For investors, this year has been a one-way ticket up for commodities, and a one-way ticket down for everything else. Markets have repriced key commodities such as oil, gas, wheat and copper to reflect the exit of Russia, the world’s second largest commodity producer, as a supplier to many countries that have implemented sanctions following its invasion of Ukraine.
Commodities are also seen to be a beneficiary of inflation and have been bought by investors for this reason too. At least superficially, neither of these factors appear to have changed recently, so why has the Bloomberg commodities index, which reflects a wide basket of key commodities, fallen nearly 15% from its peak on 9 June?
Commodities are just that, commodities. They are dug out of the ground, or grown, and sold at a market price. Some days prices are good, some days they are not. As there is minimal inherent value creation in the digging up and selling of them, they will follow the market price, both as it is today and as it is perceived in the future.
Ultimately, commodity analysis comes down to supply and demand. What a barrel of oil or a ton of copper is worth has proved historically to be very volatile based on the prevailing supply and demand balance. In past cycles, lower prices because of falling demand stopped investment in new mines and oil fields, which then created a supply shortage – so when demand increases, prices increase too. This cycle is well established.
Occasionally though, structural factors can accentuate this cycle. The super cycle of the 2000s, as China built out its infrastructure, was one such occurrence. More recently, the need to mine certain metals, such as copper, to deliver net zero infrastructure is another. In the long run though, the cycle has always returned with higher prices creating more supply and less demand, and commodity prices sowing the seeds of their own downfall.
Recent falls in commodity prices seem much more likely to be due to concerns over the strength of the global economy than concerns over supply. As commodities are used in houses, cars and other types of products that central banks want us to buy less of to reduce inflation, they will exhibit cyclical characteristics in the short term, even if in the long-term demand for them will grow. In my opinion, they may not be the safe haven perceived by investors for much longer if the global economy is entering a recession.
Should commodity prices continue to fall, this will have important implications for markets. Inflation expectations, and therefore interest rate expectations, will decrease and remove one of the key concerns for markets. Fixed income will see improved performance, as will longer duration growth stocks. This has certainly been the case in the last few weeks. While the future path of commodities is hard to predict, watching them closely will give a clear indication as to where other markets go next.
A Hobson’s choice (according to Wikipedia) is “a free choice in which only one thing is actually offered”. The term is often used to describe an illusion that multiple choices are available. Investors could be forgiven if they feel this way at the moment, with the choice on offer being spiralling inflation or a recession. They seem different, yet both end with pain. From our perspective, and being cognisant of the social consequences, a recession is much more preferable to an ongoing inflation problem.
A good way to think about this is to understand the impact of each scenario on valuations. For an equity trading on 20x its current profits, each year of profits is, as a rule of thumb, worth 5% of the valuation. As recessions rarely last more than a year, each recession is roughly a 5% hit to its valuation. Higher inflation is more problematic to valuations if it ends in higher long-term interest rates. Each 1% increase in long-term interest rates is, based on our numbers, c. 10% off the value of the same equity. This sensitivity explains the underperformance of long-duration growth stocks this year as, at times, the expectation has been for multiple percentage point increases in long-term interest rates.
Using this calculation, it becomes clear that a recession to bring long-term inflation back under control is, at least financially, a price worth paying. It would also lock in an investment environment similar to the one in recent years, where 60/40 portfolios and growth stocks find their feet again. We would also argue that the social consequences of a recession are more manageable than a long-term increase in inflation, which hits those who can least afford it the most. So, it may look like Hobson’s choice but the two options currently on offer, high inflation or a recession, lead to very different investment outcomes.
If you don’t know which port you’re sailing to, no wind is favourable
In blogs this year, we have talked in detail about the importance of an identity and a set of investment principles that we are committed to sticking to in delivering long-term performance. This nautical observation makes a good point. If you don’t know where you’re going, how will you get there?
For us, we are sailing to a cleaner, healthier and more inclusive future: we think this offers the highest probability to investors that we can both improve investment returns and the world we live in. Over the last 100 years (and longer), every generation has lived a better life than the previous one based on these metrics. Despite all the problems in the world today, and in the last few years, we think it a robust framework for investing into the future and it is the port that we are sailing to.
That said, 2022 is the first year for quite some time that these principles have not (yet) delivered an investment outcome ahead of other styles of investing. Sustainable investing leads us to low-carbon, long-duration (as in the longevity of growth we think our companies can deliver) portfolios, whereas market trends, up until the recent fall in commodity prices, have been more favourable for high-carbon, short-duration strategies.
Much like the wind, this can change and may already be, or it can stay the same. But, to follow through on the analogy, it doesn’t change the port that we are sailing to. Only if high-carbon companies become part of the climate solution, and deliver much better financial returns than history, will they appear on our radar. Equally short-duration sectors such as retail, banking and leisure will only appeal to us if they can prove their long-term growth credentials. We are cautious about either of these outcomes occurring.
Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.