A Bullish Thesis on Commodity Supercycles
On the backheel of a turbulent 2020 stock market that saw both depressing crashes at the head and exuberant runs at the tail, many investors have positioned their portfolios with “COVID-19 tailwind” equities. Such popular picks include the likes of technology (eg. $ZM, $DOCU), refurbishments (eg. $ADH, $NCK), delivery (eg. $DMP, $FDX), or home entertainment (eg. $NFLX, $PTON, $ROKU).
While equities ruled centre stage in financial markets narrative, the commodities world was arguably just as interesting, from oil futures slipping towards negative territory in April 2020, coffee prices surging to historic highs from COVID-related supply issues, or even the recent short squeeze on silver observed just at the beginnings of 2021. As vaccine distributions propel the recovery phase of economies, we’ve seen a surge in commodity prices – yielding attractive returns to their holders.
A rough brushstroke comparison of the S&P GSCI (an umbrella commodity index) against the S&P500 and ASX200 see comparable performance returns against equities:
While it does appear that commodities have had a good run, markets and hence portfolios have to be forward looking. While some may argue that these sky high prices are unlikely to persist, there are compelling reasons suggesting that the show is not over, and that we are at the precipice of a commodity supercycle.
What is a Commodity Supercycle?
As the United Nations defines it, a supercycle represents a “decades-long, above-trend movements in a wide range of base material prices, derived from a structural change in demand”. A graphic of a history of supercycles in show below, with 6 notable occurrences over the past 227 years:
The most recent occurred back in the 2000s – fuelled largely by demand emanating from the BRIC (Brazil, Russia, India, China) countries, as well as concerns over long-term supply availability. We will see that these supercycles often emerge from a perfect storm of booming demand and restrictive supply conditions.
Typically shown to ride the recovery wave after notable economic downturns, this makes fundamental sense, as these commodities are typically used as, or to construct intermediary inputs when demand for goods increases. For example, copper, nicknamed “Doctor Copper”, is often seen as a leading indicator for economic growth due to its widespread applications in many economic sectors (eg. home building, factories, electronics, power generation). In fact, a helpful multiple to look at is the copper/gold ratio. Unlike copper, gold is fairly useless as an industrial metal, and also functions countercyclically as a “flight to safety” asset – often signalling sentiment towards a contracting economy when we see its prices firming.
The graphic belows shows the copper/gold ratio historically, where we see this ratio firming up dramatically since the month of January. In fact, this ratio is now sitting at comparable levels to pre-pandemic.
This speaks even greater volumes when we consider the high bull run of gold over the course of 2020 – driven by its performance as a fear asset during the pandemic.
Thesis #1: Fiscal Stimulus Levers and Infrastructure Spending
Not only can commodities and their attributable prices be used to signal a recovery, but a recovery in itself can also simultaneously cause commodity prices to surge based on higher expected demand in the economy in a reinforcing feedback loop.
And this makes sense considering the backdrop of unprecedented rates cuts combined with accommodative fiscal policy. With a shift in sentiment amongst policy makers towards a harder emphasis on full employment rather than inflation control, the material amount of money distributed is aimed towards facilitating high aggregate employment sectors such as infrastructure.
Take Australia for example, which saw governments across Australia pulling the infrastructure lever to bolster economic recovery from the pandemic doldrums – including an additional $14 billion for new infrastructure projects over the next 4 years and supporting a further 40,000 jobs. This turns out to be a meaningful and material amount of dedicated to boost jobs and growth when taking into account an incumbent 10-year plan of $110 billion supporting 100,000 jobs.
However, the biggest fish in the pond to inspect here is China, as it accounts for around 50-60% of commodity demand in the mining space. Given the country’s relatively quick rebound out of the pandemic, and a “New Infrastructure” plan totalling the trillions set back in 2020 focussing on the likes of 5G infrastructure, data centres and high speed rail transport, the thesis for commodities will be highly leveraged towards the continual thirst from Chinese demand.
Hence, we see these infrastructure industries strongly positioned to recover post economic trough – facilitating second order effects for its constituents in materials and commodities. Take housing for example, where higher demand for complementary housing appliances such as refrigerators or air conditioners are naturally likely to follow, which in themselves are commodities intensive and which provide further tailwinds.
Thesis #2: Monetary Stimulus Levers and Inflationary Fears
As of the late weeks of February, attention in financial media has largely revolved around the observed spikes in treasury yields – in particular the 10 Year T-yield reaching crossing 1.60%, signalling investor fears of higher inflation in the future.
While growth stocks have been the prize winner of recent years, these renewed inflation fears in investor expectations have seen a series of corrections for risky assets, as higher forecasted interest rates all else equal, cause these assets to be discounted in a harsher manner to a lower intrinsic value.
Some market commentators have expressed predictions for an accelerated inflation environment despite markets having been devoid of meaningfully high inflation levels for the past decade. Notably, Lawrence Summers and Michael Burry have issued concerns over overheated inflationary pressures in the context of record low interest rates, and a $1.9 trillion stimulus package by the Biden administration.
With a democratically blue led America focused not only on ensuring an economic rebound – but a fair and equitable one at that, the Biden package targets at low to middle income households that typically display higher marginal propensities to consume their checks. These socially driven policies will all else equal, creating higher multiplier effects translating to a more pronounced boom in inflation.
How does this relate to commodities? Well this asset group has shown to be positively correlated to inflation and are commonly employed as an inflation hedge. This is generally because commodities are seen as a more secure “store of value” compared to fiat currency in times of inflationary environments. Additionally, as these commodities are traded in USD, where the greenback is negatively correlated with inflation, commodity prices become relatively more expensive to trade.
