AAM Viewpoints: Generational Opportunity Now and for the Next Decade?
For most asset classes, 2019 was a terrific year for prices. Generally, the equity and bond markets enjoyed a significant surge that all but replaced their terrible performance in the 4th quarter of 2018. By almost any measure, stocks seem fully priced and bonds have never been higher priced or lower yielding, which begs the question, “What opportunity could be left for investors to consider?”
There is one corner of the market that has been left for dead in this meteoric rise in asset prices: commodities. Commodity prices are at their lowest ratio to the S&P 500 index since the dot.com bubble. Over the past 50 years commodities have only reached this level three times. Each time proved to be a generational opportunity for those investors who could see the opportunity and had the fortitude to make the allocation.
The commodities we are looking at include energy, materials and agriculture. As a group, they peaked in their price ratio to the S&P 500 right at the top of the 2008 global financial crises. For the past decade their performance has suffered relative to stocks and, in our opinion, seem perched to outperform from here. These trends can have a very long life once they begin.
The global economy is transitioning from monetary easing to fiscal easing. Given the slowing of global economies and the massive easing of monetary policy with record asset purchases, we believe that reflation of global gross domestic product (GDP) is upon us. Economic conditions are quite supportive of this return to global growth.
- Money is cheap and plentiful.
- Energy is cheap and plentiful.
- Employment opportunities are such that anyone who wants a job can likely find a job.
- Taxes have been cut domestically and globally. Inflation has been almost non-existent.
- Governments are beginning to pass funding for all sorts of fiscal projects to re-energize their economies.
To understand the true size of the opportunity, we must first look at where commodities have been historically in relation to equities and why it is timely. We believe commodities are likely to be on the precipice of a secular move higher from here. The following chart shows the relationship between the S&P 500 and the Goldman Sachs Commodity Index over the last 50 years. As you can see, commodities are cyclical in price, moving according to demand and known available supply. After a peak in price, and a long period of price decline, capital is no longer made available to find and harvest new supplies. The current supplies tend to be expended in an environment of low prices. When demand expands, there’s insufficient supply to satisfy current demand. Prices begin to rise and, once again, capital is made available to drillers, miners and farmers to expand production. The issue is that it takes many years to find and develop new deposits of minerals and metals and for farmers to re-engage fallow land.
For a decade now, global central banks have been busy reducing interest rates, flooding markets with liquidity and monetizing sovereign debt in record amounts. The outcome of this so far is that global yields have never been lower, central bank balance sheets have never been more levered and a record amount of newly printed currency is now circulating. These actions have been so prolific globally that we have seen interest rates on sovereign debt and even some corporate debt turn negative. This has and continues to affect trillions of dollars of debt worldwide. Negative-yielding financial instruments have no value to any investor. This anomaly has been created by central banks and generally has not achieved the bank’s goals. There is significant evidence that negative rates weaken the banking system where it has been implemented. We are seeing global central banks begin to reverse negative interest rate policies. Sweden was the first to reverse it recently and more are following.
We believe this massive quantitative easing has created a bubble in bond prices.
With record low interest rates, many bond prices have never been higher. We currently see an almost insatiable appetite for bonds at a time when their expected future returns are the lowest on record. In fact, if we look at the flow of funds over the past year, we see a continuation of money moving from equity markets to fixed income in record amounts. The next chart shows how massive a move that was just last year. When you see investors chasing an asset class to the point when the return is negative, this is very likely one big asset bubble. We don’t know when or how it will be popped but we are certain that it will occur. When the asset class begins to register negative returns the appetite of buyers will certainly sour.
Commodities will likely be the benefactor of the record creation of currency around the world by central banks. History is clear: when demand is rising against a static supply, prices tend to rise as well. Additionally, commodities tend to be great inflation hedges as the sheer increase in the amount of world currency creation should translate into the global weakening of currencies. Stated another way, massive printing of new currency in excess of the rate of economic growth will likely result in weakened purchasing power of each currency unit.
We believe that the global commodity complex should benefit across the board. We think that the global increase in population will keep demand rising for agriculture, materials and energy. We would not suggest buying the actual commodities but rather companies that are involved in the production and distribution of the commodities.
Many believe that fossil fuels have seen their top, and because of carbon and its perceived relation to climate change, will spell the quick demise for oil and gas. We think this is far from true for many reasons.
First, just the sheer need for affordable energy tends to favor sources that are known and have the scale to provide the solution. Renewables are growing but are not anywhere close to meeting current needs, let alone future needs. We are not disbelievers in the need for renewable sources of energy, but we are realists in that there currently exists no credible replacement for fossil fuels.
