Commodities after Coronavirus. Make Hay While the Sun Shines
17/04/2020- Pivoting away from China = Global
supply chains being reset / supply issues
- Fiscal Stimulus / Infrastructure
Spend
- Inflation
- Opportunity. All measures are being set up to counter the ‘worst case scenario’. If the ‘worst case scenario’ doesn’t occur…stimulus packages will create tail winds for commodities.
The Impact
By the end of the 1st quarter 2020 we will have witnessed a huge global economic contraction (-12% according to JP Morgan), a decade long equity bull market come to the kind of abrupt end not seen since the Great Depression and a 50% fall in the price of Oil.
All of this coming after the 2008 global financial crisis with the one shining light since then, a relatively healthy labour market, now also faltering as unemployment numbers rise at a spectacular rate.
- Social distancing measures have been forecast at impacting 92% of global GDP
Within the commodity realm, prices
have fallen on aggregate some 38% to the end of March. However, within that
broad spectrum of commodities there are some that have performed better.
Gold, the much-lauded hedge in financial stress, has performed as advertised. Base metals, the industrial barometer of Asia, have fared well given the seasonal slowdown and protracted trade war during 2019, ditto agricultural products. On the other hand, the largest and most volatile of commodities, Oil, has suffered the greatest - falling over 30% on one day alone.
Global
Supply Chains
One consequence of the
Coronavirus pandemic and resultant re-evaluation of global relationships may be
that of supply chains. Western governments have become acutely aware that
relying on distant countries, who may not share similar democratic values, is a
strategic risk.
Global supply chains will be reset.
From a commodity perspective,
rare earths are an example of this. China produces about 90% of global supply.
From the early 90’s China was selling rare earths at such low prices that
suppliers such as the Mountain Pine Mine in the USA (once the largest rare
earth producer in the world) were unable to compete, resulting in the
shuttering of their mines.. This has happened throughout the commodity supply
chain with western producers unable to compete without government subsidies
The issue is much broader than
rare earths alone, however. Of the 35 metals the US has identified as
‘strategic’, many are mined and refined in countries the State Department would
not classify as friendly - like China & Russia.
Outside of our asset class, the most topical breakdown in
supply chains currently is in PPE (Personal Protective Equipment). The majority
of global production was outsourced to China. Shipments had been delayed to
other parts of the world during Jan/Feb, leading to shortages internationally.
Add strategic risk to an already
increasing protectionist movement (Trump/China trade war, etc) and we’re likely
to see a monumental shift in international trade and strategic supply dynamics.
The result of Covid-19 will mean supply
chains are relocated from China back to a number of countries either under the
guise of national security or perhaps in actuality being nothing short of an
employment drive.
“As resource constraints tighten globally, countries that depend heavily on ecological services from other nations may find that their resource supply becomes insecure and unreliable. This has economic implications – in particular for countries that depend upon large amounts of ecological assets to power their key industries or to support their consumption patterns and lifestyles.” Dr. Mathis Wackernagel, President of the Global Footprint Network.
Fiscal Stimulus / Infrastructure Spend
The most useful kind of fiscal stimulus is a physical one. Governments spending money on infrastructure is of far more benefit than simply writing people checks (see $10k Hong Kong handout to all citizens). It employs people to work on the projects and creates durable assets that can help boost long term economic growth.
- Trump has called
for a $2 trillion infrastructure package
- UK’s Rishi Sunak pledges £600bn on roads, rail, housing & broadband infrastructure scheme
- The EU has
lifted spending limits for all members in order to fight the pandemic
Those government infrastructure projects
all require building large and capital-intensive public and private buildings
and transport systems. These need mined metals like copper for wiring & base
metals required for producing steel (iron ore, coking coal, Nickel, etc).
The issue is that very little
additional mining capacity has been added over the best part of a decade that
will be required for these projects to complete. There WILL be
supply issues.
The Bloomberg Commodity Index
(BCOM), which tracks a broad basket of commodities, reached its lowest level
since 1986. But as the adage goes “the cure for low prices is lower
prices”. Eventually mines and other commodity producers shut operations
that are no longer profitable…and this is not a tap that can simply be turned
back on. It takes years of planning and expense to re-start or begin these
projects.
This is the current position we
find ourselves in - with aggregate prices running at lows not seen since pre
1990’s. Price levels which have caused the reduction in production of a number
of essential commodities.
To date governments have been posturing around an increase in infrastructure spend. Our argument is that the Coronavirus pandemic will now push them over the edge in terms of implementing these projects in bipartisan agreement. The issue is that should demand then increase, the commodities required for these projects are either unavailable or under the clutches of an unfriendly global foe.
After the Great Depression of 1929 US President Franklin Roosevelt pushed through a huge infrastructure spend…he called it “A new deal for the American people”. Back then it took a few years before commodities boomed. This time around we have a combined $15 trillion of globally coordinated fiscal and monetary policy seeing off traditional deflationary forces.
Inflation
When, and it is a when, fiscal
stimulus is combined with extremely loose monetary policy there are only two
likely outcomes: a deflationary spiral or an inflationary spiral. It is the latter
that we believe as the likely outcome. This will start with wage inflation as
supply chains are relocated from China back to a number of countries under the
guise of national security when in actuality being nothing short of an
employment drive (as mentioned earlier).
- US CPI inflation has risen steadily over the past six months, from an annual rate of under 2% to nearly 2.5%.
- Over the same period, the FED has cut the federal funds rate by 75 basis points, before anyone had ever heard of the coronavirus.
The collapse of both demand and
supply since the 2008 global financial crisis means that we’re unlikely to see
the falling prices and deflation that we experienced since then to date.
There will more likely be a surge
in demand as the coronavirus abates, people go back to work and businesses and
consumers borrow at historically low rates creating an uneven recovery of slow
output growth vs accelerating prices and inflation…otherwise known as
stagflation.
The FED would then usually counter this by increasing interest rates. However, this is now less likely to happen at pace when you combine a President who regularly pressured the committee to keep rates down even with record low unemployment and a country fresh out of a recession.
Over the past month:
- Balance sheet of ECB has grown by $600bn or 12%
- Balance sheet of FED has grown by almost $2 trillion or a staggering 40%
The
Opportunity
The past decade of investing has
been very simple; move trillions of global equity capital flows into the US,
chasing yield and stock buybacks and away from cyclicals. However, we believe
the macro environment no longer suits this.
As we experience government after
government pledge trillions of dollars in fiscal spending the appeal of hard
assets in an inflationary environment becomes irresistible, the debasement of
the USD continues and so too its correlation to commodities.
The plethora of policy’s built
into the financial system after 2008 has benefitted a vast majority of asset
classes, in particular equities. However, it’s always been a delicate balance. The
FED has long been attempting to lift the low inflation rate we’ve seen since
the financial crisis closer to their long-term objective. There is a real
possibility that this epidemic pushes a little too hard and they get more than
they bargained for.
Combine the potential rise of inflation with additional stimulus in the form of a global infrastructure spend and very little new commodity supply entering the market, the stars may very well be aligned.
Markets are
priced-in for deep deflation. Any positive news-flow coming out of the
Coronavirus epidemic or normalisation of those expectations could potentially
deliver spectacular returns in a previously unloved asset class.
20/04/2020
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