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While most investors have their eyes on the Nasdaq or Bitcoin, it is interesting to note that the best performing asset class since the beginning of the year (excluding cryptocurrencies) is commodities. The price of Brent crude oil is back above $60 a barrel, copper is at an 8-year high, and palladium is back to where it was 6 years ago.
After being shunned in asset allocations for more than a decade, the idea of a return to grace for commodities is starting to gain momentum among strategists. Indeed, JP Morgan has just published research according to which commodities have started a new “super-cycle.”
Last October, we argued that certain conditions were indeed in place for a permanent turnaround in the commodity cycle. What is the situation today?
A brief history of commodity super-cycles
As a reminder, this asset class tends to evolve in relatively long cycles. In the 1990s, the rise of the “New Economy” was thought to mark the end of commodity dependency. The S&P GSCI Commodity Index experienced a spectacular bear market that began after the first Gulf War. But the bursting of the technology bubble in 2000 put an end to the bear cycle. A bullish super-cycle for commodities then began. The great financial crisis of 2008 marked a new trend reversal leading to a long period of underperformance of commodities. At the end of 2020, commodities reached a new low relative to equities.
The relative performance of the S&P GSCI vs. S&P 500
The last decade is indeed characteristic of a “deflationary boom.” Against a backdrop of low or even negative interest rates and sluggish growth, investors rushed to invest in bonds and growth stocks in developed countries, to the detriment of value stocks, emerging countries, and commodities (except for gold).
These asset allocation preferences have become even more pronounced since 2015-2016. While the economic recovery should have accelerated, a series of events–Brexit, trade wars, and the pandemic–have effectively postponed the end of the deflationary cycle. Fiscal austerity in the developed world and the Federal Reserve‘s missteps in 2018 certainly played a prominent role in the underperformance of the real economy as excess liquidity took refuge in fewer financial assets.
Towards a permanent trend reversal?
Let us start with the signals emitted by the financial markets themselves, the so-called “internal indicators.” For example, copper, a metal often dubbed “Dr. Copper” by investors because of its ability to anticipate the economic cycle, is up 70% from its March lows.
Since November, the outperformance of cyclical sectors over defensive stocks is also noteworthy, particularly the energy sector, which has gained more than 50% since the beginning of November.
Also noteworthy is the very strong recovery in freight rates for containers. For example, the cost of shipping between Asia and Europe has tripled since November due to under-capacity problems.
Finally, there is a certain macroeconomic logic that could change the game in the coming years. Of course, the global economy is far from out of the woods. Most developed countries are currently in a “K” recovery, where some parts of the economy are recovering strongly while other sectors are still in recession (e.g., tourism). But let us keep in mind that the situation is very different from 2008. Banks are in a much better situation. On the other hand, we are still in a dynamic that implies the combined effect of two essential elements for an economic recovery: the fiscal lever and the monetary stimulus. In addition, there are likely to be “white swans”: a strong recovery in consumption following the arrival of vaccines, an improvement in business sentiment and a potential recovery in world trade. Finally, the weakening US dollar and the strengthening Chinese yuan could have a multiplier effect on activity in emerging countries.
Consequences for asset allocation
A new commodity “super-cycle” would undoubtedly have major consequences for the performance of the various asset classes. It would mean moving from a deflationary regime to a “reflationary” one. In this context, the bond rally would (finally) come to an end, which would imply more complicated days for the famous 50% equity, 50% bond balanced portfolio. Asset allocators should then turn to assets that protect against inflation such as TIPS (inflation-linked bonds), cyclical stocks and… commodities.
Regarding the latter, the Bloomberg Commodity Index seems to have broken its downward trend. While gold has performed very well in 2020, it is now the turn for industrial metals to take over in terms of performance. But it is potentially the energy sector that could surprise investors the most. While a synchronized recovery in global activity could be beneficial to demand, it is perhaps the supply situation that will most likely create the conditions for a rebound in black gold. Indeed, the “Green New Deal” has led to a very clear depletion of oil infrastructure, to the point where demand is expected to exceed supply this year. Such conditions could even create the risk of an energy crisis, triggering a strong rebound in commodities.
Of course, this new super-cycle remains very hypothetical. The gigantic amount of debt accumulated by governments and companies acts as a natural barrier to any violent rise in bond yields. Structural problems (e.g., demographics) continue to weigh on the strength of global growth. But as is often the case in history, inflation and cycle reversals often occur when least expected.
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