
Companies such as BP (BP), Chevron (CVX), Devon Energy (DVN) and Occidental (OXY) saw their revenues rise without any impact on demand or input costs. These higher revenues translated into higher dividend payouts for the shareholders.
Mining companies also saw a similar outcome, with five out of twelve of the top dividend payers of 2022 on the FTSE 100 (UK100) are expected to be miners per AJ Bell. Couple of the big names in this sector include Glencore (GLEN) and Royal Dutch Shell (RDS)
Gold Spot price chart
Is there enough demand for commodities?
As supply chains slowly recover, to sustain these commodity valuations there will need to be a demand increase. This might be difficult achieve as the economy begins to slow down.
Capital.com commodities analyst Piero Cingari says that we are now entering a period of economic downturn, and that "recession risks are not negligible”.
He adds that: “The Federal Reserve and other central banks are being forced to aggressively raise interest rates to reduce demand and rebalance the labour market, while consumer and business sentiment continue to be negatively impacted by the rising cost of living and input prices.”
However, Cingari says that this current scenario is not a definite signal for falling commodity prices “because we may experience a stagflation phase, which is characterized by low growth and high inflation, as occurred in the 1970s.”
What this means for stocks?
The immediate effect will likely be that commodity stocks will see their values drop, a trend already occurring in the market at the moment.
Cingari says: “The market is increasingly pricing in the chances of a recession, and shares of oil and mining companies have dropped dramatically in recent days. Both the energy sector (XLE) and the metals and mining industry (XME) have lost 20% from their relative highs hit on June 8.
"However, unless a particularly harsh recession occurs, the possibility of supply disruptions in the energy market, in particular, might establish a floor for oil prices between 90 and 100 dollars per barrel, which could keep the downside for the energy sector relatively contained.”
This is likely going to result in dividend growth slowing, however this will probably only take effect in 2023.
Outlook
In the coming months, Cingari expects safe haven commodities to keep their values
“As we have seen in previous episodes of stagflation, gold has shown to be a safe haven asset that may safeguard against inflation and economic uncertainty.”
He adds: “Copper, on the other hand, could be hurt by a slowdown in industrial activity this year. The ratio of copper to gold started to drop and it has historically corresponded to a slowdown of the economic cycle; it’s possible that we are currently in this phase”
Markets in this article
