The world moves in mysterious ways. Here we are amid a global pandemic and extraordinary China divorce and what do we get? Mining Boom 3.0.
A few weeks ago Variant Perception put out a note declaring another commodities supercycle imminent. Let’s reprise:
A new dawn for commodities
• 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 compared to themselves and to other assets
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
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
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
rising cross-asset volatility
too much leverage becoming a dangerous game
the long boom in financial assets ending, and real assets and commodities outperforming
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
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”
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
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
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
VP is bullish oil, coal, gold, silver and copper.
What to make of it? My view:
- It makes sense in theory but relies upon inflation. I see the MMT transition as only half complete so think we are still in a deflationary world punctuated by cyclical policy-driven recoveries. That said, with each fading inflation impulse we are lurching towards ever greater fiscal/monetary integration so that’s more an argument to be aware of volatility than necessarily a disagreement with the thesis.
- Bonds might likewise be thought of more cyclical than secular plays.
- Oil is in massive oversupply so beyond a year or so of recovery I’m skeptical it can get much upside beyond…say…$80 Brent.
- Bullish precious metals, especially on the investor rotation arguments.
- Forget coal. China has killed it to crunch Australia. Seaborne is buggered unless or until that lifts.
- Copper and anything EV has the most bullish base case.
- I’d add iron ore for the next nine months but beyond that it gets troubled as China slows, DXY bottoms and supply gushes out. That said if China relations keep deteriorating, and the base case is that they will, then geopolitical risk premium needs to built into iron ore and that will mitigate the downside.
So, how does Australia sit in Mining Boom 3.0? Decent. Iron ore looks better positioned than it did only a few weeks ago so long as China keeps shooting itself in the foot with Australia. That does not mean $200 forever (barring some actual disruption) but it might mean $100 over a few years rather than $60. However, that will be offset by coal in the terms of trade.
Gold is in a bull market and so are decarbonisation commodities such as copper, nickel and graphite. We have plenty of the former and some of the latter.
There is likely to be some follow-through investment for the precious and base metals but not the bulks.
So, this will be more of an income than an economic boom for Australia. Especially since the China divorce should also weigh on the AUD. The primary beneficiaries of this will be mining stocks and the federal budget rather than jobs.
As long as Depressionberg is prepared to spend it one way or another it will benefit Australia. But he’s not the sharpest tool in the shed and may stupidly shoot for a surplus instead as everyone else goes MMT.
That would lift the currency and kill the Aussie leg of the boom at the worst moment as divorce from China demands we seek new markets.