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Source of data is Bloomberg unless otherwise indicated. The information contained herein is derived from sources which are believed to be reliable and every effort has been made to ensure the accuracy of its contents.
Publication Date: January 4th 2023
“Invest in inflation. It is the only thing going up.”[1]
While this was famously quipped by Will Rogers over 100 years ago and the world is very different, the sentiment may be the same. 2022 may leave investors feeling they have missed some of the few recent performing asset classes. While equities were broadly a challenge, save for a couple sub-sectors like energy, fixed income also underwent a significant decline due to rising rates. Commodities were one of the few standouts and even there, timing was a challenge. This may leave many wondering if they missed the opportunity and ideal entry point. We don't think so. This inflationary environment is potentially very persistent and opportune as Auspice clients have experienced the last 3 years given our commodity focus[2].
To be clear, as trend followers, we are generally agnostic to market direction as well as which market. However, given our backgrounds, expertise, and the overall tilt to our portfolios allowing for more commodity "risk" than most managers in our category, we believe the current cycle is an opportunity. In fact, we believe the factors required for a generational opportunity have expanded.
Along with the structural set-up we have previously described, we believe there is a substantial additional important factor, one that could dwarf all the others, that our recent research has uncovered.
The Backdrop of the Commodity Supercycle
We believe there are two basic ingredients required for a commodity supercycle: an extended period of underinvestment in supply, and a generational demand shock. Today we have both - and more.
Following the 2000's commodities boom, CAPEX (capital expenditure) in commodities has been in significant decline[3]. After peaking in 2012-2013 it has fallen steadily in sectors such as energy and mining where there are 5-10 years (plus) development and production cycles. There is no quick fix. The recent energy price crisis in 2021 highlights the energy sector constraints, traditionally believed to be elastic. 2022 saw a record number of commodities in backwardation, more than any time in this century, a market structure that indicates scarcity prior to the Russia-Ukraine war. From a demand shock perspective, it is not just the COVID event, but rather the green transition and global effort to "build back better" infrastructure spending in both developed and emerging markets. Prior to COVID and the global unification towards greening the economy, it was estimated that the world was facing a $15 trillion infrastructure gap by 2040[4]. That gap has now increased significantly, with calls for over $10 trillion in US green infrastructure alone[5].
Chart 1 below highlights the factors we first presented in Q2 2022 with an additional node, recently added, representing a potential emerging demand shock, we believe most are missing.
Chart 1: 2020s Commodity Cycle Drivers
Source: Auspice Capital Advisors Ltd.
Multiple drivers are setting up for a commodity supercycle that could potentially rival and outlast the previous 40+ year supercycle that started in the early 1970s. Unlike the commodity boom we saw in the early 2000s which was largely attributed to one factor, the infrastructure growth of China, today there are many drivers. Furthermore, we believe higher interest rates are a significant exacerbating factor. While raising interest rates may be effective to combat "demand-pull inflation", it is far less effective for "cost-push" inflation. While raising rates can reduce demand for manufactured goods and subdue consumer spending, it does not increase short-term commodity supply or incentivize long-term commodity infrastructure investments. Furthermore, it does not reduce labour shortages, reverse aging demographics, resolve supply chain issues, nor resolve pandemics and wars. What it does do, is make spending on commodity CAPEX more expensive in a world that has already become much more difficult from a ESG perspective. It is undeniable that most western global government policies are not conducive to resource development.
As such, while demand-pull inflation may be moderating as a result of aggressive and continued central bank tightening, that does not change our view - very little has been done to help cost-push, commodity driven inflation.
It seems we are not alone in our stance. Prior to COVID in 2019[6], again in late 2020[7], and here again in late 2022[8], Goldman Sachs has predicted a multi-year commodities supercycle. It has stuck to that view even as energy prices dipped in recent months due to China’s coronavirus restrictions and a global economic slowdown suppressing demand.
“Commodities will be the best-performing asset class once again in 2023, handing investors returns of more than 40%, according to Goldman Sachs Group Inc.[9]"… “Without sufficient capex to create spare supply capacity, commodities will remain stuck in a state of long-run shortages, with higher and more volatile prices,” Goldman’s analysts said.[10]
“Despite a near doubling year-on-year of many commodity prices by May 2022, capex across the entire commodity complex disappointed,” Goldman analysts including Jeff Currie and Samantha Dart wrote on Dec. 14. “This is the single most important revelation of 2022 — even the extraordinarily high prices seen earlier this year cannot create sufficient capital inflows and hence supply response to solve long-term shortages.”[11]
What drives commodity demand from here? The obvious answer is China. The re-opening of the #1 consumer of oil is indeed a big deal. On December 29th 2022, Bloomberg also laid out a summary of how this might go for China:
“China’s reopening will be a mixed blessing for the global economy. A revival in Chinese tourism could boost business in service sectors around the world. Smoother business travel in and out of China may help ease supply-chain strains. But faster growth will spell stronger demand for commodities — pushing against an anticipated slowdown in global inflation.”[12]
However, we believe there is an overlooked and most important factor...
