Last week I wrote about copper prices which were pushing substantially higher. This was on the back of a generalized uptick in global activity as well as expectations around economic growth.
This week, we broaden the discussion on commodities to take a wider-angle view of what’s happening. We aim to look at not only base metals, but also precious metals, energy, and soft commodities.
Firstly, let us rewind. There have been massive amounts of both fiscal and monetary stimulus in the system. This has given rise to inflationary fears, now at the front of the agenda. I’ve written about this here (Inflation Consternation).
As this chart from Bloomberg suggests, as consumer prices accelerate, the general performance of underlying commodities tends to correlate. We will not get into the leads and lags, or causality discussions. Suffice to say that some commodities exhibit a much higher beta to an increase in inflation than others – illustrated below.
Similarly, the schematic below, from Bank of America Research outlines how the major investment themes from 2020 could evolve in 2021. I have highlighted the aspects of inflation, commodities, and emerging markets for effect.
These have been some of the major themes I have written about recently. Quite often we get caught up in the immediate narrative. We lose sight of the longer-term picture. The schematic below suggests that much of what is being experienced now is not necessarily unexpected when viewed in a wider context.
What’s the big picture been?
In this vein, I took the time to chart and tabulate the returns of various commodities over the last 10 years. Furthermore, I grouped these broadly into energy, general infrastructure, battery tech, automotive, precious, and softs. This was done to highlight the role that specific commodities play in investment themes.
At a glance, this heat map merely illustrates that single commodities tend to be very volatile. The large scale swings are echoed in the performance of commodity stocks that are exposed to single commodities. It also tends to suggest and if one wants a generalized exposure to commodities, that one is best served by diversifying across a very wide basket.
It is really when we start to transform how we look at the data, that more interesting insights start to emerge. Firstly, by merely transposing the data, we achieve somewhat of a time series for each commodity. Subsequent tables and heatmaps below are the exact same data as above, but merely viewed with a different lens.
A more conventional time series view of the overall commodities market illustrates that the years 2011-2015 were a tough time across most commodity markets. This correlates with a rally in the US dollar of over 38%, and largely ties in with the thesis presented in in my previous article, Every cloud has a copper lining.
From 2015 onward, these performances have been a lot more nuanced as highlighted. Energy peaked earlier and subsequently came off. Commodities exposed to the clean energy and battery tech sectors have only started to shine within the last two years. Other commodities like Palladium have enjoyed a significantly strong run since 2016 to date.
Precious metals, like gold and silver have performed in a much more muted manner. Broadly in line with the underlying movements in the dollar index. Bear in mind that the performance is reflected in the 2021 column are year to date figures, and as such are not directly comparable.
Best year in a decade?
Let us take a different perspective. The heat map below merely changes the color coding to reflect the best and worst years in each specific commodities time series. What is remarkable from this visualization is that 2021 is shaping up to be the best year for almost all commodities regardless of underlying sectoral themes (considering we are only in May).
This tends to support the view that rampant stimulus programs have given rise to underlying inflation in any type of real or physical asset. I have previously outlined my view on inflation as likely to be transient. This is simply because inflation is measured as a rate of change, and that prices would need to continue at the current growth rate in order to sustain inflation.
The caveat to that view would be if we continue to see even further stimulus programs, both monetary and fiscal, deployed on a global scale. At this stage, we cannot rule that out. But, it would stand to reason that should the underlying global recovery take hold, that stimulus could slowly be withdrawn.
It’s supply and demand dummy
Another point to note regarding the current rally in commodity prices, is the dislocation between supply and demand. Let’s go back to the time series heat map.
When there are prolonged periods of low prices in commodities as was evident in the earlier part of the last decade (red circle), commodities producers cut back substantially an exploration as well as production capacity.
This results in a reduction of supply which is slowly worked out. Thereafter, markets rebalance as demand ticks higher and eats into inventories. The reverse is also true. Higher prices will likely result and increased investment, albeit with a degree of caution.
As such, it may take some time before supply/demand dislocations are worked out of the system and prices normalize again. This will tend to differ from commodity to commodity. Lead-lag cycles from investment to actual production tend to vary quite widely.
A parting thought would be that a rise and soft commodity prices is in fact a little more concerning. Food security in many parts of the world remains poor. Any prolonged dislocations in soft commodity prices, coupled with inclement weather (see my piece on climate change and clean energy) may prove to have wider geopolitical and social consequences. But this is a topic for another day.
For now, as a consumer, there is little place to hide. The uptick in underlying commodity prices may eventually filter through to ticket prices at the store. Whether this trend is sustained is still a matter of debate.
As investors, it would be wise to match once preferred commodity exposures to longer term thematic investment trends.
Selected emerging markets will also be the beneficiary of a commodity boom. Is this the start of another commodities super cycle? (too early to tell). If so, it could have profound socio-political implications. It could be a saving grace or Dutch disease all over again.
Clean tech or green economy transition is a theme that will likely be with us for a generation. That said, one needs to be cautious when prices move this sharply and quickly. Further investigation into the supply/demand deficits and investment pipeline/lead time to production is warranted. This is likely the ambit of a future piece.
One thing is certain, this is not the first time we have seen these kinds of oddities with commodities. Commodity cycles are well-documented. We would be wise to remember that while history doesn’t repeat itself, that it often rhymes.