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A Primer On Commodity Supercycles, Inflation Where It Hurts

A Primer On Commodity Supercycles, Inflation Where It Hurts

Authored by Mark Burton, Thomas Biesheuvel, and Alex Longley via Fortune.com,

A surge in commodity prices has Wall Street banks gearing up for the arrival of what may be a new – an extended period during which demand drives prices well above their long-run trend. A major impetus is the massive stimulus spending by governments as they juice up their economies following pandemic lockdowns. The evidence includes surging copper and agricultural prices and oil back at pre-COVID-19 levels.

One theory is that this could be just the start of a years-long rally in appetite for raw materials across the board, but the reality is more complicated.

Commodity Supercycles

1. What are commodity supercycles?

A sustained spell of abnormally strong demand growth that producers struggle to match, sparking a rally in prices that can last years or in some cases a decade or more. For some analysts, the current rally is rekindling memories of the supercycle seen during China’s rise to economic heavyweight status beginning in the early 2000s. Commodities have experienced three other comparable cycles since the start of the 20th century. U.S. industrialization sparked the first in the early 1900s, global rearmament fueled another in the 1930s and the reindustrialization and reconstruction of Europe and Japan following the Second World War drove a third during the 1950s and 1960s.

2. What did the last one look like?

From around 2002, China entered a phase of roaring economic growth, fueled by a rollout of modern infrastructure and cities on an unprecedented scale. Suppliers struggled to fulfill surging demand for natural resources. In commodities, there’s often a time lag to get the product where it’s wanted since adding capacity, such as opening a new mine, doesn’t happen overnight. For more than a decade, materials including iron ore were in tight supply. Copper, priced below $2,000 a ton for much of the 1990s, broke $10,000 and oil jumped from $20 a barrel to $140.

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3. Who says this is another supercycle?

Among the bulls are analysts at JPMorgan Chase & Co. and Goldman Sachs Group Inc. The commodities rally will be a story of a “roaring 20s” post-pandemic economic recovery as well as ultra-loose monetary and fiscal policies, according to JPMorgan. Commodities may also jump as an unintended consequence of the fight against climate change, which threatens to constrain oil supplies while boosting demand for metals needed to build renewable energy infrastructure and manufacture batteries and electric vehicles, it said. Those include cobalt and lithium. Furthermore, commodities are typically viewed as a hedge against inflation, which has become more of a concern among investors.Play Video

4. Why might this not be one?

Longer-term trends point to a cooling down for some materials. For example, the energy transition that heralds a bright new age for green metals such as copper would be built on the decline of oil. Even producers of iron ore, the biggest market of mined commodities, expect prices to weaken over time as Chinese demand starts to decline and new supply comes online. It’s an even bleaker outlook for coal, with producers looking to exit the market altogether as the world switches away from the heavy-polluting fuel. Iron ore, coal and oil were the chief beneficiaries of China’s industrial expansion. Those markets dwarf copper in scale.

5. What’s been happening with oil?

Prices collapsed in 2020, even turning negative at one point, but have recovered as demand rebounded more strongly than many had expected. Early in 2021, the Organization of the Petroleum Exporting Countries and its allies were holding back crude equivalent to about 10% of current global supply. Market fundamentals have shifted, especially in the U.S. with the emergence of shale oil. Haunting traditional producers is the prospect that a prolonged period of high prices would trigger a new flood of supply beyond OPEC’s control. Even so, some oil bulls aren’t ruling out the eventual return of prices above $100 a barrel.

6. Which other commodities are rising?

Copper was on a tear in early 2021 thanks to rapidly tightening physical markets as governments plow cash into electric-vehicle infrastructure and renewables. Goldman Sachs, BlackRock Inc., Citigroup Inc. and Bank of America Corp. saw the metal moving toward all-time highs. While agricultural commodities have their own particular dynamics, soybeans and corn have rallied to multiyear highs, driven by relentless buying from China as it rebuilds its hog herd following a devastating pig disease. Agricultural prices are more dependent on global economic and population growth, rather than the decarbonization trend underpinning excitement in metal

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They Call It A Commodity Super-Cycle, What Does That Even Mean?

They Call It A Commodity Super-Cycle, What Does It Mean?

