How commodity prices can impact markets and inflation

Source: U.S. Bank Asset Management Group, January 2023

Inflation, which first emerged as a major concern in 2021, has moderated in recent months, due in part to commodity price pullbacks. Food and energy sectors are key contributors to the Consumer Price Index (CPI), recognized as a primary measure of inflation. Food and energy tend to be subject to more volatility than other components of CPI. This is because of their reliance on worldwide commodity market trends. Commodity prices played a major role in inflation surge that began in 2021, and also contributed to a pullback from peak inflation levels since mid-2022.

Commodities comprise a range of raw materials such as:

• Energy products including crude oil and natural gas
• Metals such as gold, silver, copper and platinum
• Agricultural products including wheat, corn, sugar and coffee

Commodities represent close to 40% of the Consumer Price Index (CPI) calculated by the U.S. Bureau of Labor Statistics. More specifically, energy represents about 7.5% of the index and food close to 14%. ¹ Commodity prices can add significant volatility to headline CPI numbers. At the same time, expenses like groceries, gas to fuel motor vehicles and home heating and cooling are essential costs facing consumers. Justifiably, commodity prices garner significant attention.

While commodity price increases were significant over the course of 2021 and 2022, prices began to moderate in the second half of last year. The latest reading, as reported in CPI data releases, shows that over the past year (ending in May), commodity prices were relatively flat (up 0.6% for the 12-month period). ²

What is the likely direction of commodity prices going forward, and how should you position your portfolio to reflect these trends?

A sizable drop in oil prices

Commodity price trends dating back to 2020 provide a prime example of the volatility that can impact this segment of the economy. For example, crude oil prices closed at $10.17/barrel in April 2020, just as the global economy was in the midst of a virtual shutdown in the early days of the COVID-19 pandemic. That unsustainably low-price level reflected fears of far-reaching economic fallout arising from the pandemic and activity restrictions. However, emergency monetary and fiscal stimulus measures and gradual reopening resulted in an economic rebound. Oil demand steadily rose while supplies remained relatively stagnant. In early June 2022, the price of a barrel of crude oil topped $120. That lofty price level did not hold. Since late 2022, the price of oil mostly traded in a range of $70 to $80/barrel.³

“Trends in oil prices reflect supply and demand expectations for the global economy,” says Tom Hainlin, national investment strategist at U.S. Bank. “The sudden decline later in 2022 demonstrated that many traders, who drive prices on the futures market for commodities, anticipated an economic slowdown in the coming months.”

Oil prices remain near the $70/barrel mark, and at times have even slipped below that level. According to Rob Haworth, senior investment strategy director at U.S. Bank, some adjustments may occur going forward. “The U.S. government has been tapping its Strategic Petroleum Reserve to boost domestic oil supplies. Now the plan is to start restocking the Reserve, which will add to demand.” At the same time, notes Haworth, production cuts may occur. “Saudi Arabia is starting to cut back its output in an effort to push prices higher.” The question going forward, according to Haworth, is whether forecasters who predict a slowdown in the U.S. economy are correct. “If the economy slows, energy demand could fall further, but if the economy picks up, demand could as well, which could push oil prices higher,” says Haworth.

Energy demand is likely to hold up over the long term, even with the increased focus on reducing carbon emissions to combat climate change. At the same time, supplies may not change dramatically compared to where they stand today. “OPEC and others did not put much new investment into infrastructure that could boost production,” says Haworth. “Five-year rolling inventory levels are low, so if demand for oil picks up, prices are likely to rise as well.”

Hainlin agrees that the current environment differs from what has been a usual trend in the energy industry. “Normally, when prices go up like we saw after the start of the Russia-Ukraine war, producers expand capacity. Then they reach a point of overcapacity and prices drop,” says Hainlin. “This typically leads to a boom-and-bust cycle. But instead, oil producers demonstrated significant capital discipline.” That may keep production levels down, which could support elevated oil prices over time.

Other commodity prices rise

While oil prices dropped in the first half of 2023, other commodities, such as agricultural products and metals gained in price. ‘There are some unknowns in the global agricultural market” says Haworth. The impact of the ongoing Russia-Ukraine war is one, as both countries are major agricultural providers. The weather is always a variable factor that can affect agricultural prices. “To this point, the outlook for agricultural output is generally favorable,” says Haworth.

Metals prices can be considered in two categories – precious metals such as gold and silver, and industrial metals used in manufacturing, such as nickel and copper for electric vehicle batteries. “Gold prices rose into May, then retreated a bit,” says Haworth. “Gold is often viewed as an inflation hedge, but with inflation scaling back (from a peak of 9.1.% for the 12 months ended June 2022 to 4.0% for the one-year period ending May 2023), interest in owning gold may be waning.”

As for industrial metals, Haworth says supply concerns are an issue, particularly with more robust demand driven by increased production of electric vehicles. “At the same time, the surprising turn toward slower growth in China in recent months may dampen demand for industrial metals,” according to Haworth.

Investor considerations around commodities

Investors may consider including commodities in a portfolio to hedge the impact of higher inflation. Both Hainlin and Haworth say there are limited benefits with commodities investments. “It’s difficult to earn a durable return with direct investments in commodities or commodity futures,” warns Hainlin.

“The primary challenge in doing so is that historically, it’s a very volatile asset class,” says Haworth. “Investing in commodities often requires that you make two good decisions – to buy at the right time and to sell at the right time.”

Yet there are other approaches that can provide portfolio benefits in certain environments. One effective way to capitalize on today’s commodities market is through investments in infrastructure. This includes companies involved in oil pipelines, airports, cell towers, toll roads and other forms of infrastructure. “There is strong demand in many of these areas today,” says Hainlin, “but benefitting from owning these investments doesn’t always require that prices move higher. These investments also generate regular income for investors.” Hainlin says companies in infrastructure-related businesses tend to have fixed costs but realize bigger profits in times when inflation drives prices higher.

Investors should be prepared for frequent changes, both higher and lower, in commodity prices. Talk with your financial professional about opportunities to position your portfolio to capitalize on market trends stemming from the commodities trade.