As a real-time barometer of economic cycles and global inflation, commodity prices are a crucial component of our inflationary outlook. However, given the crosscurrents of a fading inflationary surge amidst intensifying geopolitical conflicts and growing ESG-related factors, the relationship between commodity prices and inflation has evolved beyond a simplistic, positive correlation. Therefore, the following explores recent developments in commodity prices through the lens of five themes, which we'll subsequently use to assess the current sensitivity of inflation to commodity prices in a follow-up post.
Starting with the pandemic slump in early 2020, the movement in commodity prices was generally synchronous in the four years that followed. For example, they initially firmed during the post-pandemic correction and Russia's invasion of Ukraine in early 2022 before moderating as global supply-chains normalized (Figure 1).
However, that synchronicity began dissipating through the first half of this year. While energy prices settled into a range before weakening from late July, metals moved considerably higher, and agricultural commodity prices eased.
The asynchronicity of commodity prices in 2024
Source: Bloomberg and PGIM Fixed Income as of September 2024.
Although each market has its own story, we believe this divergence signals a shift toward an environment in which prices are influenced more by their respective market dynamics instead of uniformly reacting to global events. For example, while the geopolitical environment has impacted all commodities this year, its effect has been varied across the complex. While regional tensions are a factor driving energy's current range—a point we discuss further below—they are also a prevailing influence pushing metals' prices higher due to their impact on trade relationships and flows (also discussed below). Overall, the shift in price synchronicity could act as a headwind to inflation volatility over the short term, as price movements within the complex offset each other, at least to some degree.
Taking the asynchronous movement in prices a step further, we've found that the factors contributing to price movements have also become more disperse. For example, Figure 2 shows that the weight of a single component behind commodity price movement has continued to decline, following the trend that surfaced after the Global Financial Crisis and became more pronounced since Russia's invasion of Ukraine.
The influence of a single factor on commodity prices continues to fall
Source: Macrobond as of September 18, 2024.
Note: First principal component of daily price changes over the last month of the following commodities: oil, natural gas, gasoline, aluminum, copper, nickel, zinc, gold, silver, platinum, corn, wheat, soybeans, and coffee.
Here again, instead of being driven by a dominant global disruption, commodity prices are more reflective of their respective market fundamentals. Indeed, the sharp push higher in base and precious metals is largely driven by shifting demand patterns, while the tighter range in energy prices reflects sufficient capacity relative to demand. The improved balance across a larger set of factors should be another aspect that mitigates the possibility of a sudden and potentially prolonged increase in commodity prices that ultimately feeds into inflation volatility.
Although metals prices are no stranger to dramatic swings commensurate with shifting supply and demand dynamics, we believe that structural changes currently underway will raise their floor and ceiling for future cycles. We've identified three main factors that impact metals markets broadly. First, elevated geopolitical tensions are causing significant changes in trading partners and the directionality of flows. Price shocks aside, we've noted an uptick in friendshoring and nearshoring, as metals consumers focus less on lowest price and more on supply source diversification and stability. Second, domestic and regional political dynamics have become more extreme, with political parties on the far left and the far right exerting more influence. This has led to greater difficulties for mine approvals, tighter regulations, and more tariffs, putting upward pressure on production costs and, ultimately, prices.
Setting political uncertainty aside, the third factor is rooted in ESG-related variables, which can drive prices higher from a supply and demand perspective. In supply terms, environmental and social influences are applying upward pressure on prices via longer permitting processes and greater oversight of procedures, adding to extraction and production costs. However, on the demand side, certain metals are poised for robust growth as part of decarbonization efforts. For example, copper prices are set to continue their gains as the metal is a key component in electric cars, among various other technologies. Inversely, palladium is one of the main losers in the race to increased electric vehicle creations as its use in internal combustion engines is expected to fall sharply over the coming years.
ESG can drive price growth via upward supply and demand pressure
Source: PGIM Fixed Income. For illustrative purposes only.
Taken together, we believe that the incentive price to produce most metals has increased, and that increase will be passed on to buyers going forward. In future cycles, we also believe that the ceiling prices of metals may reach new heights.
After a tumultuous four years, gasoline prices appear to have settled into an elevated range that is nonetheless below the historical highs reached in 2022. At 3.5% of the consumer price index (CPI), gasoline's influence on inflation might not seem overly significant. Yet, beyond comprising half of energy's 7% CPI component, it also plays a key role in consumer sentiment. While other core components of CPI are less volatile on a short-term basis—such as housing and food costs—even small moves in gas prices can be "felt" daily. When gas spiked in 2022, consumer sentiment plunged as prices paid at the pump seemingly reinforced the full magnitude of consumer inflation.
Following the decades-high peak in 2022 retail fuel costs have settled into an elevated range
Source: U.S. Energy Information Administration, as of July 8, 2024.
