Category: Markets

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Macro Minute: Commodity Inventories

A quick note on commodities… Historically tight inventories have led to all six base metals (Aluminum, Copper, Nickel, Lead, Tin, Zinc) listed on the London Metals Exchange to trade in backwardation for the first time since 2007.

Of those six, some of the tightest markets are in Aluminum, Copper and, especially, Nickel, which has the largest deficit in its history. Using the average daily production of each metal and aggregate inventories across Shanghai, London, and United States metal exchanges, we estimate global aluminum inventories to be approximately 5.8 days of production, copper at 2.2 days of production, and nickel at just under 13 days of production. Actual daily draws from exchange are variable, but this illustration speaks to the level of tightness in the market.

All but tin have upside to the levels reached in the last period of backwardation across the sector, after adjusting metal prices for inflation.

Bear in mind that while the price run-up in 2007 was also the result of a supply shock, albeit for different reasons, there was a sharp decline in demand caused by the bursting of the housing bubble and onset of the Great Financial Crisis, just as more supply began to come to market. The setup this time appears to be different. Persistent underinvestment in commodity extraction over the past decade, coupled with increased demand driven by government net-zero goals rather than private industry (e.g., homebuilders), suggest that this rally could be much tighter for much longer. With EV penetration increasing around the world, including in China, where nearly 20% of new car sales are electric, and the fact that those vehicles require between 5-6x more metal than internal combustion engines, we could see pressures drive prices past 2007 levels.

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Special Report – A Changing Paradigm

As an investment philosophy, we believe that the best way to deliver above-market returns is to find something cheap, take a position, and hold it for the long term. We tend to avoid market timing and “short-term” investments.

Looking across asset classes, we find that many equities are overpriced on a historic basis by virtually every metric and expect future returns to be much lower than in the past decade, save for a couple of undervalued sectors like energy and materials. When the stock market is on fire, as it has been almost non-stop since 2008, investors ignore companies that specialize in raw materials and other goods. With investors too distracted by their ever-increasing portfolio of technology companies, there was a loss of interest in investing any money in increasing the productive capacity of raw materials, agricultural products, and other hard assets.

In real estate, housing around the world is already too expensive to represent a compelling investment. In the US alone, the S&P Case-Shiller Home Price Index sits a lofty 26 percent above its 2006 peak, with a 17 percent increase year-over-year for the nine US Census divisions. To put this in context, housing prices have been rising more than 5 percent above inflation for the past decade.

Products like copper and lumber seem expensive but as an asset class, commodities are the cheapest. When you factor in inflation, even after the recent run up in prices, most commodities are trading closer to their historical lows. We will further explore this asset class in detail in future reports.

Figure 1: Inflation-Adjusted Commodity Prices

Bonds have never been this expensive in history and are clearly in a bubble. As we write this letter, 10-year real yields in the United States are at their historical lows of -1.2 percent. With the Fed’s new inflation targeting policy of slightly above 2 percent, real rates could still theoretically go down to somewhere slightly below negative 2 percent, assuming the Fed cannot reduce nominal interest rates meaningfully below zero. However, for that to be true one needs to accept that we are living through some type of global secular stagnation[1] process, from the demand or the supply side.

Herein, we hope to show that such a scenario is extremely unlikely. First, we believe it highly probable that the environment of slower growth and inflation from the past few decades has more to do with a series of temporary “headwinds” arising mostly from consecutive deleveraging processes caused by the fact that almost all recent crises were balance sheet crises, and therefore deflationary. Secondly, we argue that even if we were living through secular stagnation before, we are not anymore. The underlying forces in play for the past few decades began reversing around 2015, and the Covid crisis created a catalyst for an acceleration of these forces.

If you wish to receive a full copy of this report, including our directional views across asset classes, please contact [email protected].

[1] Secular stagnation is defined as a prolonged period of low growth. While prolonged and low are not further specified, many economists define low as an average annual real output growth rate of no more than one to 1.5%, and prolonged as covering at least several business cycles. The term secular does not require stagnation to persist forever.

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2021 Annual Report

When observing macroeconomic trends, we separate our thinking between short-term credit cycles and the impulses impacting them versus slower-moving, long-term credit cycles and the prevailing policy drivers for their behavior. A tertiary layer that has been gaining steam for the better part of the past decade and is now firmly entrenched as a key driver of economic activity, market behavior, and our investment theses is sustainability. As we look ahead into 2021, we believe that we are at, or very near, a rare inflection point involving each of the three aforementioned factors that will reshape the landscape for investors globally. In the subsequent sections, we will discuss at length our views on each of these three pillars, but a summation of the key points can be found below:

  • The coronavirus pandemic caused the sharpest contraction of United States GDP and rise in unemployment of any recession since the Second World War, which resulted in an unprecedented level of fiscal and monetary support in most developed markets.
  • A combination of vaccination rates and the effects of the policy response has created an environment where cyclicals and services could benefit from the large increase in excess household savings and the most pent-up demand since the 1920s.
  • Commodities will play an important role in all of our investment horizons. In the short-term, supply-demand mismatch and supply chain disruption could provide upward pressure on the asset class, while rising oil prices might stymie consumers ability to spend on goods and services. In the medium-term, large increases in money supply used to finance government deficit spending could cause inflationary pressure to further increase commodity prices and in the long-term, government net-zero policies might result in higher carbon costs, which could raise soft commodity prices, as well as greatly increase demand for a new set of commodities integral to developing a clean energy complex.
  • Globalization has been driven by global demographic trends and trade policies since the 1980s that are slowly reversing due primarily to the working age population in China peaking last decade.
  • Labor market integration caused lower wage inflation which led to lower inflation globally. Central banks responded by progressively lowering interest rates, driving asset prices higher and causing balance sheets to expand rapidly relative to income.
  • Economic inequality across generations as voting demographics change in developed markets could lead to a redirection of capital and will influence the rate at which balance sheet issues are resolved.
  • Recent growth in sustainable and responsible investing strategies has been parabolic but encompasses a wide range of implementations. Limiting one’s investable universe through exclusion or negative screening reduces potential Sharpe ratios, while integrating material sustainability information as part of a holistic analysis of individual companies, countries, and commodities boosts them.
  • Given current government positioning, climate change mitigation and adaptation will likely be a key driver of secular trends for the coming decade. Large investments will be required to increase end-use efficiency and electrification of transportation and buildings, generate and transmit renewable energy, develop bioenergy and other carbon-free fuels, capture and store carbon dioxide, reduce emissions, and increase land sinks. Each of these verticals can shape the future path of equity, credit, and real asset prices if net-zero goals are to be met.

To arrive at these views, we have done extensive research that involves proprietary information and third-party data. If you are interested in a full copy of the report, please contact [email protected].