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AAM Viewpoints – Our Generational Opportunity Call on Commodities Remains Intact


Executive Summary:

  • Our contrarian call of a generational opportunity in commodity stocks has been supported by significant outperformance versus other sectors since the equity market bottom in March 2020.
  • The trend is likely in its infancy and we anticipate it will play out over the course of the next few years given several macro reasons including:
    • Lack of any significant investment in finding replenishing stocks of commodities;
    • Record monetary stimulus flooding the currency markets with fiat script and a renewed focus on hitting and exceeding inflation targets; and
    • A huge boost in global demand following the COVID-19-induced economic collapse in March 2020.
  • We continue to expect that the same market forces that have begun to shift performance to commodities will remain in place, and even accelerate, into 2021. We believe that the best way to participate in this trend is through ownership of stocks of companies engaged in the production of commodities as well as those of emerging markets.

In January of this year we published my Viewpoints article, “Generational Opportunity Now for the Next Decade?” The article was a contrarian call on the prices of commodities and outlined what we felt was a very significant price apex and the opportunities that created. Our “big call” for 2020 was a historically compelling opportunity to over allocate to commodities (which we framed as Metals, Materials, Agriculture and Energy) in portfolios. What we didn’t know at the time was that there was a very evil virus beginning its trek across the globe that would freeze global demand and bring some doubt as to the future of global economic growth.

Where does our call stand now?

The “generational” context of our call was based, in large part, on the historically low ratio of commodity prices to the S&P 500. To illustrate this opportunity graphically we shared a chart that demonstrated just how inexpensive commodities had become. Here is the chart we shared in January of this year:

S&P GSCI Commodity Index/S&P 500 Ratio

2020 has been a year of the pandemic haves and have nots. From the market bottom on March 23, 2020 we have witnessed some interesting shifts in performance of different industries. We have seen most of the performance come from “growth” stocks whose prices and valuations have soared to levels previously only seen surrounding market tops.


Our call was not based on value vs. growth, but it was based on expectations for a significant growth in global demand for commodities. The answer is that performance doesn’t lie.


What we are seeing on a year-to-date (YTD) measure versus performance off the March lows is a shift in leadership. The shift has been gradually away from FAANG (Facebook, Amazon, Apple, Netflix, Google) names that crowd the top of the broader indices, like the S&P 500, and into the less talked about sectors including Materials, Industrials, Transports, etc. We have not become bearish on growth companies, but we feel that their high valuations have pulled forward much of their growth prospects and that their share price will likely underperform in the future.

Here is a snapshot of performance of different market sectors from the market bottom on March 23 to December 1, 2020, as measured by Exchange-Traded Fund (ETF) performance:

Industry Sector

ETF

Total Return from 3/23/2020 - 12/1/2020

Rank

3/23/20 – 12/1/20

Rank

YTD

Materials

XLB

88.85%

1

3

Industrials

IYJ

85.86%

2

4

Transports

XTN

84.76%

3

7

Technology

IYW

82.40%

4

1

Discretionary

XLY

81.30%

5

2

Emerging Markets

EEM

63.33%

6

6

Financials

XLF

62.75%

7

9

Energy

XLE

62.60%

8

11

Healthcare

IYH

53.21%

9

5

Utilities

XLU

44.50%

10

8

Staples

XLP

39.97%

11

10

Source: Bloomberg | Past performance is not indicative of future results.

We are not trying to draw conclusions from such a small amount of data measured over a very short timeframe; rather we are simply using the data to point out the shift that we expected to materialize.

It is even more telling to look at a longer chart of commodity prices. Below is a 10-year chart of the Bloomberg Commodity Index. This chart shows the index is just breaking out of a very long-term bear market. For the reasons we outlined in January 2020 as well as the ones discussed herein, we believe that the commodity bull market is in the beginning innings.

10-year chart of the Bloomberg Commodity Index

Source: Bloomberg, 10-Year Chart of Bloomberg Commodity Index Just Breaking Out?

Three Major Tailwinds Keep Positive Trends Gaining Momentum

There are really three simple trends that have become tailwinds that may propel commodity valuations higher in the next few years.

  1. Significant under-investment in replenishing the world’s stock of commodities over the past decade.
  2. Record monetary stimulus is flooding global economies with printed money thus weakening the purchasing power of major world fiat currencies.
  3. The pandemic has prompted a huge spike in demand to restore global economies with massive fiscal stimulus.