Although we're highlighting a well-known inflation indicator, the background of how retail fuel arrived at its current range provides key context going forward. With the cost of crude oil accounting for about half of the price of retail gasoline, the disruptions from the Russian-Ukraine conflict were obvious drivers of the price rally. But an equally prevalent, yet lesser-known, factor was the plunge in U.S. refining capacity by more than a million barrels-per-day due to the idling of several U.S. refineries during the height of COVID in 2020. While refining capacity has recently increased with the addition of a massive new refinery in Nigeria, it has not fully recovered to its pre-COVID levels.
While improved refining capacity is a key component to gasoline's current price range, two other influential variables remain at play. First, with more than four million barrels-per-day in spare oil production capacity at OPEC+ and increasing production from the U.S., Guyana, Brazil, & Canada, oil markets are very well supplied. However, the second variable is that potential geopolitical risks, including the current conflict in the Middle East escalating into strikes on oil infrastructure or further crackdowns on oil sales from the region, nonetheless provide upward pressure on crude oil prices.
Meanwhile, as U.S. crude oil demand has been steady and solid, Chinese demand growth appears to have decelerated considerably. Furthermore, we view OPEC+'s decision to delay scheduled production increases as an acknowledgment of tepid global demand. Indeed, we believe the near-term outlook for crude oil prices, and therefore gasoline, is lower.
After years of stagnation, demand for electricity in the U.S. is poised for a sustained and meaningful increase as the world adjusts to the artificial intelligence "revolution." Although the demand increase is expected to occur gradually at about 2% to 3% each year for the foreseeable future, this change in electricity demand patterns carries direct implications for inflation (Figure 4).
The AI revolution is expected to reignite electricity demand
Source: U.S. Energy Information Administration annual energy outlook 2023, as of April 2023.
After retail fuel's 3.5% of CPI, consumer utilities—i.e. electricity and natural gas expenditures—account for another 3%. Although some of that electricity demand could be satisfied by renewable sources, natural gas will likely remain the primary source. Current demand levels for natural gas are around five billion cubic feet (BCF) per day, but by some estimates demand could reach 20 BCF per day to satisfy AI needs. In addition to the direct demand pull on the natural gas commodity itself, infrastructure—e.g. generation capacity, pipelines, and transmission lines—will also have to be constructed at an accelerated rate, a cost for which a significant portion is likely to make its way into utility rate bases and paid for by consumers. While gasoline is the inflation of today, your utility bill—depending on where you live—is going to be the inflation of the future.
With commodity market fundamentals back in the driver's seat and the reduced dominance of a single factor driving prices, we do not believe commodities are signaling an imminent uptick in inflation volatility. Further, with correlations among commodity prices now low, understanding the dynamics of each respective market will be crucial as we seek to assess alpha opportunities in the corporate credit sectors tied directly to each commodity. That said, with ongoing, elevated geopolitical uncertainty, increasing ESG-related risks and opportunities, and structural changes to utilities demand underway, the above themes offer a balanced and real-time perspective on the directionality of inflation over the short and long terms. In doing so, they enable us to draw an updated relationship between changes in commodity prices and inflation—indeed, a relationship that extends beyond the common perception of a positive correlation—which we'll explore in a follow up post.
Source(s) of data (unless otherwise noted): PGIM Fixed Income, as of October 2024.
For Professional Investors only. Past performance is not a guarantee or a reliable indicator of future results and an investment could lose value. All investments involve risk, including the possible loss of capital.
PGIM Fixed Income operates primarily through PGIM, Inc., a registered investment adviser under the U.S. Investment Advisers Act of 1940, as amended, and a Prudential Financial, Inc. (“PFI”) company. Registration as a registered investment adviser does not imply a certain level or skill or training. PGIM Fixed Income is headquartered in Newark, New Jersey and also includes the following businesses globally: (i) the public fixed income unit within PGIM Limited, located in London; (ii) PGIM Netherlands B.V., located in Amsterdam; (iii) PGIM Japan Co., Ltd. (“PGIM Japan”), located in Tokyo; (iv) the public fixed income unit within PGIM (Hong Kong) Ltd. located in Hong Kong; and (v) the public fixed income unit within PGIM (Singapore) Pte. Ltd., located in Singapore (“PGIM Singapore”). PFI of the United States is not affiliated in any manner with Prudential plc, incorporated in the United Kingdom or with Prudential Assurance Company, a subsidiary of M&G plc, incorporated in the United Kingdom. Prudential, PGIM, their respective logos, and the Rock symbol are service marks of PFI and its related entities, registered in many jurisdictions worldwide.
These materials are for informational or educational purposes only. The information is not intended as investment advice and is not a recommendation about managing or investing assets. In providing these materials, PGIM is not acting as your fiduciary. PGIM Fixed Income as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Investors seeking information regarding their particular investment needs should contact their own financial professional.
These materials represent the views and opinions of the author(s) regarding the economic conditions, asset classes, securities, issuers or financial instruments referenced herein. Distribution of this information to any person other than the person to whom it was originally delivered and to such person’s advisers is unauthorized, and any reproduction of these materials, in whole or in part, or the divulgence of any of the contents hereof, without prior consent of PGIM Fixed Income is prohibited. Certain information contained herein has been obtained from sources that PGIM Fixed Income believes to be reliable as of the date presented; however, PGIM Fixed Income cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. PGIM Fixed Income has no obligation to update any or all of such information; nor do we make any express or implied warranties or representations as to the completeness or accuracy.
