Equity Analysis /
Global

What the inverted yield curve means for commodity prices

  • The inversion of the yield curve is viewed as a prelude of recessions, although by no means certain

  • Commodity prices may rally in the face of negative yields and trade disruption

  • Branded consumer names could withstand the consumer spike

What the inverted yield curve means for commodity prices
Nirgunan Tiruchelvam
Nirgunan Tiruchelvam

Head of Consumers Equity Research

Tellimer Research
19 August 2019
Published by

In 595 BC, King Croesus of Lydia asked the Delphic Oracle whether he should go to war with Persia. Both Lydia and Persia were powerful kingdoms. The Oracle told Croesus that if he went to war with Persia, a great kingdom would collapse.

Croesus took this to mean that he would prevail against Persia. In fact, Persia decimated Lydia. Sadly, Croesus had tragically misinterpreted the Oracle and ignored that it was his Kingdom that would be the victim.

Today’s equivalent of the Delphic Oracle is the yield curve. The inversion of the yield curve is viewed as a prelude of recessions. Since 1970, every inversion of the yield curve has been followed by a US recession within 12-14 months.


US yield curve inversion and recession

Source: Bloomberg

A recession is by no means certain

The yield on a 10-year treasury note has fallen below the yield on a three-month bill for the first time since the global financial crisis. However, the inversion does not extend to the 30-year treasury note. 

The curve is effectively a V curve. The V curve provides some solace for those who want to avoid a recession. The inversion that the doomsayers are citing today is unlike the other instances. 

Commodity prices may rally in the face of negative yields and trade disruption

The last three instances (1998, 2001 and 2007) of the US 10-year yield falling below the US 3-month yield have been the prelude to a 2-year commodity rally. In the two years that followed the inversions of the yield curve in September 2000 and July 2006, the Bloomberg Commodity Index rose 11%.  


US Treasury yield 3-month/10-year versus Bloomberg Commodity Index
Source: Tellimer

The rally has included both industrial and agricultural commodities. Commodity prices could be due for a rally for three reasons:

First, the negative real yields for shorter-dated bonds has reduced the carrying cost of commodity. Commodity Traders are facing the lowest cost of capital since the GFC. 

Second, commodity players have drastically cut their capital expenditure since the rout of 2014. There has been a 43% drop in the Bloomberg Commodity Index since the 2014 high.

Third, the trade war has completely disrupted the commodity market, particularly soft commodities. The US is the mainstay of the world grain market such as soybean, corn and wheat. China has imposed punitive tariffs on soybean and corn. Corn prices have fallen below their cost of production.  

An early resolution in the trade war could cause a sharp spike in grain prices. Soft commodity prices cannot trade below the cost of production indefinitely. Several soft commodities such as palm oil look ripe for a spike. Palm oil has been trading at 10-year low.

Branded consumer names could withstand the consumer spike

Our principal recommendations are branded and close to the bottom of the valuation cycle. These include THBEV SP, CPF TB, NESTLE NL and NB NL. Among non-rated companies, INDF IJ and CPIN IJ look promising. Branded consumer plays are resilient to higher commodity prices and typically have steady cash generation. Also, THBEV SP and CPF TB have net gearing levels of more than 100%. They are deleveraging and converting their debt into Thai baht.

Table 1: Key recommendations
Positive
Teflon Index
P/E
EV/EBITDA
P/B
Recommendation

THBEV SP Equity

-2.4

21.5

18.9

4.3

Buy

JKH SL Equity

-2.1

14.6

14.4

1.0

Hold

NESTLE NL Equity

-2.3

19.0

11.3

19.8

Buy

NB NL Equity

-2.5

27.6

7.2

2.4

Buy

MBL BD Equity

-3.8

33.1

24.2

27.5

Hold

OLYMPI BD Equity

-3.0

19.6

14.6

6.5

Hold

CPF TB Equity

7.2

16.4

12.7

1.5

Buy







Negative

Teflon Index

P/E

EV/EBITDA

P/B


WIL SP Equity

3.2

15.2

13.5

1.0

Sell

FLOURMIL NL

11.7

12.1

3.8

0.4

Hold

JAP SP Equity

4.1

9.4

5.5

0.8

N/A

Source: Tellimer