THE NEXT

COMMODITY
SUPERCYCLE
October 2020
A new dawn for commodities

Executive Summary

• We are on the cusp of a new commodity supercycle

• There are 3 big secular drivers of this 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

Source: CFA Institute
compared to themselves and to other assets

2
Inflation and
fiscal dominance
In world of heightened inflation risks,
owning commodities is key
The coming fusion of fiscal and monetary policy

• There is a seismic shift away from monetary-policy

dominance towards fiscal-policy dominance

• The private sector’s preference for saving – despite

years of ever easier monetary policy – has meant the
government needs to spend to make up the shortfall,
supported by central banks’ government bond buying

• The pandemic has only magnified existing trends. We

are heading towards the fusion of monetary and
fiscal policy

• This has profound implications for investing and

portfolio construction

Source: Bloomberg, Macrobond and Variant Perception 4

Lake and Ocean Regimes

• The blurring of fiscal and monetary policy creates a

very different investing environment

• We have come from the “Lake Regime”, where rises in

inflation are less likely to become disorderly

• We are now in the “Ocean Regime”

• In this regime, massively expansive fiscal policy and

rapidly growing central-bank balance sheets means
garden-variety rises in inflation are more likely to
lead to unanchored and disorderly moves higher in
inflation

• Lake-going vessels are not suitable for ocean travel, as

are many portfolios not prepared for high inflation

Source: JMW Turner, Bloomberg, Macrobond and Variant Perception 5

Ocean Regime => a new investment world

• The Ocean Regime does not mean high inflation and a

weaker dollar is imminent, but it does mean the
balance of risks have changed

• Once inflation becomes unanchored, it is too late to

take action. Portfolios should begin to be made more
inflation-resilient today

• There are 3 main implications of moving to the Ocean

Regime:

 rising cross-asset volatility

 too much leverage becoming a dangerous game
 the long boom in financial assets ending, and
real assets and commodities outperforming

Source: Bloomberg, Macrobond and Variant Perception 6

Demand and
supply tailwinds
Positive dynamics for commodity demand
and supply are lining up
Demand and supply imbalances drive the commodity cycle

• Commodity prices can deviate greatly form long-run averages

• These imbalances take a long time to correct due to:

 high start-up capex for new projects

 time needed to bring new supply online as firms wait
until they are sure of price upturns

• Previous demand-driven super cycles include global

rearmament before WW2, and the reform of the Chinese
economy and its accession to the WTO in 2001. The OPEC oil
embargo in the 1970s was a supply-driven super cycle

• The next commodity supercycle will be driven by heightened

inflation risks, supply destruction and recovering demand

Source: Bloomberg, Macrobond and Variant Perception

8
Demand is set to pick up cyclically

• China’s economic leading indicators are rebounding which

points to a cyclical upturn for commodities

• Our macro-driven forecast for commodities has surged over the

past 6 months and continues to show positive expected returns
for commodities

• Liquidity and demand factors are boosting the commodity

outlook

• In our report from May of this year, China Deleveraging Over,

we noted a China rebound completes the “bullish commodity
puzzle”

Source: Bloomberg, Macrobond and Variant Perception

9
Supply conditions also cyclically tight

• The huge contango in commodity futures markets in the wake

of the Covid recession showed a mounting supply glut

• This forces producers to cut production, delay new projects and

thus supply shrinks

• Large commodity price spikes become a likelihood over the

following 18 months after recovering demand runs into tight
supply conditions

• Low inventories mean prices are more responsive to a demand

pick-up

• There are long lags to bring new supply online for many
commodity sectors, eg it can take more than five years for a
new mine to generate cash flow after initial spending
Source: Bloomberg, Macrobond and Variant Perception
10
A huge investor
underweight
The underweight in commodities will drive
investor demand
Investors are structurally underweight commodities
• The commodity asset class is massively underinvested

• The amount of capital in real assets is miniscule

• Pension funds prefer safety in fund vehicles (hedge funds, PE, etc)
to fill their portfolios

• This is also playing out in the ETF world. Total commodity ETF
AUM is a tiny proportion of the total AUM

