Hot Commodities
Oil is up 20% year-to-date; gold 16%. Cocoa is up over 150%. The point is that many important commodities have had a lively start to 2024. The Bloomberg Commodities index measures a broad basket of commodities including energy, agriculture, precious and industrial metals is up around 6%; less than you might think given the prior statistics.
There are several narratives that one could attribute to the moves. For example, geopolitical tensions from Ukraine to the Middle East and beyond could be construed as supportive for gold and oil prices. Speculation around rate cuts in the US when inflation remains stubbornly present could be fuelling demand as an inflation hedge. However, rather than speculate on the future path of prices we prefer to focus on the issue from the perspective constructing the optimal portfolio.
Commodities and related investments often have de minimis representation in investment portfolios. There are many reasons for this, primarily that they’re had a pretty rough decade in terms of performance. With the increasing dominance of technology in major equity indices representation for Energy and Materials combined for the S&P 500 is only around 6.5%. However, from a portfolio construction perspective, their importance weighs much heavier. The fundamental reason for this is that commodities and related investments tend to do best when most other assets in your portfolio do worst. The driver for this is that inflation tends to be supportive for these assets where it is kryptonite for most financial assets, especially bonds. The most recent example of this phenomenon was the calendar year 2022 where the S&P 500 fell 18%, long dated treasuries fell 31% while the S&P 500 Energy sector rose 65%.
The last sustained bull market in natural resources was in the early 2000s in the run up to the Global Financial Crisis (GFC) in what at the time was referred to as the “commodities super-cycle”. This was driven by insatiable demand from China in full swing. This meant that the commodity capital cycle was similarly expanding as companies responded to higher prices with investment to bring new supply on stream. The capex cycle in commodities is very long with new investment often taking many years or even decades to come on stream. When the bust arrived and demand took a hit, it did so at a time when supply was ramping up and given the price inelasticity in many of these markets, the impact on prices was significant. The lag effect of supply coming on stream meant that even as the economy recovered, commodities entered a protracted bear market, that would continue for another decade.
Today the situation could not be more different. This time the brutal commodities bear market has seen capex in these sectors cut to the bone. This time there will be no aggressive supply response augmenting the weak demand in terms of price pressure. For the companies, capital discipline has been the order of the day and this, combined with the time lag for any spending to bear fruit, means there is little chance of that changing in the years ahead. In the GFC, the capex cycle and the economic cycle were reinforcing. Today they are working in the opposite direction.
Resource stocks and commodities are inexpensive when compared to financial assets. Large oil and materials extraction companies trade on low single-digit price/earnings multiples, indicating that the market has little confidence that the current commodity prices can be maintained. Prices of the underlying commodities don’t need to appreciate for these companies to make healthy returns, they only need to not collapse, which given the underlying demand-supply situation is highly unlikely. In a world where financial assets are expensive, at the very least resource stocks provide a significant margin for error. Furthermore, the returns the companies are making are not being squandered – capital discipline is strong with surplus cash flows being used to pay generous dividends and buy back shares.
The very long-term chart above shows both the opportunities and risks of commodity exposure. Despite the post-pandemic bounce, commodities broadly speaking are no higher now than they were in the 1980s and 1990s. The bounce this year doesn’t even register. Not much inflation protection there. However, investors in the underlying companies have done much better. The companies themselves still make plenty of money with commodities at these prices and investors can still harvest the equity risk premium.
The mindset that an investor should adopt is not so much predicting what they think will happen but more “what if” certain scenarios happen. The 1970s saw the Bloomberg Commodity Index permanently reset from 20 to 100 in the ensuing decades. What if this index shifts higher and maintains a level of 200 in the decades ahead? Or 400? How does my current portfolio look in that world? The answer for the overwhelming majority? Not good.