Do U.S. Tariffs Change Our Commodity Outlook?

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1 FIRST A NALYSIS NEWS OR EVENTS T HAT MAY AFFECT Y OUR INVESTMENTS John LaForge Head of Real Asset Strategy Do U.S. Tariffs Change Our Commodity Outlook? March 12, 2018 Key takeaways» The U.S. recently imposed tariffs on imported steel and aluminum. The U.S. also imposed steel tariffs in 2, which led to higher domestic steel prices.» Over the long term, it is exceedingly difficult for one country to influence global commodity prices. Other factors, such as the commodity price super-cycles, often are more dominant. What it may mean for investors» Steel and aluminum prices may have room to move higher in the short term. However, these rallies should be contained by the overall dampening effect of the commodity bear super-cycle, which we expect to last for at least another five years. The tariffs have not altered our broad commodity outlook. We remain bearish in the short term and neutral-to-bearish in the long term. Nothing is more obstinate than a fashionable consensus. - Margaret Thatcher Do U.S. tariffs change our commodity outlook? The short answer is no. Tariffs on steel and aluminum imports are not enough to change our short-term or long-term views on the commodity complex. Our 2018 commodity view (short term): Bearish Steel and aluminum make up a fraction of the overall commodity complex. Most major commodity indices, such as the Bloomberg Commodity Index (BCOM), have very slight weightings in industrial metals. Energy is most often the dominant sector inside commodity indices, followed by agriculture, then precious metals. For the remainder of 2018, we are expecting commodity weakness, driven largely by energy-related commodities, such as oil. Our target for West Texas Intermediate (WTI) oil prices is between $50 and $60 (with the midpoint being $55). With that said, we expect steel and aluminum prices to rise in 2018, and possibly into The last time that the U.S. imposed tariffs in the steel industry was in 2, and the U.S. did see higher domestic steel prices. The effect was steel-price spikes in 2 and 3, and falling U.S. steel imports Wells Fargo Investment Institute. All rights reserved. Page 1 of 5

2 Chart 1 shows steel prices on a year-to-year basis. Notice the price spike, which began in 2, and continued until 8. Now, to be clear, steel prices did not consistently rise from 2 through 8 only because of a U.S. tariff. Most commodities started rising during that period, thanks to a new commodity bull super-cycle, which we begin explaining with Chart 2. Chart 1. Producer Price Index for iron and steel (year-over-year % change) 40 PPI for iron and steel (year-over-year % change) Sources: Bloomberg, Bureau of Labor Statistics (BLS), Wells Fargo Investment Institute. Yearly data: December 31, December 31, The Producer Price Index (PPI) is a family of indexes that measures the average change over time in selling prices received by domestic producers of goods and services. PPIs measure price change from the perspective of the seller. Chart 2 highlights industrial metals prices over the past 20 years. Notice that these prices generally tend to move together (and specifically to our point today, did so during the 0s). It is true that the U.S. instituted a tariff on steel imports in 2 and 3, which likely had some impact on steel prices. How much impact that change had on prices is hard to discern, however, as most industrial commodity (and most other commodity) prices were rising. Chart 2. Steel versus copper and aluminum Indexed value (PPI iron & steel and aluminum) Aluminum PPI iron and steel Copper Indexed value (copper) Sources: Bloomberg, Bureau of Labor Statistics, Wells Fargo Investment Institute. Monthly data: January 31, January 31, Wells Fargo Investment Institute. All rights reserved. Page 2 of 5

