• Higher bond yields will strengthen already favourable supplyside constraints, supporting commodity prices
• Inventories have tightened across the commodity markets, most notably in crude oil
• Commodity producers are focusing on generating dividends, positive cashflow and returning value to shareholders
• An acceleration of demand from emerging markets reinforces our positive outlook for commodity prices

It has been a long time coming, but investors are getting used to the idea that global bond yields are heading higher. This has prompted a flurry of comment on how equity and fixed income markets might react to the repricing of bonds. Rather less notice has been paid to the potential impact of higher yields and interest rates on commodity prices.

That government bond yields are increasing is not in question, especially in the US. The Federal Reserve's hikes since 2015 have slowly lifted the yields on US government debt. The current US administration is now reinforcing this trend. As the White House's lack of fiscal prudence becomes clearer, global investors are re-evaluating US bond risk, with knock-on implications for inflation, the dollar and equity markets.

In the commodity arena, rising bond yields will make it more expensive for producers to borrow. As a result, new projects will look less attractive and the supply response to higher commodity prices down the road could be significantly impaired. However, a potential headache for commodity producers could be an opportunity for investors.

Higher yields will help to strengthen already favourable supply-side constraints, which means that should commodity prices take off they could exceed expectations.

UNCHARACTERISTIC DISCIPLINE

Inventories have already tightened substantially across the commodity market as producers show uncharacteristic discipline at this point in the cycle. In our view, outside of the bond markets there are three key factors supporting supply constraints.

One is China, the world's biggest consumer of natural resources, which has been restricting supply in many commodities: specifically, coal, steel and aluminium for environmental reasons. China's concerted action has already had the effect of pushing up the prices of coal, iron ore and base metals and has had a positive impact on the materials sector.

At the end of 2016, OPEC and the Russians formed an alliance that has removed 1.8 million barrels per day (bpd) of oil production from the market. Again, this is an unprecedented situation. Looking back over a 40-year horizon, OPEC's attempts to get Russia to cooperate on cuts has never worked.

Now we have more than a year's evidence that demonstrates this time is different. OPEC and Russia started cutting production at the end of 2016 and, having gone through 2017, look like they will keep the market balanced through 2018 as well. They appear notably unified in their coordination.

EYE ON THE WEATHER

We talk to producers across the spectrum of base metals, precious metals, bulk commodities and energy. In the conversations we have been having, producers remain focused on repairing their balance sheets and creating shareholder value rather than just increasing production.

Agricultural commodity inventories are also tightening, which will be significant if we suffer a harvestdamaging weather event. This year has already seen substantial increases in prices for grains and oilseeds. These have been the result of two fairly localised weather events: the first affecting wheat in the south-west plains of the United States; the second impacting soybean production in Argentina. A further weather event affecting the northern hemisphere could push agricultural prices significantly higher still.

POSITIVE OUTLOOK

The commodity sector has never been so disciplined about limiting new production as prices stabilise and in some cases increase. This rigour comes at a time when contemporaneous global growth in emerging and developed markets is supporting demand for key commodities. If anything, we are seeing an acceleration of demand in the emerging markets as a weaker dollar has supported releveraging, growth and investment.

As we stated at the end of last year, we believe the favourable demand/supply dynamics are particularly constructive for base metals. Over the medium term, precious metals should also benefit from higher inflation.

There remain areas of uncertainty and potential volatility. The steel and aluminium tariffs announced by the US administration were, in and of themselves, not significant for medium-term commodity prices. That changes as they result in retaliation and escalate into trade war.

In the meantime, we are seeing stabilisation and some firming up in the commodity markets. We have never had China exercising supply discipline, and never had OPEC working successfully with Russian producers. Couple these supportive factors with the shift taking place in bond markets and we remain confident that commodity prices have the potential to push significantly higher in 2018.

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