Over the past decade commodity prices have lagged with waning global growth. As demand waned against ample supply of things like copper, aluminum, lumber, fertilizers, etc., investment in finding new sources of these items was cut off. As current supply is used up and not replaced with new finds, the markets become vulnerable to any demand spikes. The pandemic caused a number of physical commodity markets to crash as demand shutdown overnight with the closure of global economies. The most notable is oil, which briefly traded near the closing of the March contract at negative $37 per barrel. This exacerbated the shortage of supplies as many providers ceased operations or were forced to reorganize operations in bankruptcy.

Governments around the world doubled down on central bank monetary easing (quantitative easing) taking interest rates to zero (if they weren’t already there) and flooding markets with liquidity. In the U.S., M1 – which is a measurement of currency in circulation – demand deposits and other checkable deposits rose an astounding 44.19%, from approximately $4 trillion to $5.733 trillion in a matter of months. A broader measure of monetary supply is M2 – which adds money market and savings deposits – which rose 23.21%. The sheer expansion of the supply of dollars dwarfed all prior monetary expansions on record.

Bloomberg, 5-year U.S. M1 Growth

Source: Bloomberg, 5-year U.S. M1 Growth | Past performance is not indicative of future results.

The net effect was to weaken the currency and spur spending by making money plentiful and cheap. Remember, a weaker currency makes U.S. goods and services more affordable in international markets. This also lines up with the Federal Reserve Board’s renewed quest to create significant and durable inflation.

Fiat currencies are weakening globally. A look at the dollar index (DXY) shows that the trendline has been clearly broken to the downside and further weakness should be expected. A weaker U.S. dollar, as measured against other global currencies, can be inflationary.

Bloomberg, 5-Year Dollar Index Trendline Broken?

Source: Bloomberg, 5-Year Dollar Index Trendline Broken? | Past performance is not indicative of future results.

All this fiscal and monetary stimulus has caused a spike in demand for commodities globally. Here in the U.S. we have seen it manifest itself as demand for single family homes, durable goods and technology. A typically reliable leading indicator of economic growth is copper. We have often referred to copper as “Dr. Copper, the commodity with a PhD” since it is used broadly in manufacturing everything from smart phones to automobiles and everything in between. Copper has been an earlier barometer of global growth spurts as it is generally one of the first commodities to experience a jump in demand. Copper is widely used in the manufacture of goods that are in demand in an expansion. Copper has reacted very bullishly from the pandemic lows in March. At the end of November, we saw copper hit an eight-year high in Shanghai on increased demand (Source: The Macro Strategy). We see the trend continuing for years as copper has become in short supply with no new feasible supplies likely available for years.

Bloomberg, 1 Year Copper Prices

Source: Bloomberg, 1 Year Copper Prices | Past performance is not indicative of future results.

Finally, demand is not just strong in the U.S. since China was the first to be affected by COVID-19 and the first to emerge from the pandemic. Asia is really leading the world in its return to economic growth. With interest rates at or near zero, money to borrow is plentiful and has never been more affordable. The Fed has been quite clear that in the U.S. rates will hover near zero until three things happen:

  1. The U.S. economy escapes a recessionary plunge and growth reemerges.
  2. “Full” employment in the U.S. economy returns.
  3. The inflation rate eclipses the Fed’s long-term target of 2% and it appears that the inflation is a durable trend and not fleeting.

We believe that demand will continue to grow for commodities as global economies climb out of the pandemic. Vaccines and therapeutics plus massive fiscal stimulus are having their intended effect on restarting growth. We see global Purchasing Managers Indices (PMIs) trending sharply higher, yield curves are steepening indicating impending growth and the contangos (situations when the futures price of a commodity is higher than the spot price) in the energy market forward curves turning into backwardations (the opposite of contango) indicating that supply excesses of crude are disappearing.

Green energy trends toward utilizing more and more electricity and batteries in autos, trucks, manufacturing and technology propels demand for the commodity used. For example, battery manufacturing uses large amounts of lithium and cobalt. Autos use steel, aluminum, copper, palladium and plastics. Smart phones use rare earth elements. “Plug-in” clean energy products use electricity, which is still largely produced using natural gas, coal as well as wind and solar.

We stress that this trend is global in nature. Better days for commodities likely equate to better days in emerging markets. Many emerging market economies are tied to prices of commodities which they produce and export. Examples would be Chile and copper, or Russia and oil. So, we believe investors don’t need to buy miners if they would rather own economies that depend on mining.

Conclusion

We feel strongly that the next super cycle in commodities has, in fact, begun and will likely last for years. The historically low ratio of commodity prices to equity prices that we outlined last year has begun to dissipate and a rotation into materials, metals and energy has begun. We stress that our best estimate is that cycle likely has years ahead of it.

 

CRN: 2020-1202-8785 R


This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

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