Gold versus the Rest

It has been a grim year for many commodities, writes Patrick Farrell

 
A confluence of weakening economic growth, particularly from China, plus an adjustment after some post-pandemic exuberance, has seen the prices for energy, industrial metals and ‘energy transition’ commodities such as copper and nickel drop. Gold, in contrast, has reached new highs as geopolitical tensions have increased. This situation may be about to reverse.

Energy markets are generally below their level of a year ago, as the world has adjusted to the supply disruption created by the war in Ukraine. Russia has surprised markets with its ability to keep output relatively high. Record production for oil and natural gas in the US has also helped keep supply ticking over (and prices lower) for much of the past 12 months.

Against this backdrop, natural gas prices are down almost 40% year-on-year, while coal prices are down around 35%. Oil prices are largely flat, despite some fears of a spike in the Autumn of 2023. There has also been weakness in other commodities prices. A number of the ‘energy transition’ materials have had a tough readjustment after a spike in prices during the pandemic. Steel prices have dropped 30%, while nickel and copper have also been weak.
 

Gold as a safe haven

 
The notable exception to this general pattern of weakness has been gold. The gold price is up 11.5% year-on-year as concerns over mounting geopolitical tensions and the rising US budget deficit have created demand for a safe haven (away from the Dollar). It has also been influenced by the stabilisation of interest rates and inflation, as higher real yields tend to hurt the gold price.

The gold price is now at its highest level in 25 years and has shown some signs of weakness since the start of December. While geopolitical tensions remain high, the pressure points are well-understood and are likely to be factored into the gold price already. At the same time, gold prices tend to be inversely correlated with real (inflation-adjusted) yields. While inflation has been falling and interest rates not moving, real yields have been moving higher. They have started to drop a little since the start of November, but remain near their highest point since August 2020. This is a tough hurdle for gold to overcome and it looks vulnerable from here.
 

Loosening financial conditions

 
It seems inevitable that financial conditions will loosen in the year ahead, even if the timing and extent of a shift in central bank policy is still unclear. There are likely to be stimulus measures from China at some point, as its government seeks to address weakening growth. In the meantime, US policymakers seem disinclined to rein in spending and growth continues to outpace expectations. This is an environment that should favour more economically-sensitive parts of the commodity complex.

There are other factors at work. Supply is impaired. There have been problems in the Suez Canal as Houthi rebels seek to disrupt global trade. This is influencing freight rates and may weaken supply mechanisms. There are also supply problems created by climate change, with changing rainfall patterns proving disruptive. Geopolitical tensions are prompting greater protectionism around critical commodities, which is also likely to drive up prices.

Bringing new supply on stream is not easy. Environmental restrictions are making it much harder to secure approval for new mines. There is a significant upfront cost to the mining companies even before the mine takes off. Stricter bribery and corruption rules are also making it tougher for companies to develop new mining sites: companies cannot risk hard-won ESG scores by becoming involved in under-the-counter deals. In the meantime, existing mines are ageing, and it is becoming more difficult to extract materials from them. At a time when demand is growing, particularly for those commodities needed for the energy transition, this is likely to push prices higher.

The opportunities within commodities may lie in some of the areas that have struggled most over the past year. Energy transition materials, such as copper and nickel, for example, have dropped to more normal levels. A lot of mining companies have cut their exposure to nickel, which is likely to create a supply problem further down the line. It is in this type of area that there may be the strongest opportunities.

With any commodity exposure, there is a question on how to take exposure: invest in the commodity directly, or in the companies that are mining it? Our view is that while many mining companies appear to be in good shape, with sound balance sheets, strong cash flow and low capital expenditure commitments, commodity prices may rise before companies see the benefit.

This is a slow process that is likely to evolve over the next 12 months or more. Energy transition technology is changing all the time, which can affect demand patterns, and the pathway for global economic growth is not yet clear. Nevertheless, after a tough year, there may be better times ahead for key parts of the commodities complex.
 
Patrick Farrell is Chief Investment Officer at Charles Stanley