India – The Emerging Demand Shock
India may create a new emerging demand shock that we believe is already well underway. While China has the world's largest population at 1.426 billion, India at 1.417 billion is set to claim this title in 2023. India is already the fastest-growing economy in the world, having clocked 5.5% average gross domestic product growth over the past decade[13].
The amount of commodities consumed by a country is a function of 2 factors: population and income - but it is not a straight line. As a rule of thumb - the demand shock occurs within the middle class of a population when countries spend to industrialize and urbanize. There is disproportionate commodity demand between $4000 and $20,000 GDP per capita. China hit $4024 in 2002 and rose to $17603 (2021)[14]. India hit $2267 in 2021, but the middle class is the key: it is at $6220[15]. It is in the demand sweet spot with the added benefit of being an educated and democratic nation. India currently has the 3rd largest middle-class after China and the US. It is expected to be the largest by 2027[16]. India's middle class is estimated to be 31% of the whole as of 2021, 41% by 2025, and projected to rise to 63% by 2047[17].
“The middle classes of all countries have been the key drivers of the global economy in the last century. During the past several decades, world economic growth has occurred, mostly because of increased consumption in the middle classes of the United States, Europe, and other advanced countries.”[18]
India’s emerging middle class will drive demand for the resources needed to supply the construction of modern infrastructure and cities, and to power homes and industry. This includes demand for Copper, Metallurgical Coal and Iron Ore which are set to double by 2030 from when demand started to increase in 2016[19]. The energy resources will be massive to accommodate a rising middle class economy that will demand the luxuries of a western lifestyle including cars and everything created by the petroleum industry - an exhaustive list for another day. As illustrated in Chart 2, the share of global middle class consumption to current and projected, shows India pulling ahead of western European and other Asian markets.
Chart 2: Share of Global Middle Class Consumption, 2000-2050
Source: The Emerging Middle Class in Developing Countries
Importantly, as per Chart 3 below, the estimated absolute value of consumption by India in 2030 is roughly three times larger than what China consumed in 2020 and the United Stated consumed in 2009. We believe this factor alone is poised to create a global commodity demand shock beyond what was experienced in the early 2000s with China.
Chart 3: Middle Class Consumption – Top 10 Countries (billions of $USD and global share)
Source: The Emerging Middle Class in Developing Countries
Recent Developments Heading into 2023
After a slight softening post the Russian invasion of Ukraine, commodities started to show signs of renewed upside late in 2022. We believe, as do others, that commodities are likely set to reaffirm their upward trajectory led by the recent metals rally, highlighting the lack of CAPEX, inflationary green transition, and build-back better infrastructure spending, alongside a massive demand base in India and China. As trend followers, and agnostic to direction, we have experienced a shift across the metals sector with short positions largely exited and long positions added. This has occurred in both the Precious and Base metal sub-sectors. While not the way we decide to implement a trade, it should be noted that base metals often lead commodity cycles. Fundamentally this makes sense as we note falling stockpiles in metals, as of December 31st 2022, the lowest level in at least 25 years (Chart 4 below). The London Metal Exchange is entering 2023 with the smallest available warehouse stockpiles in at least 25 years, potentially setting the stage for significant squeezes, spikes, and price appreciation.
Chart 4: Base Metals Shortages
Source: https://www.mining.com/web/lme-ends-chaotic-year-with-metal-stockpiles-perilously-low/
As quantitative traders agnostic to direction it is encouraging to see many commodity markets resume their upwards price trends despite looming recessionary fears – quite the technical/fundamental combination as India may be set to surpass China as the #1 global commodity consumer.
Finally, as further indication of the growth, opportunity, and timeliness surrounding India, the relative strength and outperformance of the India Nifty 50 equity index is worth noting. Whereas global equities have faced significant selling pressure in the last year, the Nifty 50 was making new highs at the end of November. See Chart 5 below.
Chart 5: India Nifty 50 Equity Index
Source: Auspice Capital Advisors Ltd. & Bloomberg
Notably while the Nifty 50 Indian Equity Index tracked the performance of global equity benchmark MSCI ACWI and the S&P500 in the first year and a half of this decade, since the second half of 2021 there has been a significant divergence: H2 2021 through the end of 2022 the Nifty 50 is +14.97% versus -14.03% for the MSCI ACWI and -10.54% S&P500. See chart 6 below.
