DBC: Nobody Wants Commodities, Time To Buy Commodities – Invesco DB Commodity Index Tracking ETF (NYSEARCA:DBC) No ratings yet.

(Source – Pexels)

It is safe to say that commodities as a whole have been in an economic depression since around 2011. Despite a more than doubling of the global money supply, inflation has continued to fall and excess capacity has created a general glut. A “General Glut” occurs when there is, structurally, too much supply and too little demand in an economy.

In my opinion, this had been one of the primary drivers of falling inflation over the past 35 years. Globalization caused U.S. workers to compete with far cheaper counterparts in developing nations, causing a huge increase in the supply of most goods due to falling production costs. On top of that, efficiency improvements from technological innovation have added an additional layer of rising supply while rising household debt has constrained demand.

However, these factors are beginning to change and potentially huge rewards may come to those who are willing to adjust their portfolios accordingly. Chiefly, this means lowering exposure to bonds and raising exposure to commodities. With wages finally rising above interest rates, a positive inflationary feedback loop has been set up. Even more, retiring baby boomers will sell bonds at an increasing rate while young people’s demand for goods will rise supported by higher wages. This will likely support commodities and harm bonds.

In my opinion, the easiest way to allocate to commodities is through the highly liquid Invesco DB Commodity Index Tracking ETF (DBC).

The Invesco DB Commodity Index Fund

Specifically, DBC invests in the top 14 most heavily traded commodity futures contracts. This means the fund has ample exposure to energy, agriculture, precious metals, and base metals so it is highly diversified to represent the commodity complex as a whole. Because the fund is based on futures, it has a large money market position that gives the fund a net yield of around 1.25% after expenses.

Because the fund is the most popular total commodity basket ETF, it is very liquid with a total AUM of nearly $1.4B. Let’s see how that figure has ranged over time to see what our fellow investors are up to:

ChartData by YCharts

As you can see, the fund’s total AUM is at the lowest value in around twelve years. This is an excellent sign because it implies there are few other speculators in the market that could be causing commodity prices to be above their fundamental value. It also is a sign that investors have largely capitulated and are too bearish on commodities.

As the famous commodity investor Jim Rogers once said:

If everyone thinks one way, it is likely to be wrong. If you can figure out that it is wrong, you are likely to make a lot of money.

Before we dig into my macro view of why exactly I believe (nearly) everyone is wrong, let me first list the specific holdings of the fund.

Weight Commodity ETF (if available)
12% Gasoline (UGA)
11.60% Heating Oil
11.10% Light Sweet Crude (USO)
11% Brent Crude (BNO)
5.33% Natural gas (UNG)
6.10% Corn (CORN)
5.44% Wheat (WEAT)
5.42% Sugar (CANE)
6.20% Soybeans (SOYB)
10.60% Gold (GLD)
2.62% Silver (SLV)
4.36% Zinc
3.88% Aluminum (JJU)
4.25% Copper (CPER)

(Invesco)

As you can see, it is heavily weighted toward energy commodities which gives it some extra cyclical exposure. Perhaps even more important, here is the global asset exposure of the fund:

Note, these coefficients are found using least squares.

(Data Source – Google Finance)

As you can see, DBC has a positive correlation with stocks and a negative correlation with everything else. The negative correlation with treasury bonds and the U.S. dollar is a sign that the DBC’s primary driver is inflation and the secondary driver is economic growth (as seen in S&P 500 correlation). Importantly, the fund has pretty low exposure in general and is highly idiosyncratic which is a good sign for those looking for diversification.

The Case Against the General Glut

As inflation has consistently failed to materialize for many decades despite falling rates, it has become very unpopular to bet on higher inflation. Now that almost nobody is making such a bet, it is perhaps the most opportune time to do so. Indeed, there are many signals that point to an imminent rise.

Following the strong employment report on Friday, we can see that wage inflation for non-supervisory workers continues to march far above CPI and interest rates:

(Federal Reserve)

If wage growth is above CPI, then consumers’ real ability to consume is expected to rise which generally serves to boost demand greater than supply and, over time, cause inflation to rise.

Even more, wage growth has been below interest rates which means that, up until relatively recently, most workers borrowed against future purchasing power. Now, most can take out a mortgage at a lower rate than their expected income growth, meaning that they can increase future consumption despite borrowing. This has the same impact as wage growth is higher than CPI.

Together, this creates a Goldilocks environment that is extremely inflationary. If you’re curious, average mortgage rates were above wage growth from the mid-70s until just a few months ago. Now that wage growth is above mortgages, an inflationary paradigm shift is building.

While these demand factors are rising, the U.S. is also at maximum production for oil and gas (which dominates DBC):

(Federal Reserve)

While the U.S. is producing as much oil as possible, supply constraints are factoring into the rest of the world. Around three weeks ago, a small group of terrorists was able to knock down half of Saudi Arabia’s oil production for some time. While the crude market has since fallen back to its price before the attack, it seems the market is far too complacent when it comes to clearly growing tension in the Middle East.

Every month once Persian gulf tensions seem to have died down, another boat is taken or an attack occurs that lets us know it is far from gone. In my opinion, it seems that Iran wants to repeat its 1970 experiment of taking the world hostage via crude oil. While they don’t get to legally export much crude anymore, in my opinion, they have aided in many actions that could severely distort the market and cause higher prices. While the probability is low, the price of energy commodities could easily double or more if supply is cut in the Persian gulf where nearly a quarter of global oil flows.

Like wages with commodity demand, crude is the primary driver of commodity supply shocks. The price of crude goes up, and the cost of mining or even farming rises.

Take a look at total U.S. petroleum inventories:

ChartData by YCharts

To add even more positive catalysts to crude oil and commodities in general, the total inventories of oil are falling by the month. As this falls, crude prices are likely to become increasingly sensitive to supply and demand shock factors.

The Bottom Line

Overall, it seems clear that the large economic and societal trends that have pushed inflation low and caused consistent underperformance in commodities are shifting. Supply buildups are slowing, the rate of industrial capacity growth is essentially zero, and wages are climbing much faster than prices and interest rates.

Even more, most people are so opposed to commodity investing today due to such a long period of underperformance that there are few longs in the market to cover shorts. This could catalyze a rapid price rise in many commodities.

While DBC is a bit more volatile than most equities and far more volatile than bonds, I find them much less risky than both today. Unlike stocks and bonds, commodities have a natural price floor at the cost of production. Today, most commodities trade at or even below their cost of production so the downside risk in DBC is very low compared to the upside potential. Of course, we still maybe a few months to a year before the rally I expect begins, but I still believe DBC is a great long-term buy.

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Disclosure: I am/we are long USO,DBA,PPLT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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