Goldman Sachs is doubling down on its bullish bet on commodities.
The firm’s commodity strategists reiterated their call in early February, just before the stock market got rocked by concerns about inflation and higher interest rates.
But that’s exactly the kind of environment that would help commodities outperform other asset classes, says Goldman Sachs, along with strategists at other firms.
Their call has been prescient: Commodities are the best-performing asset class in the year to date and have outperformed the stock market by 8%.
“As we have argued since going overweight in 2016, the strategic case for owning commodities has rarely been stronger,” Jeffrey Currie, Goldman’s head of global commodity research, said in a note on Tuesday. “Strong global economic growth that is late-cycle in the developed markets with room to run in the emerging markets supports demand growth that is depleting global supply chains.”
Currie says many investors remain skeptical, scared away by the weak returns from US energy producers over the past decade and concerns that OPEC and Russia are artificially lifting oil prices by limiting supply.
But skeptical investors don’t have only themselves to blame — they could also point to the length of this recovery, which has delayed what has historically been the strongest period for commodity returns, according to Currie.
Returns are typically very weak during the early phases of the cycle — the contraction and recovery — which lasted for a decade from December 2007, he said. That’s because of weak demand paired with excess production.
“Commodities can post very large negative and weak returns during the recession/recovery phase, but massively outperform equities in the expansion/slowdown phase of the business cycle,” Currie said.
It may seem counterintuitive to recommend commodities just as economic growth starts to show signs of slowing. But Currie says that commodity prices are determined by the relationship between supply and demand — so even if demand growth slows, prices can rally if the level of demand remains above that of supply.
Commodities’ prices relative to their futures contracts indicate that this is already the case for many. For example, oil has entered into backwardation, meaning spot prices are higher than prices for futures contracts. Currie counted 13 out of 24 commodities in backwardation.
Currie described this state as a “scarcity premium.”
“Think of oxygen: If it became scarce, we would pay an enormous premium today for it, as we don’t need it tomorrow if we don’t have it today,” he said.
Currie added: “Financial markets cannot possess this characteristic, which is why gold cannot go backwardated since it is not consumed like oxygen, energy, or grains. But it is this scarcity premium that creates the late-cycle diversification benefits of commodities, particularly in relation to inflation.”
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