So they have come up with a new name for inflation blowing out producer prices, a commodity super-cycle. This doesn’t have to be destructive as long as you are paying attention to our rapidly changing world. My chief concern in all of this is actually the government. I fear they will come in a wreck the entire economy and control what they don’t destroy.

Commodities have been suppressed for a long time and we have already begun to see the beginning fragments of the super surge. Energy prices recently went insane crush families and small businesses alike and the elite are telling us this was just a prequel of what is to come.

By Variant Perception

There are three big drivers of the commodity supercycle:

  • The long era of monetary-policy dominance is over, leading to a heightening of inflation risks not seen since the 1960s
  • Investors are deeply underweight and will need real assets such as commodities as a hedge against inflation
  • Commodities are generationally cheap, both compared to themselves and to other assets

It is rare in macro-forecasting when the stars align so perfectly. The combination of substantially different inflation risks, capital scarcity across several commodity sectors, and 50 years’ of underperformance compared to financial assets make commodities one of the most compelling long-term investment opportunities at the moment.

Commodity Super Cycle
Chart Source: Bloomberg, Macrobond and Variant Perception

Policy Drivers of Supercycle

The convergence of fiscal and monetary policy represents a profound change to the investment landscape.  Monetary policy, hitting up against zero rates and with central banks’ balance sheets already bloated, it is becoming ever more incumbent on more fiscal policy to boost economies and inflation.

But policymakers should be careful what they wish for.  Large government deficits financed by pliant central banks have preceded every high and hyper-inflationary episode of the 20th century, from Weimar Germany in the 1920s, to Hungary in the 1940s, to Argentina in the early 1990s.  QE has lulled people into a false sense security as it was not inflationary.  QE created a supply of dollars, and relied on the banking system to “transmit” those dollars.  But a private sector still licking its wounds from the financial crisis did not want to borrow, and banks did not want to lend, which meant borrowing and therefore inflation did not sustainably pick up.

Chart Source: Bloomberg, Macrobond and Variant Perception

The pandemic accelerated a trend that was already in place: the increasing impotency of QE.  Now we need QE combined with large government deficits, which is a very different beast to QE on its own as it creates supply of money and a simultaneous demand for that money.  History shows this has much greater inflationary potential.

Changing Inflation Regimes

We are shifting from the “Lake Regime” to the “Ocean Regime”.  In the Lake Regime of the last 20-30 years, cyclical moves in inflation were contained and containable as monetary policy on its own still had teeth.  But in the Ocean Regime, where we are today, the underlying risks to inflation have shifted, and garden-variety moves in inflation have a greater likelihood of becoming unanchored and disorderly.

Source: JMW Turner

This does not mean inflation is imminent, but it does mean any short-term rise in inflation could turn into something longer-lasting and persistent.  However, the nature of inflation is that it does so abruptly and with little warning.  It is just like how Ernest Hemmingway described how one goes bankrupt, “first slowly, and then suddenly”.

What Should You Do?

This is why action must be taken today to make portfolios more inflation-resilient.  Looking to the high-inflation 1970s, commodities were the only major asset class to deliver a positive real (ie inflation adjusted) return.

Chart Source: Bloomberg, Macrobond and Variant Perception

When we combine this structurally positive backdrop for commodities with a capital-cycle analysis the case for commodities becomes more compelling.  In short, sectors suffering from capital scarcity tend to outperform as lack of competition causes returns to fall below the cost of capital.

Source: Capital Returns

Based on our analysis, several sectors in the commodity space, such as gold and silver mining, integrated oil and gas, and copper are among the most capital-scarce sectors globally.  Underinvestment in supply means these sectors will not be able to respond to the strong recovery in demand we should see this year as the world emerges from the pandemic.

When demand meets excess supply of dollars meets an investment community severely underinvested in real assets such as commodities, the only thing that can respond is price.  This is what we have been seeing, with commodities up 43% since April last year.

Commodity Super-Cycle
Chart Source: Bloomberg, Macrobond and Variant Perception

The shorter-term gains may be behind us, but the potent structural backdrop for commodities and real assets we have outlined support a much longer-lasting commodities supercycle that is beginning.

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