A new commodity boom
Commodity prices are booming. This is consistent with strong growth, equity outperformance and rising long-term yields. It is also a reason why people are worried about inflation. One thing for investors to think about is the commodity intensity of the carbon transition – we need different natural resources to oil, gas and coal – but the needs are still significant. This has implications for how investors manager their ESG portfolios but also for expectations on future commodity price levels. With carbon prices also rising, the transition to net zero could have some interesting inflationary implications. That is an inevitable result of internalising the costs of saving the planet! In the end, a price worth paying.
The world is experiencing a commodity price boom. It is consistent with rapid growth and global businesses striving to rebuild output and inventories. Demand, at least in the major economies, has been supported by government assistance and liquidity provision. It is typical that as demand recovers after a recession, it does so more quickly than supply which, in the case of commodities, is relatively inelastic. Hence price pressures and backwardation in commodity markets (the situation where spot prices are higher than futures prices). This early cycle price pressure usually gives way to a normalisation of commodity markets as supply increases and the futures curves move back to contango (where futures prices are higher than spot prices). But this process takes time and in this cycle, it could take longer than usual.
Pedal to the metal
In addition to the reopening surge in demand, there is also the structural demand for commodities related to increased investment in communications and digital infrastructure, electrification of transport and investment in renewable energy and smart energy grids. Copper, lithium, nickel, and cobalt are all metals essential for the shift to a lower carbon economy. All have seen significant price increases so far in 2021. No wonder the materials index of the S&P500 has outperformed the market by 8% so far this year. It’s similar story in the UK where the industrial metals share price index has outperformed the FTSE100 by 10% year-to-date. The members of such equity sub-sectors don’t always have the best environmental, social and governance scores (ESG) because of the legacy businesses (coal, for example) and the impact of mining on the environment. Yet they can’t be ignored because of lot of what they mine is essential to the transition. I won’t address that issue in depth here, but it requires a smarter and more dynamic approach to responsible investing than just exclusion policies. There are metals that are essential to solar photovoltaic generation, to wind power, to carbon capture and storage and to electric vehicle and battery production. Suffice to say, increased demand for these resources needs supply to be expanded and producers need capital in order to do that. We perhaps should be prepared for certain commodity prices to remain high for some time.
It is not just basic commodity prices that are rising. Commodities need to be shipped to points of production and consumption. Shipping capacity has not been able to respond quickly to the bounce in demand given that ships were “mothballed” during the depths of the pandemic and because of the delays caused by the Suez Canal shut down early this year. The Baltic Dry Freight index is a composite measure of shipping freight costs widely used as a global trade indicator. It has risen by 139% so far in 2021 and currently stands at its highest level since the global economy emerged from the financial crisis in 2010. The cost of commodities is up, and the cost of transporting commodities is up.
There are plenty of other lights flashing on the “inflation-alerts” board. Semi-conductor supply is impaired and DRAM prices have shot up this year. Many of the mega-tech companies and electric vehicle leaders have noted the seriousness of the chip shortages and warned of production cuts as a result. In the US ISM index of manufacturing companies, the prices paid index in April came off a little but still stands at a reading of 60.7 which is the highest since 2004 and, before then, since 1984. Lumber prices are off the charts relative to their history and of course energy prices have shot higher since the drama of oil futures prices turning negative last year. Bringing it back to the energy transition, carbon credit prices on the European Union’s emissions trading system hit €50 per metric tonne for the first time ever this week. Rising traditional energy prices and carbon hedging costs should help accelerate the transition to more renewables, but that in itself increases demand for those commodities that are needed in the renewables sector. Higher inflation will be the cost of internalising the external costs of fossil fuel combustion, at least for a while.
How elastic is labour?
Central banks continue to argue that the inflation we are readying for will be transitory. Inflation bond markets believe them so far with longer-term break-evens stabilising. The standard argument from economists is that, while there maybe frictional inflationary pressures in basic materials, there is no shortage of labour or opportunities for global supply arbitrage in manufactured goods and services. As I was writing this, the weekly US jobless claims data was published for the week ending May 1st. There were still half a million new claims for unemployment insurance. Before the pandemic, this was running at less than half that level. The Labour Department in the US also reported that there are close to 3.7mn people registered as “continuing claimants” for unemployment insurance. I will publish this note before the April non-farm payroll data is released but the consensus is for the unemployment rate to have fallen to 5.8% in April on the back of another strong month of job growth. Yet this is still an unemployment rate well above pre-COVID levels. It remains to be seen how fractured global labour markets were by the pandemic and whether their flexibility has been challenged to the extent that re-opening will run into staff shortage problems and force wage rates higher. On the basis of the data, labour markets still have some slack which would argue for limited wage inflation. We will see.
