It has been quite the turnaround for commodities. At the start of 2020, there appeared little to recommend them: there was nothing to ignite a new pricing cycle and they were blighted by their poor-ESG record.
Investors were sounding the death knell for extractive industries, amid a green revolution. There were rare exceptions, such as gold, but most commodities remained mired at multi-year lows.
Since then, commodities have been whipped up in the general market excitement over, first, fiscal and infrastructure spending and, now, economic recovery.
The oil price has moved from around $40 per barrel in late October to its current level of $58. Iron ore prices have doubled over the past 12 months, while copper prices have also seen a notable lift.
Market participants have built growing enthusiasm – Goldman Sachs, for example, recently upgraded commodities to “overweight” in its portfolios, saying base metals in particular look set to grow. Its reasoning is that commodities provide the best hedge against inflation and looked set for another bull market.
Some hedge funds have gone one step further, saying that commodities are on the cusp of a new supercycle, similar to that seen from 1998 to 2011.
This hasn’t yet translated into fund flows
The most recent European fund flows report from Refinitiv showed commodities funds shedding a net €0.1 bn in December, only just behind property and absolute return funds.
Morningstar’s latest report paints a similar picture with commodity funds down €461m in December and €1.65bn for the final quarter of 2020. This suggests that commodities markets may still be in the early stages of this shift in direction.
Inflation protection is clearly part of the story. While it has been relatively benign during the crisis, as recovery builds there is a question over whether liquidity can be withdrawn quickly enough to prevent an inflationary shock. Money supply still very high. Investors are looking to commodities to protect portfolios against inflation.
Fed expected to remain accommodative
Inflation expectations are already ticking up. While the most recent higher Eurozone inflation numbers are likely due to one-off factors, such as the end of the VAT reduction in Germany, breakeven inflation rates have been rising, particularly in the last few weeks.
Mobeen Tahir, associate director, research at WisdomTree says: “It appears from bond markets that markets are pinning their hopes on economic recovery and expect inflation to pick up.”
At the same time, he says, the US treasury yield curve has steepened, “not because markets are expecting rates to rise”.
“Primarily because inflation expectations have risen. Real yields remain very low. Bond markets are expecting the Federal Reserve to remain accommodative even if inflation picks up.”
He adds: “Commodities are one of a pool of asset classes that can provide a natural hedge against inflation. There’s a clear historic precedent for this…particularly for moderate increases in inflation.”
Other factors also at work
Fawaz Chaudhry, research analyst at Fulcrum Asset Management, says that the idea of a ‘super cycle’ has some basis in reality, notably in metals.
He says that the government response to the pandemic has been to cut services. People can’t fly, or eat in restaurants, or go on holiday. With the money they have saved on services, they have bought goods.
“From fridges, to phones to cars and even home,” he says. “They have had more savings to deploy.”
He points out that Chinese exports (where many of these goods are manufactured) have soared by around $300bn in the last six months. This demand shock comes on top of a considerable reduction in supply and is likely to persist until that supply emerges. This takes time.
Chaudhry adds that far from ESG being an argument against the mining sector, it is an argument in favour of a super-cycle in metals. “The green revolution is very metal-intensive. New wind and solar plants need a lot of metal, as do electric vehicles. As money from fiscal stimulus packages goes towards decarbonisation, demand for nickel and aluminium is forecast to increase by 14x, for copper by 10x and for lithium by 9x.”
Renewable energy systems consume around five times more copper than conventional power generation systems.
He suggests the arguments for other commodities is weaker. Oil is rising because of a shrinking of supply, which is likely to be reversed when the price hits $65-$70 per barrel. Gold has been benefiting from low real yields on bonds and may become less attractive as economic recovery gathers steam.
Emerging Market skew
Another point to note from this revival in commodities is its impact on emerging markets. For some time, China has been the dominant force in emerging markets, but booming commodity prices will benefit, among others, Latin America, Africa and smaller Asian nations.
The EM indices remain skewed towards China and may not register this pick-up.
The excitement around certain commodities is justified. There are compelling arguments for a longer-term up-cycle in metals pricing. Importantly, metals may play an important role in the green transition.
Many investors remain structurally underweight mining and those emerging markets that would benefit from this shift. It may be time for a rethink.