April 16, 2021 5 min read
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While most investors have their eyes on the Nasdaq or Bitcoin, it is interesting to note that commodities are the asset class with the best performance since the beginning of the year (excluding cryptocurrencies). Brent crude is back above $ 60 a barrel, copper is at an 8-year high and palladium is back at 6 years ago.
After avoiding asset allocation for more than a decade, the idea of a return to mercy for commodities is gaining traction among strategists. In fact, JP Morgan has just released research showing that commodities have started a new “super cycle”.
Last October we argued that certain conditions were indeed in place for a permanent trend reversal in the commodity cycle. How is the situation today?
A Brief History of Super Goods Cycles
As a reminder, this asset class tends to develop in relatively long cycles. In the nineties, the rise of the “New Economy” should mean the end of the dependence on raw materials. The S&P GSCI Commodity Index saw a spectacular bear market that began after the first Gulf War. However, the bursting of the technology bubble in 2000 ended the bear cycle. Then began a bullish super cycle for commodities. The great financial crisis of 2008 marked a new trend reversal that resulted in a long period of underperformance in commodities. At the end of 2020, commodities hit a new low compared to stocks.
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The relative performance of the S&P GSCI versus the S&P 500
Indeed, the past decade has marked 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, which had a detrimental effect on value stocks, emerging markets and commodities (excluding gold).
These preferences for asset allocation have become even more pronounced since 2015-2016. While the economic recovery should have accelerated, a number of events – Brexit, trade wars, and the pandemic – have effectively postponed the end of the deflationary cycle. The austerity measures 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.
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On the way to a permanent trend reversal?
After the 2020 recession, some micro and macroeconomic indicators point to an imminent turnaround.
Let’s start with the signals from the financial markets themselves, the so-called “internal indicators”. For example, copper, a metal often referred to as “Dr. Copper” by investors for its ability to anticipate the business cycle, is up 70% from its March lows.
The cyclical sectors have also outperformed defensive stocks since November, particularly the energy sector, which has risen by more than 50% since the beginning of November.
The very strong recovery in freight rates for containers is also noteworthy. For example, the cost of shipping between Asia and Europe has tripled since November due to capacity issues.
After all, there is certain macroeconomic logic that could transform the game in the years to come. Of course, the world economy is far from the forest. Most developed countries are currently in a “K” recovery, with some parts of the economy rebounding strongly while other sectors are still in recession (e.g. tourism). But let’s remember that the situation is very different from 2008. The banks are in a much better position. On the other hand, we are still in a dynamic that implies the combined effect of two essential elements for an economic recovery: fiscal leverage and monetary stimulus. In addition, there are likely to be “white swans”: a strong recovery in consumption after the introduction of vaccines, an improvement in business sentiment, and a possible recovery in world trade. Finally, the ailing US dollar and the stronger Chinese yuan could have a multiplier effect on activity in emerging markets.
Consequences for the asset allocation
A new commodity “super cycle” would undoubtedly have significant consequences for the performance of the various asset classes. It would mean moving from a deflationary to a “reflationary” regime. In this context, the bond rally would (finally) end, which would mean more complicated days for the famous 50% equities and 50% bonds portfolio. Asset allocators should then turn to inflation-protecting assets like TIPS (inflation linked bonds), cyclical stocks and … commodities.
Regarding the latter, the Bloomberg Commodity Index appears to have broken its downtrend. While gold did very well in 2020, now is the time for industrial metals to take over the performance. But it is possibly the energy sector that could surprise investors the most. While a synchronized rebound in global activity could be beneficial for demand, it is possibly the supply situation that most likely creates the conditions for black gold to rebound. Indeed, the Green New Deal has significantly depleted oil infrastructure, to the point where demand this year is expected to exceed supply. Such conditions could even harbor the risk of an energy crisis and trigger a strong recovery in raw materials.
Of course, this new super cycle remains very hypothetical. The vast amount of government and corporate debt is a natural barrier to violent spikes in bond yields. Structural problems (e.g. demographics) continue to weigh on the strength of global growth. But, as has often been the case in history, inflation and cycle reversals often occur when they are least expected.
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