(Cover Photo Source: Maksym Kaharlytskyi)
At TEAM Asset Management, one of the challenges dominating our thoughts of late has been a rapid deterioration in the risk to potential reward outlook across a range of asset classes.
The destabilising consequences of the numerous monetary and fiscal bazookas deployed by global governments now includes a new chapter: the rise of the organised, risk-seeking retail investor (for further details, see our recent update Can’t Stop, Won’t Stop, GameStop!). Whilst much of the media’s attention has been focussed on a small, unloved pocket of the US equity market, evidence suggests retail participation as a proportion of overall turnover across financial exchanges in many parts of the world is higher still.
Furthermore, we have the unprecedented volume of IPO and SPAC issuance in recent months, an explosion in margin debt, the startling performance of shares of a number of deeply shorted (and deeply unprofitable) companies relative to broader indices, and a record high in call vs put volumes. Our general observation that short-term risks across many financial markets are elevated should not therefore come as a surprise.
One area that has continued to interest us is commodities. As a distinct asset class with returns that are largely independent of stock and bond market performance, the premise behind the inclusion of commodities across TEAM’s range of investment solutions is straightforward: to offer inflation protection, genuine diversification, and enhanced return potential.
In contrast to the broad financial markets, commodities are ‘real assets’ which means they tend to react differently to changing economic fundamentals. Most obviously, they tend to benefit from rising inflation. As demand for goods and services increases, the price of those goods and services usually rises, as do, in turn, the prices of the commodities used to produce those goods and services. Because commodity prices usually rise when inflation is accelerating, investing in commodities can provide portfolios with a hedge against inflation.
In contrast, both stocks and bonds tend to perform better when the rate of inflation is stable. Faster inflation (‘faster’ in today’s world typically means a rate of inflation above that considered acceptable by central bankers) reduces the value of future cash flows from stocks and bonds because that future cash will be able to buy fewer goods and services than they would today.
Between 1999 and 2020, annual returns on the Bloomberg Commodity Index have had a reasonably low correlation with the MSCI World Equity Index, and almost zero correlation with the Bloomberg Barclays Global Aggregate Bond Index:
The above table illustrates what may be the most significant benefit of broad exposure to commodities: diversification. In a diversified portfolio, asset classes tend not to move in synch with each other, which tends to reduce the volatility of the overall portfolio. Lower volatility reduces portfolio risk and may improve the consistency of returns over time. However, we must also recognise that diversification does not ensure against loss.
TEAM have been steadily accumulating exposure to the commodities sector over the past twelve months, primarily via precious and industrial metals, where our preference has been for copper (see price chart 1 below). Evidence continues to point to a global structural deficit of the metal, with credible estimates suggesting that global copper consumption will exceed copper mining supply and recovered copper scrap by around 380,000 tonnes in 2021.
Turning to the inventory picture, total copper inventories at the three major metal exchanges (LME, COMEX and the Shanghai Futures Exchange) have declined by almost 52% from 638,375 tonnes in March 2020 to 306,223 tonnes at the time of writing (see chart 2 below). Meanwhile, there remains a lack of new meaningful copper projects coming on-line for at least two years with the potential delay of Mongolian Oyu Tolgoi expansion project.
(source: Bloomberg. Includes the Shanghai Futures Exchange, LME and COMEX).
On the demand side, according to the World Bureau of Metal Statistics, Chinese copper consumption grew 17% YoY in 2020, assisted by the country’s rapid and successful response to the Covid pandemic. For context, the rest of the world, large parts of which are still grappling with stop-start lockdown measures, registered a 6.5% YoY decline, leaving total global aggregate consumption at +6%
In addition to the above, copper has also benefited from the introduction of an added demand dynamic, namely the generation of electricity from ‘renewable’ sources, which is highly copper intensive (copper is a highly efficient conductor of electricity and can assist in reducing carbon emissions). According to external research estimates, renewable energy systems use between 4 and 12 times more copper than traditional power generation systems, to ensure efficiency.
TEAM have also steadily accumulated positions within the agricultural, or ‘softs’ commodity space, where we continue to observe an incredibly interesting demand and supply imbalance playing out.
On the demand side, the global consumption of grains has risen by a total of 50% (to an annualised growth rate of 3%) since the year 2000, with China and emerging markets leading the rise in demand on account of increasing per capita incomes and growing levels of protein consumption. In China specifically, we continue to observe the replenishment of the country’s hog supply following the devastating African swine-fever outbreak in 2018/2019 that enveloped the country and decimated over 40% of the country’s total hog population.
Indeed, as recently as February 9, the US Department of Agriculture raised its forecast for China’s 2021 annual corn imports to a record 24 million tonnes, up 6.5 million tonnes, or 37%, from its January 2021 projection, and over 16 Million tonnes more than the total 2020 figure of 7.6 million tonnes. The USDA’s Foreign Agricultural Service commented, ‘China’s demand for feed stuffs continues to rise as its swine herd recovers from African swine fever’.
On the supply side, according to respected independent consultancy the Hackett Financial Advisory Group, a multi-decade weather system is in the process of developing through 2021-2022 which is likely to produce extreme outcomes (harsh, freezing winters and long, extended droughts in summer).
This could have a devastating impact on key crop-producing regions of North East China, swathes of the US and parts of Latin America throughout 2021 due to delayed planting seasons. Production shortfalls are expected to be as great as 30% across a range of agricultural products, which we expect to result in sustained, upward pressure on prices.
Whilst prices across many grains have already risen substantially in the short-term, the long-term price charts going back to the 1970’s offer a more helpful perspective. The performance of the S&P GCSI Agriculture Total Return CME Index (launched in 1969) is shown below, indicating that we remain far away from levels that might be considered extreme in a historical context:
Our desire to express our positive view through an appropriate financial instrument is a somewhat less complicated exercise than it was twenty years ago.
The emergence of investment vehicles benchmarked against commodity indices has provided investors with a simple method of gaining exposure to the asset class. The vehicle we have chosen across our strategies tracks the prices of 11 different agricultural commodities. Moreover, there is a high level of exposure to the three core commodities we believe will be most impacted by the supply and demand dynamics in 2021 and beyond.
One potential advantage of taking this diversified approach is that individual commodities are often not correlated with each other, and thus returns should be less volatile than the returns seen from any single commodity. Another advantage is that commodity indices have existed for decades, providing ample historic data for asset allocation studies and research. We have utilised the short-term price weakness across the sector in recent weeks, which we view as transitory in nature, to introduce further meaningful agricultural commodities exposure across our range of investment strategies:
(source: TEAM, reflects TEAM MPS growth strategy)
Whilst commodity exposure has traditionally represented only a small percentage of our industry’s multi asset investment approach in the past, both the economic and inflationary outlook, and rapidly changing structural dynamics within a number of sectors, point to an increased presence for the asset class the foreseeable future.
Combined with our recent decision to greatly reduce our direct fixed interest content across all strategies in favour of assets with a similar risk, but much more positive return dynamic represents our forward-thinking approach to a rapidly evolving economic and market outlook.