‘Year of the Dragon’ to breathe fire into commodity markets?

By Nitesh Shah, Head of Commodities and Macroeconomic Research, WisdomTree

Commodities had been under pressure in the past year, but we believe there are several reasons to be cautiously optimistic about the asset class in 2024 – the Chinese ‘Year of the Dragon’.

The key drivers of negative commodity performance in the past year were:

• Rising interest rates in many developed countries
• China’s economy stalling under the pressure of a real estate blow up
• Sentiment around the energy transition losing momentum

We believe all three will reverse course this year.

Interest rates to fall

Consensus strongly believes that we will see interest rate cuts this year. While we thought that markets were getting a little ahead themselves in terms of the timing and scale of the cuts at the beginning of the year, markets have recalibrated their views and are pricing in the first cuts for Federal Reserve and European Central Bank around the middle of the year.

We believe that rate cuts will be positive for most cyclical asset classes, including commodities. Our observation is that lower real interest rates are price positive for commodities (Figure 1). The line of best fit indicates that the 1% decline in real rates would be consistent with a 6% increase in broad commodity prices.

Figure 1. Commodities and real rates

Chinese ‘Year of the Dragon’ may breathe fire back into commodity markets

Noting China’s disappointment in 2023, will the country step up a gear in 2024? China will announce its economic growth targets in March 2024. In its December 2023 Central Economic Work Conference, a mixed message of “pursue progress while ensuring stability, consolidate stability through progress and establish the new before abolishing the old” was given. It’s hard to decipher a call to bold action from this.

China’s property slump has simply gone on too long for policy makers to continue with the 2023 piecemeal stimulus approach. Sentiment has already been damaged severely and the market needs support. In response to the broader sentiment slump, Chinese authorities have been relying on the so-called ‘national team’ – a group of state-run funds to buy equities in February 2024. That has certainly led to an upswing in equity markets since markets reopened after the Chinese New Year celebrations. To strike at the heart of the problem, policy makers could focus on the real estate sector itself.

Policymakers have turned to ‘three major projects’: affordable housing, urban village renovation and emergency public facilities. A boost to funding for the People’s Bank of China (PBoC)’s Pledged Supplemental Lending (PSL) program seems to indicate spending on these projects will rise (Figure 2). Support via this channel does not involve a broad-based rate cut.

Figure 2. PBoC’s pledges supplimental lending

The PBoC additionally cut key mortgage interest rates by the most since 2019 in February 2024. Reluctance to cut interest rates in a broader fashion stems from fears of currency depreciation. But as other countries cut their interest rates (see section above), then China will feel less restraint.

We should also note that China’s demand for commodities has not been dented severely. Commodity price weakness seems to stem from perception that a weak economy will drive commodity demand lower.
For example, we believe that China had been increasing its grid spending during a period of relatively low copper prices, as it aims to opportunistically accelerate its transition to a lower carbon economy. Copper is essential for renewable technologies and the grid infrastructure improvements needed to accommodate an increasing number of electric vehicles on the road.

Xin san yang

Apparently, a new buzz word is circulating among Chinese officials and state media – Xin san yang – the “new three”, referring to solar cells, lithium-ion batteries and electric vehicles (EVs). China is a leader in the production and exports of these goods. While the “old three” – household appliances, furniture, and clothing – had a negative contribution to export growth in 2023, the new three were positive.

Solar cells, lithium-ion batteries and electric vehicles are metal-intensive industries and a widening international market for them could go some way to replace the slowing metal demand from the domestic real estate sector. Moreover, while property is more steel/iron ore intensive, the new three are more base metal intensive.

Energy transition

Our long-term outlook for commodities is conditioned on an energy transition taking place: the migration away from fossil fuels and greater reliance on renewables in an effort to reduce green-house gases.

After strong momentum behind the energy transition in 2021 and 2022, investor interest began to fray in 2023. 2022 marked a high-water mark given the sheer scale of the US Inflation Reduction Act (IRA) that was signed into law (despite its name, the act was a piece of legislation designed to spur investment in green technology). However, in 2023 the European Union adopted its Fit for 55 legislation (aimed to reduce greenhouse gas emissions by 55% by 2030 relative to 1990 levels). It is also on the cusp of signing Critical Raw Materials Act (CRMA) into law. The CRMA is similar to the US IRA – providing tax credits to those on-shoring the supply chain of electric vehicles, wind turbines and other green goods (but on a smaller scale).

The COP28 in December 2023 concluded with a roadmap for “transitioning away from fossil fuels” – a first for a UN climate conference. That could potentially galvanise the energy transition once again.

Although the extended discussions failed to agree on a “phase out”, the avoidance of stalemate allows planning and resources to be devoted to the “phase down” strategy. At the COP28 more than 130 national governments, including the European Union, agreed to work together to triple the world’s installed renewable energy capacity to at least 11 000 GW by 2030. That would be in line with the International Energy Agency’s Net Zero Emissions by 2050 scenario (if coupled with the doubling of the annual rate of energy efficiency improvements every year to 2030), see Figure 3.

Figure 3. A trippling of capacity will put the world on track for a net zero scenario

Conclusions

After a challenging 2023, commodities appear poised for a breakout as rate cuts come to the fore. The late December 2023 rally provides a glimpse of what could happen when the cuts are delivered.

While the largest consumer of commodities – China – remains in a tough spot in terms of its economy, we recognise that its demand for commodities remains resilient as it modifies it ‘business model’. That may mean that some commodities will do better than others though. We believe China will continue to stimulate and its ability to do so may improve as other countries around the world loosen monetary policy (as the country is worried about currency depreciation).

While investor attention to the energy transition could be fading, policy makers are intensifying their resolve. Breakthrough agreements at COP28 are a case in point. Our long-term outlook for commodities is conditioned on the energy transition and we believe that the potential for medium-long term supply deficits in metals will generate a commodity Supercycle.

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