Is it time for a fresh look at commodity investing?

Shaun le Roux

- Commodities are deeply out of favour globally, and local managers have also been bearish on prices.
- Looking back over the last 120 years there have been three periods of distinct outperformance by commodities compared to financial assets, and they coincided with economic recessions and even a depression.
- During these periods commodities (and other real assets) not only outperformed financial assets, but also offered portfolio protection against inflation.
- We argue that the conditions today closely reflect those scenarios and that the current global macro environment calls for a differentiated approach to managing portfolio risk and a shift from the default use of bonds in times of high volatility.
- We see good long-term investment opportunities in the commodity sector

Commodities are fundamental to the functioning of economies. In addition to their key role in the South African economy, resource shares are also an important component of our stock market. However, they can be quite volatile as they experience multi-year cycles and therefore their popularity tends to wax and wane over time.
Currently, commodities are deeply out of favour in global markets, and local fund managers have been persistently bearish on commodity prices over the past three years (according to the Bank of America survey). Nevertheless, we believe there are currently good investment opportunities in the commodity complex and they are underrepresented in most investment portfolios.

There are several reasons for pessimism in the market, key of which is long-term underperformance. Commodity prices have declined in real terms over the last decade while the US stock market has appreciated sharply over this period, dominated by the mega-cap growth stocks. The combined weight of energy and materials in US stock indices for example is dwarfed by individual stocks like Apple, Microsoft and Nvidia.

This is in part because of the concerns around the global macro environment with lingering recessionary fears in the US weighing on markets for a few years now. The Chinese economy has also faltered and its commodity-intensive property sector has been in sharp decline. China remains the single largest consumer of most commodities.

Environmental, social and governance (ESG) concerns have also hampered investment into the sector. The carbon intensity of mining and the push to wean the world off fossil fuels have removed or reduced ESG conscious investors from the pool of capital providers. New production also increasingly comes from less politically stable jurisdictions like the Democratic Republic of the Congo (DRC), which are not deemed as particularly investment friendly destinations.

Against this backdrop it is worth noting that history provides a valuable perspective. If, instead of focusing on the past decade, one zoomed out and looked at the past century, you would observe that there are a few periods where commodities (and other real assets) not only handsomely outperformed financial assets, but also offered portfolio protection against inflation.

Over the last 120 years, there have been three periods of distinct outperformance by commodities: the 1930s, 1970s/80s and early 2000s to 2010. Those periods coincided with economic recessions and even a depression.

As global natural resources investors Goehring & Rozencwajg put it: “A simple equally weighted portfolio of energy, base metal and agricultural stocks bought at the market peak in 1929 more than doubled by 1938 compared with the broad market that remained 50% lower. Indeed, owning commodity stocks throughout the Great Depression was the only way to preserve one’s wealth.”

We think those periods of superior returns from commodities over financial assets were characterised by three key conditions:
• Stock market indices were expensive in 1929, 1969 and 1999 and subsequent returns were poor. These periods were also characterised by concentrated markets where a select group of stocks came to dominate and drive markets higher.
• Global macro conditions were inflationary.
• The preceding decade had seen very limited investment in the supply capacity of commodity-extracting (old economy) sectors, with capital flowing to new economy and financial assets.

We would not only argue that each of these conditions exists today, but that there are a number of drivers of demand that should more than compensate for the potential economic headwinds over the medium term.

The transition to a lower-carbon world is very metal-intensive and the current projections of the metals required to build out the envisaged solar farms, wind turbines, electricity grids and electric vehicles will require significant new green metal capacity.

Looking towards the end of the decade – it is not currently clear how supply will meet the anticipated demand for transition metals like copper. We therefore expect the markets for most commodities to be tight over the medium term, given the persistence of underinvestment in capacity and likely sources of demand.

Given healthy fundamentals and low valuations, our clients have relatively high exposure to a number of commodity-related themes. An added benefit of gold and energy securities is the portfolio protection they offer against many of the likely future macro risks. We have also leveraged our global process to identify several opportunities outside of the JSE, especially in the energy and shipping sectors.

We have furthermore taken a non-consensual view that the outlook for the platinum group metals (PGM) sector is favourable from current levels. We think market participants are overly focused on the demand implications of highly optimistic future penetration rates for electric vehicles (EVs). Positioning is very bearish, and we are seeing all-time highs of investors taking speculative short positions in palladium. We think that after a period of aggressive destocking by purchasers, supply constraints and deficits will force an inflection in the months ahead.

Ultimately, we believe that the current global macro environment calls for a differentiated approach to managing portfolio risk. Whereas many market participants still default to G7 bonds as a means of reducing portfolio risk, we argue that we are in a macro environment in which bonds and equities are likely to be positively correlated.

Real assets are going to play a very important role in protecting a portfolio against inflation in times to come, and while resource stocks can be volatile over the shorter term, we remind investors that this volatility works both ways and that commodities can offer protection and upside in an environment where expensive, well-owned financial assets start to struggle.