The remarkable lack of price disruption this year has not been evident in all markets – oil and commodities have been the notable exceptions.
Price disruption in commodity markets is often created by a temporary imbalance between supply and demand. While Chinese stimulus measures adopted in 2016 to support growth boosted demand for oil and other commodities, the picture has rapidly changed this year.
China’s central bank has shifted toward monetary tightening and there has been further deleveraging of the financial system. The combination of these factors has led to a significant decline in commodity imports, such as iron ore and copper.
At the same time, the deal struck by the Opec last November to cut oil production – and extended this morning – has been challenged by increased US supply. US oil inventories are near all-time highs as shale producers there have responded to rising prices by increasing production.
They have become a larger contributor to global oil supply and can now operate profitably at lower price levels given increased efficiency. This puts further pressure on Opec.
All of this means the path for oil prices is far from certain and there could be further bouts of volatility ahead.
The vulnerable currency markets
The Russian rouble is most at risk. Russia is a large oil exporter, and the current valuation of the rouble is not reflecting the recent oil price correction.
It is not just about emerging market currencies, though. The combination of lower commodity prices and a potential Chinese slowdown means that currencies such as the Canadian and Australian dollars are also vulnerable given their dependence on commodity exports.
While this may already be reflected to a large extent in the valuations of these currencies, both of which have depreciated since the end of March, further bouts of weakness are possible in the current climate.
Credit markets are not immune to a potential downside trend in commodity prices either. Energy is one of the largest sector weightings in the US high yield market, comprising almost 15 per cent of a typical index. This exposure makes it more vulnerable to moves in oil prices. Shorting the US high yield market as a hedge against further oil price disruption may therefore be an option, particularly as spreads are currently trading at expensive levels.
But what happens if the supply/demand imbalance sorts itself out quicker than expected? US treasury inflation-protected securities (TIPS) market could be a potential beneficiary should prices stabilise. TIPS valuations have suffered lately from weak consumer price index prints, and breakevens are trading at the low end of recent ranges. A stabilisation in commodity prices – in particular, if the price of oil stays above US$40 per barrel – could benefit TIPS.
Ju Yen Tan is global fixed income portfolio manager at T. Rowe Price