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Soaring Commodities: Supercycle or Superficial?

May 21, 2021

As financial markets fixate on rising inflation, one asset class garnering significant attention of late is commodities. We have written extensively on our view that a grinding commodity bear market would follow the oil price crash in 2014-15. This has largely played out as expected, with broad commodity indices staying relatively flat at depressed levels from 2016 to early 2020. After plummeting during the COVID-19 market panic, commodities have come roaring back to life; requiring us to challenge our existing hypothesis. The key question is: has COVID-19 ushered in a new commodity supercycle, or are we just witnessing a cyclical bounce?   

Beginning with the constructive outlook, infrastructure development is a key focal point of the synchronized and sizable fiscal stimulus announced by governments in major economies worldwide in 2020. “Green initiatives” are at the forefront, and overhauling electrical grids to support the proliferation of renewable energy sources should provide a structural boost to commodity demand. The global pivot to electric vehicle (EV) adoption will further this trend, as EVs are much more copper-intensive than traditional vehicles and expanding networks of charging stations will require additional resources. The commodity bear market of the past decade has discouraged capital investment, which will impair the ability of producers to quickly ramp-up a meaningful supply response.

However, numerous signs point to the current rally being transitory in nature. Pandemic-induced supply chain disruptions have put pressure on commodity prices, while a booming housing market in numerous countries (notably the US) has temporarily increased demand. In the short-term, rising financing costs (which generally track bond yields) may weigh on appetite for building projects. Longer-term, the world’s most critical source of commodity demand will ebb as China moves from an investment-driven to a domestic demand-driven economy.

Additionally, while the term “commodities” is a convenient catch-all, the underlying components of broad commodity indices are diverse. Despite its influence waning in recent years, energy still dominates, making up nearly 54% of the S&P GSCI Index. Per the chart below, energy has had an outsized influence on historical commodity index returns, as major events in the oil market have marked a number of critical turning points. Coordinated global efforts to reduce fossil fuel emissions thus provide a substantial headwind for the aggregate commodity market.

Given the above considerations, it is imperative to separate the various commodity sub-categories (energy, agriculture/livestock, industrial metals and precious metals) and analyze each individually. Currently, all are rallying in unison, which we believe is unsustainable. From a shorter-term perspective, the recent crash in lumber futures may provide a warning signal to the broader market that a cooling off period is both warranted and forthcoming. Accordingly, we recently decreased exposure to metals and mining equities. However, over a longer time horizon, we maintain a favourable view of industrial metals, which have the most compelling demand drivers. As for a new commodity supercycle, we expect a bifurcated scenario where the influence of oil and gas continues to decrease, while industrial metals increasingly gain commodity market leadership.

GLOBAL STRATEGY OVERVIEW

Cash

Given the structural overvaluation and counter-cyclicality of the US dollar (not to mention the US government’s burgeoning fiscal deficit), we remain bearish on the currency from a longer-term perspective. Conversely, on a shorter-term time horizon, the dollar has been oversold and rising US treasury yields will encourage capital inflows from “carry trade” and yield-starved fixed income investors alike. We remain underweight the US dollar in client portfolios, but have materially increased exposure to the currency this quarter.

Bonds

US high yield bonds are trading at historically low yields and tight spreads versus US treasuries, despite somewhat elevated default rates. In comparison, US dollar-denominated EM sovereign bond spreads are also tight, but not at extreme levels. With their superior credit quality, EM sovereigns offer a more attractive risk/reward trade-off. We have rotated out of US high yield bonds and added to hard currency EM sovereign bond exposure this quarter.

Equities

Global equities are in a bull market, rebounding significantly off of the lows reached in late-March of 2020. The “initial burst” recovery phase is likely nearing an end and underlying fundamentals (earnings growth and cash flows) now need to catch up to expectations. Equities could be in for a bumpy patch as the market reconciles predictions against realities. Given a constructive economic environment, we remain modestly overweight equities, but have further trimmed exposure this quarter.

Opportunities

Our expectations for rising industrial metals prices was rapidly affirmed by financial markets. With disruptions in mining supply chains during 2020, substantial fiscal stimulus earmarked for infrastructure projects and surging global growth expectations, metals and mining equities have staged an impressive rally. With much of the “good news” now discounted in the price, we have elected to take profits and step aside for the time being as the asset class is showing signs of overheating.

Gross-of-fees performance ($CAD) as of April 30, 2021. Returns for periods greater than 1 year are annualized.

Performance statistics for ETF Managed Strategies are calculated from documented actual investment strategies as set by Forstrong’s Investment Committee and applied to its strategies mandates, and are intended to provide an approximation of composite results for separately managed accounts. Actual performance of individual separate accounts may vary with average gross “composite” performance statistics presented here due to client-specific portfolio differences with respect to size, inflow/outflow history, and inception dates, as well as intra-day market volatilities versus daily closing prices. Performance numbers are net of total ETF expense ratios and custody fees, but before withholding taxes, transaction costs and other investment management and advisor fees. Past performance is no indication of future results. A rate of return for one year or less is not annualized.
Portrait of David Kletz, VP & Portfolio Manager of Forstrong Global.

David Kletz

Vice President, Portfolio Manager

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