In other words, the presence of looming inflation could provide a tactical upside to commodity prices. The chart below details commodities’ relative outperformance during high inflation environments:
Thesis #3: Accelerated Climate Change Focus
However, the commodities story is not purely a cyclical phenomenon that rides on the back of economic recoveries as a value play. Digging deeper, there may be structural tailwinds when we consider a worldwide shift towards a Green Revolution to quell the negative consequences of climate change.
The implications of climate change are twofold. Firstly, it creates higher variance in temperatures, which heightens the probability of extreme weather events such as typhoons, bushfires, tsunamis, etc.
Just recently, the electricity and water systems in the state of Texas went into a 3-day disruption amidst the harsh winter weathers, as its infrastructure was not winterized to deal with such extreme temperatures. In light of the situation, it isn’t farfetched to predict a necessary overhaul of Texas’s incumbent infrastructure when we consider that Texas is actually the world’s 9th largest economy and consumes more energy than any other US state.
Secondly, these catastrophic episodes of climate change have accelerated the impending pressure by governments to shift towards renewables – as we see increasing capital is being deployed into new stage innovation and infrastructure in the energy sector.
Propelled by the Biden Administration’s agreement to return back to the Paris Accords and their declaration of the Green Investment Policy, as well as China’s commitment towards Net Zero Emissions by 2060, the centre stage is set for a synchronised push towards divorcing away from a reliance on fossil fuels and replacing the shortage with clean energy sources.
Of course, structural tailwinds to green capex creates higher demand for base metals used in the production of clean energy sources such as solar panels and electric vehicles. These commonly include the likes of nickel, cobalt, zinc, copper, and silver.
For example, Goldman Sachs’ head of commodities research Jeffrey Currie – a longtime bull towards the commodity supercycle, has stated his preference for silver due to its applications into solar panel technology as a cost effective conductor of electricity. Given that 20% of industrial demand for silver comes from solar panels, marrying this fact with the expectations of a 40% rise in solar capacity from Biden’s green policies spells significant tailwinds for the metal.
Thesis #4: Commodities Supply Lags
Demand being just one side of the equation, we also have to consider the supply-side factors and implications of commodities. Here, market expectations posit a commodities supply shortage, as commodity bulls point out lower capex spending guidance in the mining sector due to COVID-19.
While supernormal profits via high commodity prices will serve as a price mechanism to draw in supply, the reality of getting a mine started and running can typically range around 4-5 years for small-scaled projects, and 10 years for large mines due to the stringent processes of exploration, feasibility and geological studies, capital raisings and environmental approvals.
As James Stewart, a PM of the Ausbil Global Resources Fund suggests, “In 2012 total mining capex was about $US75 billion, and then it fell like a stone to hit $US20 billion in 2016. While it’s picked up since, in many areas the mining industry is nowhere near where it needs to be just to replace annual consumption, let alone expand production.”
Take copper for example, which requires around 300,000 tonnes of new production per year to maintain a constant supply threshold. This roughly translates to $10 billion of capex, yet the copper mining production pipeline has dramatically dropped to a decade low:
This is exacerbated with short to mid-term supply headwinds in South America – that accounts for over 1/3rd of global iron ore and copper production. In particular, Brazil has fared miserably in terms of pandemic control under president Jair Bolsanaro’s hard stance against masks and distancing, with the country compiling the world’s second highest COVID-19 death toll, with cases nowhere near stable levels to warrant a return to normalcy.
This has led to multiple mine shutdowns that have halted production – for example the court mandated closure of Vale’s Coneicao, Caue and Periquito iron ore mines after 188 workers tested positive for COVID-19.
While the world is hopeful for a swift and effective vaccine rollout in Brazil and other countries, there is still an air of uncertainty baked into a rapid restart of production. With these industries commonly employing a high labour count, gradual phased approaches should be the normative way to limit COVID-19 spread.
One may predict governments like Brazil ignoring this phased approach and immediately shifting the gear stick to full throttle, however this simply exacerbates the risk of increased community transition that could bring the nation back to square one. Ultimately, we come to the “perfect storm” equation: supply depletion + fervent demand = the foundations of a commodity supercycle.
While the likes of commodity supercycle is not guaranteed, the ingredients are certainly in place to facilitate its occurrence. On the demand side, cyclical forces bolstered by both fiscal and monetary levers have given compelling reasons to be long commodities due to higher organic demand, as well as their employment by inflation-weary investors.
The bull case is further substantiated by an aggregated focus towards renewable adoption by the world’s two largest economies in the USA and China, where rare earths metals are set to prosper. Finally, while basic economics entails supernormal profits to subside by profit motivated firms entering and flooding the market with supply, we see significant lags in supply shifts in the real world still impacted by mine closures and prospective entrants stifled by the lengthy bureaucracies of getting their projects to an operational stage.
Victor Yan is the Vice-President of Publications for UNIT – University of Melbourne, specializing in financial investments and economic policy.
Janus Henderson: https://www.janushenderson.com/en-au/investor/article/are-we-entering-the-next-commodities-supercycle/
SP Global: https://www.spglobal.com/marketintelligence/en/news-insights/research/capital-expenditure-in-the-mining-industry-to-drop-by-us-54b-in-2020
Disclaimer: The views expressed in this article are solely that of the author’s, and do not necessarily reflect the position of UNIT nor the University of Melbourne. The advice given is general in nature and does not consider an individual’s personal financial circumstance. Transacting off this information is done so at one’s own risk, and individuals are encouraged to consult a finance professional before making investment decisions based off of this article.