Could the stars be aligning for commodities?
Commodities have long been out of favour with investors, but have recently enjoyed a good run, more than matching returns from broad equity indices for the first time in many years. Increased cross-commodity demand from China, significant supply side discipline in the oil sector as well governmental commitments to maintain fiscal economic support have all been important factors.
Whether we are in the early stages of another super-cycle in commodity prices and returns has become a key debate. We, and an increasing number of investors, see several structural similarities between the early 2020s and the early 2000s, the last time commodities began a long and powerful ascent to record prices.
Now, as then, we have seen significant underinvestment in commodity supply with capex in oil and gas and global mining sectors falling by around 40% since 2011. In the early 2000s, China represented a major source of accelerating commodity demand. Today, we may be about to embark upon an unprecedented period of co-ordinated global capital investment to facilitate the energy transition. The switch to clean energy sources and electric vehicles may prompt an acceleration in demand for key raw materials.
There are also some key differences. Today, focus on climate change is likely to limit fossil fuel investment even as prices rise, potentially creating a historic supply shock. Additionally, increased geo-political tension is ushering in a period where supply chain resilience and strategic stockpiling could re-enforce demand from agriculture to metals.
Detailed below are what we believe are the five main reasons why commodities are set to achieve growth and why investors should now consider the sector.
Commodities valuations are cheap. This is not only relative to other assets such as equities, as the chart below illustrates, but also when compared to history.
It is also worth noting that when commodities outperform, it is often by a large margin, as the chart below shows. Previous periods of strong performance have been supported by certain conditions coming into place. For example, the early 2000s saw China’s boom following a period of underinvestment due to the bear market in the 1990s. We believe these fertile conditions are moving into place once again.
As we move into a post-Covid world, governments around the world are enacting a combination of fiscal and monetary policies that will be much more positive for commodities.
In response to the global financial crisis of 2008, major global central banks sought to rescue economies with the unorthodox policy of quantitative easing (QE). Although, this policy saw financial assets outperform real assets over the past decade, it was very negative and deflationary for commodities. However, the era of pure QE is now over.
The past 12 months has seen major central banks around the world respond to the Covid-19 pandemic with a combination of unconventional monetary and fiscal policy. The speed and size of these packages has been unprecedented. In contrast to 2008, a multi-trillion-dollar fiscal expansion, including direct helicopter money to households and companies, has been delivered.
Some countries are running fiscal deficits in excess of around 15% of GDP – something which has not been seen since wartime. In the context of their existing debt burdens, this makes inflationary policy more attractive. We believe that the co-ordinated combination of aggressive fiscal and monetary policy means that inflation is on the way. And this is beneficial for commodity prices.
The energy transition is set to see demand for metals accelerate sharply in the coming years as the world starts the switch to EVs and more renewable energy sources. The chart below shows the expected increase in demand for copper for use in EV batteries and associated charging infrastructure that will be required as part of the switch.
Other commodities are also set to experience a rapid uptick in the coming years. Demand for agricultural commodities, such as corn, soya beans and pork are also likely to rise, driven largely by China. Supply chain disruptions due to export restrictions during the Covid-19 crisis have also led several countries to roll out long-term plans to build food strategic reserves, wheat in particular, in order to lower their import dependency.
The increase in demand from China is due to the country’s lack of arable land and subsequent inability to expand its agriculture sector. Rising demand for these commodities, particularly pork, is also being driven by China’s rising urban middle class.
Underinvestment always precedes the next commodity cycle and the chart below shows that capital investments in major integrated oil and gas companies declined by 52% between 2013 and 2020. Capital expenditure in the copper industry declined by 44% between 2012 and 2020.
The only thing that can stimulate investment in these sectors is an increase in the price. If even half of the expected demand comes through, then supply will prove to be insufficient, which will push prices higher and stimulate investment.
Intervention by the US Federal Reserve (Fed) during the Covid-19 pandemic to shore up the finances of companies and consumers has had the effect of capping the dollar’s appreciation. Given an unlimited supply of dollars from the Fed in any crisis, investors have sought more attractive safe haven options out there, such as the euro.
Concerns over the US’s twin deficit (the financial deficit and the current account deficit) have also contributed to the fall in the value of the dollar (see chart below). And we expect this to continue in the next few years.
Moreover, the US dollar’s pre-eminent “reserve” currency status could start to fade as the euro looks set to gain in strength and prominence as Europe’s leaders take a more proactive approach to stimulating economic activity.
And a weaker dollar is most definitely positive for commodities. Although most commodities are produced in emerging markets, they are usually priced in dollars. When the dollar is weak, the price of these commodities in dollar terms rises.
Some investors focused on environmental, social and governance (ESG) factors may be reluctant to invest in commodities due to concerns over their environmental impact in much the same way that they wouldn’t invest in energy stocks.
However, it is important to note that some of these commodities (metals, in particular) are essential to ensuring the energy transition and the move to a low carbon economy takes place. Insufficient supplies of copper or nickel would be problematic for developing EV batteries or connecting solar parks and wind turbines to the electricity grid.
By investing in futures contracts, for example LME copper, investors can have confidence over the supply chain. They can also be confident that the underlying contract is not for metals produced with sub-standard safety measures.
It is also worth noting that by taking an active investment role ESG-focused investors can engage with companies in the sector and help bring about change. And in a final call out for the sector, commodities remain a necessity, and are often essential in allowing the global economy to function.
This article is issued by Cazenove Capital which is part of the Schroders Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority.
Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested.
This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements.
All data contained within this document is sourced from Cazenove Capital unless otherwise stated.
The value of your investments and the income received from them can fall as well as rise. You may not get back the amount you invested.