In my lifetime I have previously witnessed a similar situation. During the 1970s and 1980s a series of events occurred in the energy complex that warned the globe of impending danger. These events began with the Arab Oil Embargo (’73-’74) when middle east countries cut off oil supplies to the western countries who were energy dependent on imports. This crippled the U.S. economy and our stock market (Dow Jones Industrial Average lost roughly 50% of its value). Anyone who owned an automobile had to wait in long lines at gas stations just to get a limited ration of fuel. The best scientific minds of that time had determined that we had found all the significant oil reserves there were to find, and that the world would likely run out by the end of the century. This fear-induced mania of running out of oil was so fever pitched (much like the carbon scare today) that President Nixon and Congress instituted several law changes that would provide a mass conservation of the remaining supply. Those included a significant reduction in the speed limits on American highways from 70 mph to 55 mph in 1974. We created the Strategic Petroleum Reserve in 1975. The thermostats in our homes were lowered from 72 degrees to 68 degrees. In 1975 Congress passed the Corporate Average Fuel Economy (CAFE) standards which set in motion fuel economy and emissions standards that would need to be achieved by car manufacturers in the future. Finally, we banned the export of crude oil from the United States in 1977. All of this because the best science of the day foretold the end of the earth’s oil supply as we knew it.
Fast forward to the 21st century. We now know that the science back then was dead wrong. In fact, since then the United States has become one of the largest oil producers globally. We have scrapped the lower speed limits and massive lines at the gas pump are unheard of today. America is now exporting oil and gas. CAFE standards are being challenged as concerns about fuel efficiency these days has died down.
The solution to the problem of “peak oil” and environmental emissions in the 20th century were solved by science and technology. The United States led the world in addressing tailpipe emissions and much more efficient and effective ways of finding and producing oil and gas. The solution for the carbon generation issue (CO2) will also likely be solved by science and technology rather than by simply abandoning fossil fuels.
Just one example of a technology solution that address CO2 emissions was recently introduced by the Massachusetts Institute of Technology (MIT). MIT revealed a new weapon in the fight against climate change. MIT has successfully devised a system to remove CO2 from the atmosphere and direct it to greenhouses, sequestration and breakdown to non-harmful elements. The system’s inner workings are detailed in a paper called Faradaic Electro-swing Reactive Adsorption for CO2 Capture. The device at the heart of the system behaves like a large battery. It absorbs carbon dioxide from a gas stream that passes over its electrodes as it’s being charged. It then blows out pure CO2 as it discharges. MIT has launched a company called Verdox to commercialize the system which could have applications for turning CO2 emissions into beneficial uses like the bottling of soft drinks and the creation of plant food.
The point we are stressing is that energy assets are the cheapest they have been in many years. The next chart illustrates how inexpensive energy equities are currently. If you believe, like we do, that the carbon issue will be solved by many factors including science and technology, then energy is a commodity that will likely benefit from increased demand in the future. For those of us old enough, we have seen this panic before.
Finally, we are bullish on the prospects of higher inflation because global central banks are doing everything within their means to create inflation. They have targeted inflation creation for years. Even after a decade using all the textbook methods, as well as some non-traditional methods (QE), they have had only limited success in achieving their stated goals. The markets and investors have generally lost faith in the reappearance of inflation and have accepted the perceived fate of minuscule interest rates forever.
History, however, tells us a different story. Inflation, as well as deflation, throughout history has been cyclical and can be dormant for a time but is never gone. Long-term interest rates likewise rise and fall with inflation expectations over time as well. When you see a rise in one, you will likely see a rise in the other. We don’t expect rates to skyrocket overnight but we do believe that rates will normalize over time. As most market stewards know, reversion to the mean is almost impossible to escape. Global trends may take time to turn but typically always do. We never fight the Fed, or especially global central banks. They likely will not stop their inflationary policies until they see their goals realized. By that time, they may have gone too far and may have difficulty controlling the inflation they helped create.
Our conclusion is that the world economy is ripe for a resurgence of commodity prices. We believe the long bear market that has surrounded the group is likely changing. Our overweight to the group will likely last for many years. We believe investors should consider the equities of companies that find, produce and transport commodities.
There other ways to participate in the coming trend. The potential opportunity may even be more prolific in Emerging Market countries whose economies are tied to commodity exports. When you think of copper, you think of Chile. Iron ore brings to mind Australia, Brazil and Africa. The list goes on. The data that we have reviewed indicates this group may be currently mispriced versus global equities and bonds. We think that as global economic activity expands, the demand for energy, materials and agriculture should lead to increased prices. Central bank actions over the past decade support higher prices as well. We feel this is truly a generational opportunity for investors.
CRN: 2020-0110-7909 R
This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.