Any forecasts, estimates and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Forecasts and estimates have certain inherent limitations, and unlike an actual performance record, do not reflect actual trading, liquidity constraints, fee. These materials are not intended as an offer or solicitation with respect to the purchase or sale of any security or other financial instrument or any investment management services and should not be used as the basis for any investment decision. PGIM Fixed Income and its affiliates may make investment decisions that are inconsistent with the recommendations or views expressed herein, including for proprietary accounts of PGIM Fixed Income or its affiliates.
Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government agency or private guarantor, there is no assurance that the guarantor will meet its obligations. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be suitable for all investors. Diversification does not ensure against loss.
In the United Kingdom, information is issued by PGIM Limited with registered office: Grand Buildings, 1-3 Strand, Trafalgar Square, London, WC2N 5HR.PGIM Limited is authorised and regulated by the Financial Conduct Authority (“FCA”) of the United Kingdom (Firm Reference Number 193418). In the European Economic Area (“EEA”), information is issued by PGIM Netherlands B.V., an entity authorised by the Autoriteit Financiële Markten (“AFM”) in the Netherlands and operating on the basis of a European passport. In certain EEA countries, information is, where permitted, presented by PGIM Limited in reliance of provisions, exemptions or licenses available to PGIM Limited including those available under temporary permission arrangements following the exit of the United Kingdom from the European Union. These materials are issued by PGIM Limited and/or PGIM Netherlands B.V. to persons who are professional clients as defined under the rules of the FCA and/or to persons who are professional clients as defined in the relevant local implementation of Directive 2014/65/EU (MiFID II). In Switzerland, information is issued by PGIM Limited, London, through its Representative Office in Zurich with registered office: Kappelergasse 14, CH-8001 Zurich, Switzerland. PGIM Limited, London, Representative Office in Zurich is authorised and regulated by the Swiss Financial Market Supervisory Authority FINMA and these materials are issued to persons who are professional or institutional clients within the meaning of Art.4 para 3 and 4 FinSA in Switzerland. In certain countries in Asia-Pacific, information is presented by PGIM (Singapore) Pte. Ltd., a regulated entity with the Monetary Authority of Singapore under a Capital Markets Services License to conduct fund management and an exempt financial adviser. In Japan, information is presented by PGIM Japan Co. Ltd., registered investment adviser with the Japanese Financial Services Agency. In South Korea, information is presented by PGIM, Inc., which is licensed to provide discretionary investment management services directly to South Korean investors. In Hong Kong, information is provided by PGIM (Hong Kong) Limited, a regulated entity with the Securities & Futures Commission in Hong Kong to professional investors as defined in Section 1 of Part 1 of Schedule 1 of the Securities and Futures Ordinance (Cap.571). In Australia, this information is presented by PGIM (Australia) Pty Ltd (“PGIM Australia”) for the general information of its “wholesale” customers (as defined in the Corporations Act 2001). PGIM Australia is a representative of PGIM Limited, which is exempt from the requirement to hold an Australian Financial Services License under the Australian Corporations Act 2001 in respect of financial services. PGIM Limited is exempt by virtue of its regulation by the FCA (Reg: 193418) under the laws of the United Kingdom and the application of ASIC Class Order 03/1099. The laws of the United Kingdom differ from Australian laws. In Canada, pursuant to the international adviser registration exemption in National Instrument 31-103, PGIM, Inc. is informing you that: (1) PGIM, Inc. is not registered in Canada and is advising you in reliance upon an exemption from the adviser registration requirement under National Instrument 31-103; (2) PGIM, Inc.’s jurisdiction of residence is New Jersey, U.S.A.; (3) there may be difficulty enforcing legal rights against PGIM, Inc. because it is resident outside of Canada and all or substantially all of its assets may be situated outside of Canada; and (4) the name and address of the agent for service of process of PGIM, Inc. in the applicable Provinces of Canada are as follows: in Québec: Borden Ladner Gervais LLP, 1000 de La Gauchetière Street West, Suite 900 Montréal, QC H3B 5H4; in British Columbia: Borden Ladner Gervais LLP, 1200 Waterfront Centre, 200 Burrard Street, Vancouver, BC V7X 1T2; in Ontario: Borden Ladner Gervais LLP, 22 Adelaide Street West, Suite 3400, Toronto, ON M5H 4E3; in Nova Scotia: Cox & Palmer, Q.C., 1100 Purdy’s Wharf Tower One, 1959 Upper Water Street, P.O. Box 2380 -Stn Central RPO, Halifax, NS B3J 3E5; in Alberta: Borden Ladner Gervais LLP, 530 Third Avenue S.W., Calgary, AB T2P R3.
© 2024 PFI and its related entities.
2024-4075
Collapse Section