Last week, I talked a bit about commodities as a recession canary or, perhaps more aptly, commodity prices as a manifestation of the recession trade, which isn’t difficult to spot if you know where to look.

There’s a tendency among the general investing public to eyeball the S&P or the Nasdaq 100 and make an assessment about market-implied recession probabilities. That’s the wrong way to think about it. Both of those benchmarks are dominated by mega-cap growth shares, which is to say long-duration equities. Those tend to benefit when bond yields move lower, which can create the perception of obliviousness in “broad” equities. More recently, some of the same mega-caps were immune to a move back higher in yields thanks to the A.I. tailwind.

So, you can’t always glean much in the way of macro insight from glancing at US equity benchmarks. Commodities, on the other hand, can be a useful barometer, notwithstanding volatility and some well-documented disconnects between the physical and paper markets. A confluence of factors has undercut raw materials in 2023, chief among them recession concerns and, relatedly, underwhelming data out of China.

Commodities are down ~10% broadly this year, and spec positioning across crude contracts is bearish enough to prompt warnings from a certain royal with a penchant for wrong-footing markets.

“I keep advising them that they’ll be ouching — they did ouch in April,” Prince Abdulaziz bin Salman said this week in Qatar. “I would just tell them: Watch out!” (He likes “ouching,” but somebody really should tell him it has a silly, unserious ring to it in English, and that “hurting” or “stinging” would be preferable if he’s trying to scare specs.)

OPEC+ delivered a surprise production cut last month, and although another broadside isn’t especially likely, the royal rhetoric was notable as it came just days ahead of a June 3-4 meeting in Vienna.

With the above in mind, I wanted to highlight two brief excerpts from a new Goldman note describing a “great de-stocking” in commodities. The full piece is a dozen pages, and it’s well worth a read, but Jeff Currie captured the gist of it in two short passages detailing an “unprecedented” physical de-stocking and an “equally large” financial de-stock. As you’ll note from the excerpts, Goldman now sees scope for a sizable rally looking out 12 months.

Again, I should note that the following passages penned by Currie represent a very small fraction of the full piece, which is detailed and expansive:

While it is tempting to blame the large selloff in oil and commodities on financial liquidation given unprecedented paper selling, physical selling is nearly as large. Bulls, like ourselves, find comfort in the fact that end-use demand across the commodity complex has not shown recessionary signs and investment in supply remains elusive, but this misses the point that we were wrong on price expectations. Despite weak manufacturing-related demand, overall demand and inventory data across the commodity complex support our more bullish view. Yet, prices continue to move against our forecasts. What is the explanation? It is likely the largest commodity de-stocking the complex has ever witnessed; hence, the ‘great de-stocking.’ Such unprecedented de-stocking should not be surprising. Markets have rarely seen such a sharp rise in funding costs from such a low level. And, given the rare inflationary backdrop faced by governments around the world, they are using every tool at their disposal. French, Chinese and US SPRs are down c.250 million barrels, and the recent collapse in clean freight rates and long-awaited decline in Iranian floating storage is indicative of Western governments taking a less discerning approach to sanctioning commodity supply, including Russia where supply has surprised to the upside. US shale oil DUCs have also been de-stocked. However, it is not just oil and governments fighting inflation. The analogy extends to metals and non-energy sectors as goods production and manufacturing in the West has been lower than demand. In our view, recessionary concerns, higher rates and healing in global goods supply chains have led to a broad de-stocking of wholesale goods and inputs. While this creates weaker industrial production and stokes recessionary fears, it does not reflect weak end-use demand in the West which, in our view, is skewed to the upside from here on improved supplies in gas and energy markets in Europe.

Financially, paper commodities experienced a similar de-stock given the cost of holding positions against higher funding costs and more volatility. In the past 30 days, oil has seen 250 million barrels of paper selling and copper 0.4 mt of paper selling. This makes industrial commodities like copper and gasoil net short, bringing managed money in commodity indices to a new low going back to the early 2000s. For crude oil, net positioning is now as short as it was during COVID when inventories reached record levels, breaching capacity constraints which caused oil prices to quickly turn negative. Why has market positioning swung so negatively? In our view, mounting concerns over the health of the financial sector, US debt ceiling risks, fears of an impending demand slowdown in the West as well as a disappointing recovery in China in April have further raised fears of an upcoming US or global recession. The bottom line is markets have cashed in on their insurance policies in the form of physical and financial hedges. On net, this leaves the entire complex exposed to upside should recessionary risks not materialize. From a portfolio perspective, this also makes a strategic commodity allocation a very good hedge. Commodities and rate markets have priced in a recession while equities have only priced in the positive aspects of that outcome via lower interest rates and lower commodity prices. The absence of a recession would likely lead to higher oil and commodity prices as well as higher rates, to which equities would likely react poorly. We now forecast the S&P GSCI to return 30.3% on a 12-month horizon.