The second leg of the commodity rally, after the vaccine announcement, saw prices soar +30%, heterogeneously though. Cyclical commodities outperformed precious metals and agricultural. Furthermore, dispersion within each commodity group has been elevated while pairwise correlations were low. There has been clear differentiation across commodities function of the pulse in their supply, their end-use drivers, as well as from market flow dynamics.
Since June, however, the asset class has been running through turbulences. In addition to profit taking, weakness in commodity prices has reflected investors' doubts about the 'reflation trade'. Doubts started with evidence of a plateauing Chinese economy. Leading on the way out of the pandemic, the largest world importer of commodities is now losing some traction. Targeted Chinese authorities tightening, seeking to ease structural imbalances, also contributed to moderate the activity. Second, unsettled supply chains and chip shortage slowed several industries, especially auto manufacturing heavily using commodities. Third, declining visibility on U.S. spending plans, scaled down over the political process, hit commodities most exposed to infrastructure. Fourth, the more hawkish June FOMC, which acknowledged strong U.S. growth and sustained inflation in the short-term, led markets to reprice an earlier tapering than planned, denting in the appetite for risk assets. Meanwhile, the Fed and investors conviction that inflation would normalize in the longer run, eroded demand for inflation hedges. Also, the dollar jump after the FOMC hit assets denominated in dollar. Finally, Chinese efforts to stem commodity prices, that are eroding corporate margins and consumers' purchasing power, also weakened the asset class.
In our view these turbulences are temporary. They might moderate the commodity rally but could also prolong it. Metal strategic stocks that China plans to release would need to be rebuilt later. Also, structural commodity drivers are not China centric. They include decarbonation, the rise of electric vehicles, infrastructure spending, and a housing boom, which would particularly benefit base metals. Moreover, demand elasticity to prices would play out more favorably. Besides, the uncertain inflation path, with a big wildcard from fiscal spending in the U.S., would still require inflation hedging.
Hedge funds have unevenly reassessed the 'reflation trade'. CTAs, most strongly hit by weakening commodity prices, have little changed their overall commodity exposures, but are reweighting energy futures. Global Macro managers have neutralized their commodity exposures and favor equity indices to express their cyclical bias. U.S. and European L/S equity managers have also neutralized their commodities-sensitive stocks in June. They are now buying cheaper base material stocks on dips at the expense of industrials. Their allocation to commodities remains moderate though, all the more so they are cutting their overall net exposures and reweighting defensive and growth stocks. U.S. L/S HY credit managers broadly left their commodity exposures unchanged, with a greater focus on energy.
Overall, hedge funds do not seem to be giving up on the 'reflation trade' but are cutting exposures ahead of the summer, while preparing for more delicate trading conditions in Q3.