Since penning the column ‘The case for commodities’ (10 July 2020) and adding to portfolio exposure, the sector has enjoyed a strong run and investment trust discounts have narrowed. There are now siren calls suggesting caution and that profits should be taken. However, any short-term volatility apart, patient investors should refrain. The prospect of handsome dividends, long-term secular trends, rising inflation and geo-political tensions are some of the reasons the prices of these real assets are likely to climb higher. However, stock and sub-sector selection will continue to be important given the various influences at work.
In the summer of 2020, the market was reflecting real concerns about the impact of Covid-19 and the sheer uncertainty of the outlook. Any debate focused on the extent of economic contraction and deflation, rather than whether it would happen. It was therefore counter-intuitive to be increasing exposure to commodities given the sector’s fortunes traditionally march in step with the economy, even though valuations were looking attractive. However, a number of factors suggested the sector was better placed than most and ought to do well over the medium term, and many of these still exist two years on.
On the demand side, a number of long-term trends remain supportive of commodities, including urbanisation and a growing population. Governments globally continue to increase infrastructure expenditure given the lack of investment in previous decades and the need to help steer economies away from recession or worse. Climate change is another positive trend in that many minerals are important to helping governments reduce their carbon footprint. It is unlikely, for example, that an economic slowdown will significantly affect the push for electric vehicles.
Shorter term factors also continue to be supportive. Governments across the world have been introducing huge fiscal stimulus packages in an effort to avert recession and this seems unlikely to change for reasons covered in previous pieces. Geo-political tensions apart, the gradual introduction of more resilient and local supply chains as economies recover has also been boosting demand. And while global growth will be chequered, regional nuances continue to bode well – the economic stimulus measures introduced in China should help Asian economies generally to maintain momentum.
However, some things have changed. Two years ago, the market had very little faith in the sector after a poor decade of financial discipline and performance. Sentiment has improved in recognising the sector has been proactive in putting its house in order. Companies are much more focused on capital discipline. Exploration and extraction have been curtailed – and capacity reduced as a result. Balance sheets hold much more cash and less debt. The sector has been generating close to record free cash flow. It therefore entered the economic crisis in better shape than most.
This has been evident from the generous payouts from the mining sector in particular, both by way of regular and special dividends, at a time dividends elsewhere have been under severe pressure. The mainstream investment trusts held in most of the ten real portfolios managed on the website www.johnbaronportfolios.co.uk - BlackRock World Mining (BRWM), CQS City Natural Resources Growth & Income (CYN) and BlackRock Energy & Resources Income (BERI) – which were on discounts of between 12 per cent and 20 per cent, while offering yields of 5.9 per cent, 6.9 per cent and 7.2 per cent respectively, have travelled a long way since.
Long-term secular trends
It is therefore understandable that some commentators are advising caution. One reason is that dividends from the large diversified mining companies have benefited from much higher iron ore prices than expected, but may suffer because prices today are lower than in 2021. However, this tends to underplay the progress seen when it comes to other minerals. For example, copper miners have spent years paying down debt while investing in new mines, and this has left them in a much better position to increase shareholder returns in 2022 – even though some have traditionally been reluctant to do so.
Time will tell. But it is the longer-term secular trends including the push to net-zero, industrial manufacturing, transportation and food that encourage optimism, more so than when compared with oil and gas – with decarbonisation being perhaps the most important. In the lead up to and including COP26, the announcements and commitments from major economies, including China and the US, have been impressive – while recognising there is still much to do. The scale of investment required to meet these targets is significant, with commodities playing a key role in facilitating this transition.
Yet again the market is possibly underestimating both the seriousness of the commitment and the impact the energy transition will have on various commodity markets. Copper, battery related materials (lithium, cobalt, nickel) and rare earths are some of the key beneficiaries. Each will see significant demand growth as renewable energy investment is increased, the grid is upgraded, electric vehicle penetration grows and the requirement for battery storage increases.
Meanwhile, somewhat ironically, a greater focus on the environmental and social impact of new mining activity, including factors such as water availability, usage and waste treatment, have increased the obstacles to bringing on new supply. These increase the return hurdles required to justify new investment which helps to explain why, after some years now of increased demand, companies are not rushing to increase capacity. This may continue for some time.
Furthermore, some fund managers, including those at BRWM, are expecting structural change in various commodity markets once carbon is correctly priced, particularly when it comes to the aluminium and steel industries given their energy intensity. China's steel industry alone accounts for 5per cent of global greenhouse gas emissions. As carbon taxes become more prevalent, those companies with existing access to low carbon power or with superior decarbonisation technology will not only benefit from lower taxes, but may also be able to charge premiums for their products given the demand for sustainable materials.
There are other reasons to continue to be positive about the sector’s outlook – the prospect of higher inflation being one of them. The column ‘Preparing for inflation’ (12 March 2021) outlined why rising inflation was now part of the investment equation (in contrast to suggestions at the time that deflation was the greater threat), and how portfolios were being positioned accordingly. The allure of real assets generally increases in such an environment.
While the commodities sector has traditionally produced strong real returns during the early inflationary stage, it usually comes into its own once it is apparent the inflationary genie is out of the bottle. Of course there is no reason why this should be the case every time, but then there is also no reason why it should be any different this time. After a period when the central banks were talking of inflation being ‘transitory’, the dial has finally shifted with markets now factoring in an increased number of interest rate rises.
Meanwhile, the Russian invasion of Ukraine has reminded the world that geo-political risk seldom goes away. It also marks the coming of a new Cold War. For too long the West has harvested the peace dividend, in part believing that democracy required little investment as the concept would sweep the world. But the concept is fragile – it needs nurturing, encouraging and protecting – for there are many who do not value it. Most of the world’s population as represented by their governments at the recent UN vote on Russia’s aggression did not condemn the invasion. Defence and soft power budgets are going to rise.
And in such a world, where ideological lines are more evidently etched into alliances, the securing of commodities and rare minerals will become a more important consideration on the chessboard. It was ever thus, but is more important now. And as ever, there may be frustrations which will result in prices being higher than the market rate would otherwise suggest. There may well be occasions when premiums are paid in one guise or another to ensure security of supply.
Market volatility aside, long-term investors will be rewarded for their patience.
|1 Jan 2009 – 28 Feb 2022|
|Portfolio (per cent)||401.7||286.2|
|Benchmark (per cent)*||215.4||155.7|
|YTD (to 28 Feb)|
|Portfolio (per cent)||-9.6||-4.4|
|Benchmark (per cent)*||-4.2||-3.8|
|Yield (per cent)||3.2||3.8|
|*The MSCI PIMFA Growth and Income benchmarks are cited (total return)|