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Can commodities recover? Four factors to watch

The renewed decline in commodity prices since the end of June has pushed broad commodity indices to mid-2009 levels on a spot-price basis and to 2002 levels in terms of total returns. Most commodity prices should prove a challenge to high-cost producers. While this suggests to us that commodity prices have room to recover in the long run as supply consolidates, risks in the second half of this year are high.

For investors looking for a turning point, we suggest watching four factors over the next three to six months: Crude oil supply, Chinese growth, the trajectory for Fed rates, and supply prospects for grains.

An oil trader works on the floor of the New York Mercantile Exchange.
Getty Images
An oil trader works on the floor of the New York Mercantile Exchange.

The crude-oil market has yet to rebalance after ending the first half of this year with a 2 million barrel per day surplus. Cuts in capital expenditure and drilling activity and ongoing strong demand should rebalance the oil market over the next six to 12 months. However, the second half of this year is likely to remain bumpy. The market has yet to buy into the story that U.S. production is peaking, and that rebalancing will not experience significant delays due to potential incremental supply from Iran. Over the next two to three months, our view that U.S. crude-oil production is peaking should become visible in the data. Moreover, we should get more clarity on the potential Iranian supply prospects.

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In China, leading economic indicators give little confidence that GDP growth will stabilize at 6.5 percent to 7 percent in the quarters ahead. Activity in the Chinese property sector, as expressed by the floor space of buildings under construction, is still decelerating at a steady pace. As a result, we have cut our growth estimates for Chinese base-metal demand by up to 30 percent. An excessive build-up in corporate debt is one of the factors behind the broader slowdown, and without material additional fiscal stimulus and monetary-policy support, further disappointment is likely. This could keep base-metal prices at depressed levels.

In the U.S., market expectations for higher U.S. interest rates remain modest, pricing in a Federal Reserve interest-rate hike in December and rates of about 1 percent at the end of 2016. This leaves room for expectations to shift higher as our base case calls for a first rate hike in September. Once the market re-prices more Fed activity, precious metals should come under renewed downward pressure, with financial investors trimming their gold positions. Unfortunately, Asian interest in the metal remains soft, with material losses since 2013 and the People's Bank of China buying less gold than initially expected. An even larger drop in the gold price might be required to prompt physical buying.

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Lastly, investors should watch favorable supply prospects in the grains industry. Easing weather concerns have shifted the focus back to a solid North American harvest outlook. Drier and warmer weather in the Midwest has helped crop ratings for corn and spring wheat to recover. Ratings for soybeans have stabilized. With almost 75 percent of the crop having pollinated under favorable conditions, supply in corn should be ample. Soybeans have room to catch up with corn once the market realizes that global year-end inventories for 2015 should increase by more than 10 percent to 92 million tons. Wheat is also likely to see excess supply of 11 million tons, which should cushion moderate production losses due to a likely El Niño this year.

With the exception of China, the second half of the year should bring clarity to three of our four key drivers. First, the peak in U.S. crude-oil production should become visible in the coming months. Second, the Fed is highly likely to hike rates this year – in December if not in September. And third, we will know the quantity of grain inventory more precisely at the end of the year. With that information becoming clearer, we expect commodity prices to find a trough in the second half of this year.

However, the potential for commodity-price increases in 2016 should be seen as a one-off process rather than the beginning of a longer bull cycle. First, the sharp run-up in China's and Asia's private debt still casts an overly large shadow. Second, urbanization is expected to fall for the first time in decades. Although investors will continue to find tactical opportunities in commodity markets, they should not yet count on a permanent broad-based recovery.

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Commentary by Dominic Schnider, head of commodities at UBS Wealth Management, which oversees $1 trillion in invested assets. Follow UBS on Twitter @UBS.