Commodities and Supercycles
Commodities and Supercycles
Commodities represent one of the most reliable indicators of the global economy, but what are they exactly? Explained in just 8 minutes!
What the Commodity?
Commodities are widely available basic goods that are substantially fungible and typically treated as equivalents regardless of who produced them. Commodities are typically mass-produced, used as inputs for mass production, and part of the mining, agriculture, and forestry industries as well as in the extraction of raw materials.
There are three types of commodities:
Soft or grown: wheat, sugar, rice, and beef
Hard or mined: oil, gold, and copper
Energy: electricity and fuel
When exchanged, commodities must meet certain specified minimum standards or grading typically referred to as a basis grade, which changes annually.
Why should I care?
The global commodity market is estimated to be worth upwards of $20 trillion (roughly the size of the U.S. economy). Commodities are a fundamental part of the economic machine as they represent the raw materials behind most of the products and services we consume daily.
Secondly, to the investor, commodities are typically seen as a hedge for inflation. As inflation accelerates and the prices of goods rise, commodities tend to follow suit. As they rise with inflation, they remain neutral against the decreasing purchasing power of the underlying currency, which is why commodities represent one of the most reliable indicators of the global economy.
Introducing Mr. Market’s confidante, Dr. Copper:
Copper is utilized in virtually every sector of the economy and in everything around us (e.g., consumer goods, machinery, construction, transportation equipment). Due to its ubiquitous nature, analysts across the financial sector look to copper (Dr. Copper that is, and yes, he has a PhD in economics) as a bellwether for the global economy. Unlike Mr. Market, Dr. Copper is (slightly) more emotionally stable and fairly grounded in the economics of supply and demand – often able to diagnose which cycle the economy is currently in. For example, when demand for copper falls, prices are likely to follow, indicating an economic recession may be on the horizon.
What commodities tell us about the economy:
Commodities are cyclical in nature, with fluctuations above and below their long-term price trends for extended periods of time (roughly 5-15 years), which are known as upswings and downswings.
Upswing: The current price of a commodity is above its historical average.
Downswing: The current price of a commodity is below its historical average.
Upswings occur due to a lag between supply and demand. Demand upticks fast (consider the rise in demand for lithium due to the demand for electric vehicle batteries), while supply lags to respond (a lithium mine can’t be built overnight). As a result, prices rise.
Higher prices and stable operating costs lead to increased margins. In turn, suppliers invest in developing additional materials to benefit from those higher earnings. As supply increases and satisfies the demands of the market, prices begin to drop and the commodity enters into a downswing.
The Commodities Supercycle!
A commodity supercycle is defined as a “decades-long, above-trend movement in a wide range of base material prices” derived from structural changes in demand. Essentially, numerous commodities are moving in the same direction, at a somewhat similar pace.
Supercycles are historically driven by rapid industrialization and population growth, which causes a demand for urbanization, infrastructure, and food. As demand for these raw materials grows faster than the speed at which they can be produced, prices tick upwards and the cycle begins.
Mass industrialization and rearmament have triggered the last 4 commodities supercycles:
1890s - 1930s: Industrialization of the United States in the second half of the 1800s
1930s - 1960s: Global rearmament prior to the Second World War
1960s - 1990s: Reindustrialization of Europe and Japan – also aligned with the US’s “War on Poverty”, Cold War, Korean War, and Vietnam War.
1990s - Present? Southeast Asian sustained population growth and rapid industrialization (particularly China and BRICs).
The Bank of Canada leverages a statistical approach called an asymmetric band-pass filter in their commodities price index (BCPI) to identify the larger trends of commodities. The Bank tracks 26 commodities that are produced in Canada and sold globally. Numerous investment banks have created their own commodities price indices so as to follow and identify overarching trends.
The chart below illustrates the 6 commodities supercycles since 1805; each of which lasted roughly 25-35 years. In a way, these supercycles tell the story of human development.
As the world becomes further globalized and interconnected through trade, cycles have become shorter and more volatile. Historically, only a handful of countries or regions have experienced rapid growth or industrialization at any given time. This asymmetric distribution of demand limited the upward and downward swings. Today, nations are simultaneously increasingly globalized and growing, which creates increasing pressure on suppliers to deliver raw materials leading to higher prices and larger swings.
Closing in on the 30 year mark... Time for a new supercycle?