• There is a risk of a huge supply-demand imbalance in commodity

markets as investor preferences shift towards real assets

• Marginal capital inflows can lead to outsized price gains

Source: Bloomberg, Macrobond, Mercer and Variant Perception

12
The end of the road for 60/40 portfolios
• Bonds are now a poor equity hedge given near-zero or negative
yields

• The traditional 60/40 portfolio is now riskier, and with lower

return potential

• Risk-parity solutions rely on equalising contributions to risk from

different asset classes

• This means employing higher leverage on asset classes with lower

volatilities – but leverage is a dangerous game in the Ocean Regime

• Risk-parity relies on a negative correlation between stocks and

bonds to work

• In the Ocean Regime, this correlation will likely become positive –

making risk-parity much more risky
Source: Bloomberg, Macrobond and Variant Perception 13
Making the most of commodities in a portfolio
• A buy-and-hold portfolio of commodities has historically not served
investors well, but an actively managed portfolio has

• Commodities offer a rebalancing premium in portfolios because

they are volatile and are not correlated to each other

• Thus an equally-weighted portfolio of CRB commodities that is

rebalanced frequently can enhance the value of commodity
allocations in portfolios

• Rebalancing volatile commodities forces you to buy low and sell

high

• See our report from July 2020, Portfolios for the High Seas

Source: Bloomberg, Macrobond and Variant Perception

14
The capital
cycle
Finding the most capital scarce commodity
sectors to invest in
The capital cycle tells us what to buy

Plenty has been written about the capital cycle over the years, but by far the best is Capital Returns: Investing
Through the Asset Cycle, by Marathon Asset Management.

This inspired us to create our own Capital Returns framework to screen for capital-scarce sectors that outperform
capital-abundant sectors on a 1-3 year forward basis.

Source: Bloomberg, Macrobond and Variant Perception 16

 Capital scarcity drives higher future equity returns

• The capital cycle follows a mechanical and

repeatable process:

1) large industry-wide investment coincides

with a peak in investment returns
2) this attracts new entrants, eroding
incumbent company returns and become
unprofitable
3) firms exit and capital flows away, creating a
much more profitable environment for the
survivors

• This process typically takes 2-3 years for

investment returns to materialise from the point
of peak capital scarcity

Source: Bloomberg, Macrobond and Variant Perception 17

Oil and Gas
No more hate
Energy reminiscent of goldmining bear market in the 2010s

• Goldmining equities saw a multi-year bear market after

the 2011 peak in gold prices

• They then experienced a protracted bottoming process,

lasting even after gold prices stabilised in 2016

• It was only the surge in gold prices from 2019 that

propelled goldmining equities higher

• We see the potential for a similar dynamic to play out for

the energy sector – currently in its sixth year of a bear
market

Source: Bloomberg, Macrobond and Variant Perception

19
Capital is very scarce for energy companies

• According to our Capital Returns framework, oil

producers saw an extended period of abundant capital
availability before the 2014 oil price crash

• After the crash, capital become increasingly scarce –

this is forcing the industry to rationalise, reducing
competition for the survivors

• We proxy for capital scarcity using Capex + R&D to

Asset ratio, D&A to Asset, and ROIC

Source: Bloomberg, Macrobond and Variant Perception

20
Cyclical leading indicators positive for crude

• Cyclical as well as structural factors are starting to improve

for oil

• Our leading indicator for crude oil is rising and has turned
positive

• This has been driven by signs of economic recovery - led by

China - and tight supply

Source: Bloomberg, Macrobond and Variant Perception

21
Energy can be a minefield - stock selection is important

• It is important to differentiate different companies

within energy and identify the best assets to invest in

• Capital-intensive industries like energy are subject to

large boom-bust cycles

• As a whole, the energy industry has failed to achieve

sufficient return on invested capital through the cycle
for shareholders

• The chart on the right from our report: Improving Stock

Selection - October 2019, shows the aggregate
destruction of value as boom turns to bust

Source: Bloomberg, Macrobond and Variant Perception

22
Coal
One last puff of the cigar butt
 Coal: vital for EM, a pariah in DM

• Coal still accounts for more than one-third of global

electricity generation

• Coal’s share of electricity generation in EM countries

like China and India is in the range of 60-70%. In the
US/European union, the equivalent share is 10-15%