Chart 6: India Nifty 50 Equity Index Versus Equity Benchmarks
Source: Auspice Capital Advisors Ltd. & Bloomberg
While not a perfect proxy, we think the strong performance of the Nifty 50 in a weak global equity environment is indicative of the significant growth taking place, and accordingly increased commodity consumption, in India. This, alongside other noted factors, could be setting the stage for a commodity supercycle that rivals any previous.
Is it too late to invest in commodities? The below Chinese proverb captures our sentiment.
"The best time to plant a tree was 20 years ago. The second best time is now."
Sources
[1] https://www.thenationalnews.com/business/money/2021/07/07/how-to-protect-your-income-and-invest-if-inflation-surges/
[2] See performance for Auspice funds at http://www.auspicecapital.com/resources#p2
[3] http://www.auspicecapital.com/alt-invest/2022/9/1/commodity-supercycle-update-where-are-we-today
[4] https://www.weforum.org/agenda/2019/04/infrastructure-gap-heres-how-to-solve-it/
[5] https://truthout.org/articles/progressives-unveil-10-trillion-green-infrastructure-climate-justice-bill/
[6] https://www.cnbc.com/video/2019/01/16/goldman-sachs-bullish-on-commodities-for-2019.html
[7] https://www.reuters.com/business/energy/goldman-proclaims-dawn-new-commodity-supercycle-andy-home-2021-01-05/
[8] https://www.goldmansachs.com/insights/pages/gs-research/2023-commodity-outlook-an-underinvested-supercycle/report.pdf
[9] https://financialpost.com/pmn/business-pmn/goldman-says-commodities-will-gain-43-in-2023-as-supply-shortages-bite
[10] https://financialpost.com/pmn/business-pmn/goldman-says-commodities-will-gain-43-in-2023-as-supply-shortages-bite
[11] https://financialpost.com/pmn/business-pmn/goldman-says-commodities-will-gain-43-in-2023-as-supply-shortages-bite
[12] https://www.bloomberg.com/news/articles/2022-12-28/china-economy-faces-bleak-few-months-faster-rebound-next-year?leadSource=uverify%20wall
[13] https://www.morganstanley.com/ideas/investment-opportunities-in-india
[14] https://data.worldbank.org/indicator/NY.GDP.PCAP.PP.KD?locations=CN
[15] https://data.worldbank.org/indicator/NY.GDP.PCAP.CD?locations=IN
[16] https://www.asianstudies.org/publications/eaa/archives/the-middle-class-in-india-from-1947-to-the-present-and-beyond/
[17] https://timesofindia.indiatimes.com/business/india-business/middle-class-nearly-1/3rd-of-indias-population-to-be-2/3rds-by-2047-report/articleshow/95239621.cms
[18] https://www.asianstudies.org/publications/eaa/archives/the-middle-class-in-india-from-1947-to-the-present-and-beyond/
[19] https://www.afr.com/companies/indian-superpower-fuelled-by-aussie-coal-20180704-h128h9
Disclaimer Below
IMPORTANT DISCLAIMERS AND NOTES
1. The Nifty 50 is a benchmark Indian stock market index that represents the weighted average of 50 of the largest Indian companies listed on the National Stock Exchange.
2. The S&P 500 is an index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe. Price Return data is used (not including dividends).
3. The MSCI ACWI Index (MSCI ACWI), MSCI’s flagship global equity index, is designed to represent performance of the full opportunity set of large- and mid-cap stocks across 23 developed and 24 emerging markets. As of May 2022, it covers more than 2,933 constituents across 11 sectors and approximately 85% of the free float-adjusted market capitalization in each market.
Futures trading is speculative and is not suitable for all customers. Past results are not necessarily indicative of future results. This document is for information purposes only and should not be construed as an offer, recommendation or solicitation to conclude a transaction and should not be treated as giving investment advice. Auspice Capital Advisors Ltd. makes no representation or warranty relating to any information herein, which is derived from independent sources. No securities regulatory authority has expressed an opinion about the securities offered herein and it is an offence to claim otherwise. Please read the offering documents before investing.
Certain statements in this document are forward- looking statements, including those identified by the expressions “anticipate”, “believe”, “plan”, “estimate”, “expect”, “intend”, “target”, “seek”, “will” and similar expressions to the extent they relate to the Fund and the Manager. Forward- looking statements are not historical facts but reflect the current expectations of the Fund and the Manager regarding future results or events. Such forward-looking statements reflect the Fund’s and the Manager’s current beliefs and are based on information currently available to them. Forward-looking statements are made with assumptions and involve significant risks and uncertainties. Although the forward-looking statements contained in this document are based upon assumptions that the Fund and the Manager believe to be reasonable, none of the Fund or the Manager can assure investors that actual results will be consistent with these forward-looking statements. As a result, readers are cautioned not to place undue reliance on these statements as a number of factors could cause actual results or events to differ materially from current expectations.
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