3 Commodity view beyond 2018 (long term): Bearish/neutral Commodities are global in nature as they are produced and consumed by many different countries. The U.S. is a large consumer of commodities and commodityrelated products, so the U.S. market impact cannot be dismissed in the short term. Over the long term, however, history suggests that it is exceedingly difficult for one country to influence global commodity prices. Other factors often are more dominant, such as the commodity price super-cycles that we like to discuss. Commodity prices move together over long periods of time, which we call super-cycles. The average bull market super-cycle has lasted roughly 16 years; the average bear about 20 years. The last bull market for commodity prices ran for roughly 12 years, from 1999 through These statistics can be found in the two tables shown with Chart 3. The shaded areas in Chart 3 represent the commodity bear super-cycles, while the white areas cover the bull super-cycles. An important note is that most commodity prices generally move up together, and down together, over these long cycles. Chart 3. Commodity bear market super-cycles Commodity bull super-cycles Commodity bear super-cycles Percentage gain Length (years) Percentage gain Length (years) % % % % % % % % % % % 12.2 Current bear -37.8% 6.9 Average bull 235.0% 15.9 Average bear -53.4% 19.8 Sources: Bloomberg, Prices by G.F. Warren and F.A. Pearson, Bureau of Labor Statistics (BLS), Bureau of Economic Research (NBER), Wells Fargo Investment Institute. Monthly Data: 1/31/1800-2/28/2018. The Commodity Composite measures a basket of commodity prices as well as inflation. It blends the historical commodity composite from George F. Warren and Frank A. Pearson; the U.S. Bureau of Labor Statistics Producer Price Index for Commodities; the National Bureau of Economic Research Index of Wholesale Prices of 15 Commodities; and the Thomson Reuters Equal Weight Commodity Index. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results Wells Fargo Investment Institute. All rights reserved. Page 3 of 5

4 Some of you may be thinking that not all commodities follow one another. As the logic goes, we do not consume wheat like we do oil, or silver. Over the short term, this is the case. As an example, we consume oil throughout a year differently than we consume wheat. However, over the long run, commodity prices generally follow one another regardless of consumption patterns. Chart 4 showcases three different commodities, which are consumed year-to-year quite differently. Notice, though, that their prices generally track one another, and the rest of the commodity complex (green line), over the long term. Chart 4. Oil, wheat, and silver versus commodities (1914 present) Commodity composite Crude Oil Silver Wheat Indexed level Sources: Bloomberg, Kitco, U.S. Department of Agriculture (USDA), Prices by Warren and Pearson, BLS, NBER, FRED, Wells Fargo Investment Institute. Monthly data: 1/31/1914-2/28/2018. Values shown in log scale. Indexed to as of 1/31/1914. It is evident from Chart 3 that commodity bull super-cycles almost always end badly. It is not a coincidence that most commodity prices crashed between 2011 and It started with copper and industrial metals in 2010, bled into precious metals in 2011, moved to food commodities in 2012, and eventually hit oil in The crash occurs because prices tend to rise too far, too fast, which invites lots of competition and substitution. When thinking of too far too fast, you can think of oil prices for the 10 year period from 1998 to 8 prices rose more than fifteen-fold, from roughly $10 to $150 per barrel. Competition and substitution bring with them excess supply, which swamps commodity prices. And, unfortunately for commodity bulls, excess supply is not something that corrects itself overnight. As we stated earlier, the average commodity bear super-cycle has lasted nearly 20 years, with the shortest being 12 years. As of 2018, we believe that we are seven years into the current commodity bear supercycle as most commodity markets remain swamped in excess supply. We are expecting at least another five years of the same trend. For most commodity prices, this means lots of range-bound price action and capped rallies. For steel and aluminum specifically, there may be room for these commodity prices to move higher in the next few years, but if the history of commodity super-cycles is a good guide, even these rallies should be contained. The bottom line is that our commodity views, both in the short and long term, have not changed with recent U.S. tariff talk. We remain bearish in the short term and neutral/bearish in the long term on the commodity complex Wells Fargo Investment Institute. All rights reserved. Page 4 of 5

5 Risk Considerations Investing in commodities is not suitable for all investors. Exposure to the commodities markets may subject an investment to greater share price volatility than an investment in traditional equity or debt securities. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Commodities may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or other factors affecting a particular industry or commodity. Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. General Disclosures Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company. The information in this report was prepared by Global Investment Strategy. Opinions represent GIS opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report. The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. Wells Fargo Advisors is registered with the U.S. Securities and Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors. Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company. CAR Wells Fargo Investment Institute. All rights reserved. Page 5 of 5