Recently, Goldman Sachs, S&P, JP Morgan, The Economist, and Business Insider have started talking about the new “supercycle.” Is it a marketing ploy or an actual structural trend? The timing is eerily similar to past supercycles with the pandemic acting as the trigger and governments worldwide pushing for massive changes in manufacturing and industrial processes.
Pandemic trigger: Stimulus packages and inflation-friendly policies
As the Coronavirus pandemic halted global travel in 2020, energy-related commodities were devastated (WTI Oil prices turned negative in April 2020). Countries began lowering interest rates and issuing unprecedentedly large stimulus packages causing precious metals like gold and silver, which are typically considered safe haven assets, to uptick since they thrive in times of uncertainty and economic turmoil.
Governments around the world are interpreting the pandemic as a humanitarian and social crisis rather than a financial one. Policymakers are currently focused on driving full employment and providing financial support to low-income households (a.k.a. stimulus checks) through massive aid packages and unprecedented fiscal and monetary policies.
Small businesses and low-income families are more likely to spend the additional income provided by government aid and help jumpstart the overall demand for goods and the commodities needed to produce them. Additionally in the coming years with wages expected to continue rising generating additional disposable income, analysts expect commodity-intensive sectors like construction and the light industry (e.g., house appliances) to flourish.
Hedging inflation drives up demand for commodities
As central banks continue exercising expansionary monetary policy (i.e., lower interest rates, quantitative easing, and increased money supply) to support the economy, the same policies also weaken local currencies and may increase inflationary risks. As a result, savvy investors typically look to hedge against inflation by buying commodities that are considered safe havens. Foreign investment typically upticks because commodities are denominated in U.S. dollars and a weakened U.S. dollar makes commodities cheaper to obtain (see below the inverse relationship between the strength of the U.S. Dollar vs. the CRB commodities index, USD = Green, Commodities = Blue).
Additionally, with wages rising and a potential doubling of the minimum wage in the U.S., some experts argue that the wage-price inflation spiral may occur; further contributing to inflation.
The Green Revolution
Experts believe that the global pandemic recovery may be strongly spurred by climate change related policies that will spur a renewed industrialization process (think the Big Push in China that made it the world’s second largest economy, but green and global). The U.S. has declared climate change a national emergency, rejoined the Paris Agreement and prioritized environmental issues in its agenda. China and Japan recently committed to carbon neutrality by 2050 and 2060 respectively, and the U.S. has urged China to incur tougher emissions targets as well. The globally synchronized decarbonization push seems like it will begin shortly.
Goldman Sachs estimates that the capital expenditure driven by decarbonization efforts could be similar to that of emerging markets during the early 2000s; generating $1-2T in annual investment in infrastructure over the next decade. As demand for low-cost renewable energy is prioritized by governments globally, and carbon permits continue to rise to record prices, the price of fossil fuels increase further driving demand for clean energy. Additionally, fossil fuel companies may look to maximize returns on their existing portfolio in a “last hurrah”, while looking to invest in a more diversified playing field.
Lastly, recall that upswings are often a result of a rapid increase in demand with slow to respond supply. Over the past decade, industries that grew rapidly during the industrialization processes of the last century (e.g., mining) with little reliance on technology have been aggressively slashing their exploration budgets. Throughout the pandemic these “old economy” industries have focused on short-term survival over capital investments; meaning, supply is limited and hasn’t grown in capacity. As demand is expected to surge shortly, these suppliers will have to scramble to adapt and may create the lag necessary to trigger an upswing.
So, is it a supercycle?
The short answer? Time will tell; hindsight is 20/20 after all. The counter position argues that the key drivers of this potential supercycle – the Green Revolution and the global unemployment recovery – may not happen as fast as it has in the past, or at least… as fast as investors think it will. A global energy transition is unlikely to boom overnight, especially on the backdrop of continued economic deterioration.
What’s an investor to do?
It doesn’t matter whether analysts believe it is enough to deem it the beginning of a commodities supercycle or if the current trends meet the technical definition of a supercycle.
What matters is that the current macroeconomic context sets up a strong argument for a years-long boost in commodity demand. For the curious investor, there are numerous ways in which to capitalize on the expected commodity upswing. Consider:
Broad approach: with exposure to commodities indices
Inflation hedging approach: via precious metals
Short-term movements: in industrial metals and non-renewable energy
Long-term growth targets: with exposure in clean/renewable energy and rare earths
See the February 16, 2021 edition of The Curious Investor for specific targets or check out the WTM Tracker
interesting article about commodity.