In the UK there are plenty of anecdotal stories of staff shortages in the retail and other service business sectors (I tried to visit a cycle shop last Monday and it was closed for 2 hours because of staff shortages). Brexit has led to the departure of EU citizens that populated many jobs in coffee shops, retail outlets and restaurants. The most recent weekly earnings numbers are still distorted by comparison with a year ago but if the y/y remains close to 4.5% it will be a concern for the Bank of England. In its latest policy announcement, it said it was too early to tighten policy but that it would stop asset purchases by the end of 2021. That was no big surprise but it’s a sign that we will gradually move towards some kind of reduction in monetary accommodation in the coming years. The big risk to markets is that bonds and central banks have misjudged the inflation picture and it is going to be more than transitory. Investors should be prepared for another “inflation-monetary tightening-bond sell-off” shock at some point.
How to invest in a commodity boom
Taking it for a given that the rise in commodity prices is consistent with reflation and a period of above trend growth as demand is mobilised, what other investment themes are likely? Historically, equity returns have been positively correlated with commodity price increases while bond returns have been negatively correlated. The logic is that higher prices raise inflationary expectations and central banks need to raise rates. Within fixed income, short-duration strategies, inflation linked, and emerging market debt have historically been better performers than high quality interest rate sensitive bonds. On the equity side, a more value, cyclical bent is worth considering given that the rise in commodity prices provides a short-term earnings boost to the most cyclical parts of the economy. I have already mentioned the outperformance of basic materials and mining stocks while there needs to be a more selective approach to industrials given the cost increases that many businesses will face. However, the Q1 US GDP report revealed just how strong investment spending was at the beginning of the year. With inventories run down, this should continue. This will be to the benefit of the broader intermediate goods suppliers, including technology. On the FX side, currencies like the Australian dollar, Canadian dollar and Chilean peso should benefit from higher prices for metals.
Prices and decarbonisation
The medium term picture is interesting if my earlier discussion about commodity prices and the energy transition has validity. Technologies that can deliver more efficient use of basic metals in things like solar panels and electric batteries will be well rewarded given the scarcity of those natural inputs and the risk of more focus on the environmental impact of their extraction and transportation (not to mention national security considerations and their global geopolitical significance). I often come back to thinking about the potential of hydrogen as a major energy source for industry and for long-distance transport and how the value chain for green hydrogen offers potential investment opportunities. Much of the shift to a zero carbon emissions economy relies on more and more creative uses of finite resources. Hydrogen, generated by renewable energy mostly needs sunlight, wind and water (and some very clever technology and chemistry). History is full of examples of how price developments and technological processes are intrinsically linked in economic progress. What we are seeing in commodities today is very much part of this story. Economists and investment strategists will have plenty to say in the coming years on this topic. Chemists, engineers, and physicists will have plenty of work.
Winning the English way
Three of the major soccer leagues in Europe will be won by teams that made up the twelve clubs that wanted to form a European Super League. It is possible that both major UEFA knockout competitions will also be won by teams from that group. Six of the twelve were from England and those teams currently occupy four of the top six league positions in the Premier League. In Spain, the three members of the twelve are the top three in La Liga and in Italy the three “Super Leaguers” make up three of the top four spots in Serie A. For fans, winning the domestic league and challenging the best from other teams in Europe (including those from Germany, the Netherlands, Portugal, and France, amongst others) is what creates excitement and enthusiasm for the current pyramid structure. Thankfully, the idea has gone away for now. Anyway, it looks like the EPL is the Super League with English teams making up 3 or 4 of the 4 finalists in the Champions’ and Europa League finals. City, Chelsea and United got there on merit. Barca, Real, Atletico and the Italians didn’t. Try harder next year amigos!