• Coal companies are treated as pariahs, given the

ascendance of ESG investing

• Coal investing within DM fits into the “last puff of the

cigar-butt” category

• In EM, the runway appears longer

Source: Bloomberg, Macrobond and Variant Perception

24
Coal is a China story

• China’s coal-fired generating capacity is 50% of the world

total

• China coal-fired capacity is set to keep growing over the

next decade and offset losses in DM countries

• The Chinese economic cycle has typically led export prices

for coal

• Chinese real M1 growth has led API2 coal prices

consistently

Source: Bloomberg, Macrobond and Variant Perception

25
US coal companies are at cycle lows

• The US natural gas glut has crushed the coal industry

• Low natural gas prices have accelerated switching trends

toward gas-fired power plants away from coal

• Coal is relatively easy to store and remains important for

utilities as a low-cost way to ensure grid resilience

• Surging US coal inventories have historically been a contrarian

sign

• More coal burning will be encouraged as natural gas prices

normalise by rising over the next 12 months

Source: Bloomberg, Macrobond and Variant Perception

26
Gold and silver
The 1st and 2nd placed metals to invest in
Own what central banks are short of

• After years of selling their gold, central banks around

the world have been steadily increasing their gold
reserves

• As the dollar is progressively devalued and

inflationary risks rise, central banks are diversifying
away from the dollar

• Moreover, as the US flexes its financial muscles and

uses the dollar as a tool of diplomatic punishment,
countries such as Russia and China are turning away
from the USD, and increasing their gold reserves

• Owning what central banks are short of will likely

prove a highly profitable endeavour

Source: Incrementum AG, Bloomberg, Macrobond and Variant Perception 28

Investment demand for gold soaring

• Gold is not only a hedge for inflation, it is a hedge

against uncertainty

• 2020 has seen investment demand for gold soar as

the global economy grapples with the impacts and
uncertainty from lockdowns

• Consumer demand, eg jewellery, has collapsed this

year as recessions hit around the world

• However, demand for ETFs and other investment

products has picked up the slack – accounting for an
unprecedented 42% of gold demand in 1H20

• Investment demand for gold is likely to remain strong

in the Ocean Regime of heightened inflation risks

Source: World Gold Council, Bloomberg, Macrobond and Variant Perception 29

Don’t forget 2nd placed silver

• Silver is similar to goldminers in that it offers extra risk

– but potentially greater reward – compared to gold

• Silver is cheap compared to the gold price, with one

ounce of gold buying 77 ounces of silver. This was a
low as 40 ounces in the early 2010s and 20 ounces in
the early 1980s

• Silver is a “by-product” metal, with the majority of

supply coming from mines whose main output is
another metal – meaning supply is slow to respond

• Supply constraints, relative cheapness and growing

investment demand are a recipe for explosive silver
growth in the coming years

Source: Incrementum AG, Bloomberg, Macrobond and Variant Perception 30

Copper
Copper’s clean sheet
The Age of Copper
• Copper will play a pivotal role in the clean energy revolution
sweeping across the world

• Policymakers are creating permanent demand in renewable energy

and EV-related (electric vehicle) infrastructure

• EVs use 4x more copper compared to a normal passenger car’s

internal combustion engine. Solar panels and wind turbines require
12x more copper than previous methods

• Copper has many useful properties that make it a core input for
manufacturing and electrification: high durability, high malleability,
high electrical and heat conductivity, no loss of quality upon
recycling

• It also has antimicrobial properties – an additional source of

demand from the healthcare industry amid the pandemic
Source: Bloomberg, Macrobond, The Economist, Copper Alliance and Variant Perception 32
The Chinese copper whale
• China’s dominance in the copper market has been growing

• China consumes more than half of the world’s copper but only owns
~5% of global copper resources

• The push towards self-sufficiency is clear with many Chinese miners

recently acquiring stakes in overseas copper deposits

• Still, China’s demand for refined copper is booming. The core driver
comes from policy stimulus aimed at stepping up fixed-asset investment

• Western policy is shifting towards “Chinaficiation” with massive

infrastructure spending on the horizon

• The West will join China with an ever greater appetite for copper

Source: Bloomberg, Macrobond and Variant Perception

33
Copper risks going into a huge deficit
• If copper demand starts to accelerate, then the dearth of new
projects could push the copper industry into a huge deficit

• Even for projects that are due to go live, the potential to discover
new copper is limited

• Only 102 million tons of copper has been discovered in the last 10
years (992 million tons was discovered between 1990-2008 with
much less investment, according to SPGMI's Reserve Replacement
Report)

• There are also copper supply risks in eg Chile – the world’s biggest
producer – due to worker protests and strikes

Source: S&P GMI, Bloomberg, Macrobond and Variant Perception 34

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