A brief follow-up from last month

Following last month’s Absolute Return Letter, I received a fair number of responses accusing me of being biased and being unnecessarily negative on Trump, blah, blah, blah. Of course, I was negative (and still am). I am a European, and Trump is outright dangerous for us Europeans. Why should I pretend otherwise?

It is about time that Americans (on both sides of the political spectrum) begin to accept that we are all entitled to having an opinion. I wish certain diehard Trumpists would put their eagerness to criticise us Europeans aside ‘just’ because most of us don’t like their candidate.  We can’t all agree on absolutely everything.

Time to go big on commodities?

Now to something far more important. About five weeks ago, I wrote a research paper called Time to Go Big on Commodities? where I argued that we could be close to an inflection point where commodities begin to outperform equities again (as they have done for long spells before). Equities have dramatically outperformed commodities for years, but there are some very solid reasons why that could be about to change. If you subscribe to ARP+ and haven’t read it yet, I suggest you do so.

In the paper, I used some information from Goehring & Rozencwajg that I cannot publish in the public domain (I have no permission), meaning that I cannot simply copy and paste from the research paper. That said, I can certainly share some of my observations which I will do now.

Four times over the past 125 years, commodities have reached extreme levels of undervaluation relative to equities. It happened in the late 1920s, in the mid to late-1960s, again in the late 1990s, and we are now in the fourth episode of severe undervaluation since 1900. After each of the first three episodes, commodities went on to dramatically outperform equities; hence why it is tempting to conclude that the same is going to happen this time, but is it?

I have managed to locate a chart which, at least partially, illustrates this dynamic. The chart only goes back to 1970 but, as you can see in Exhibit 1 below, commodity valuations are now in line with, or even lower than, previous inflection points.

What do those four episodes have in common?

A closer inspection of the four troughs mentioned above reveals several similarities. To begin with, in the lead-up to all four inflection points, commodities plummeted by 50% or more, i.e., the underperformance has, in all four instances, been significant.

Secondly, the four episodes of commodity despair have all been accompanied by stock market manias. In other words, dual forces – declining commodity prices on one hand and exuberant equity markets on the other – have, in all four cases, driven the commodity-to-equity return ratio to extremes.

Thirdly, each instance of extreme commodity undervaluation was preceded by an extended period of benign monetary policy. In the 1920s, the Fed experimented with its first round of QE. In the 1960s, President Johnson toyed with his “Guns and Butter” policy programme. In the 1990s, Greenspan steered the Fed towards ever-easier monetary policy, and the 2010s were characterised by worldwide money-printing, following the Global Financial Crisis.

Fourthly, as commodities fell out of favour and equities soared, capital was diverted away from capex programmes in various commodities. During the first three episodes, the supply/demand imbalance eventually pushed commodity markets from surplus to deficit, resulting in years of strong commodity returns.

Last but not least, the first three episodes coincided with a shift in the global monetary system. In 1931, economic hardship forced the UK government to come off the gold standard. In 1971, under President Nixon’s leadership, the US also abandoned the gold standard which led to the collapse of Bretton Woods. And, in 1999, the fallout from the Asian currency crisis led to a wave of EM currencies being pegged to the US dollar at artificially low levels.

The link to our megatrend philosophy

I first wrote about the concept of wealth regimes in early 2008, where I argued that wealth-to-GDP is long-term stable, and that it will always mean-revert, should the ratio diverge significantly from its long-term mean-value. It happens that wealth regimes and equity-to-commodity performance cycles are linked. There is almost always a wealth regime change around the inflection point in the equity-to-commodity performance cycle.

Take for example the inflection point in the 1960s and compare it to the two wealth regimes depicted in Exhibits 2a-b below, identified by Woody Brock of Strategic Economic Decisions, Inc. As you can see, equities delivered a robust return of +8.3% annually in the years leading up to the inflection point in the 1960s only to deliver a miserable -4.9% per annum in the years following the inflection point. As you can also see, the annual increase in household asset wealth dropped from +5.7% in the prior regime to only +0.6% in the latter.

I draw two conclusions from that observation:

1. Equity returns have a significant impact on overall household wealth, particularly in the US where investments in public equities account for a much higher proportion of overall household wealth than it does elsewhere.

2. Given the close link between equity returns and wealth and given the fact that I expect commodities to do better than equities in the years to come, overall household wealth will probably be negatively impacted by this dynamic.

The latter of those two conclusions syncs with “Mean Reversion of Wealth-to-GDP” which is (I believe) the aggregate result of the seven megatrends we have identified. In the US, wealth-to-GDP has averaged about 3.8x over the last 75 years. (Before 1950, the data available is less accurate.) It is 5.7x at present, meaning that the ratio must mean-revert in the years to come. If we are close to another inflection point, and commodities begin to deliver higher returns than equities, that could also mark the starting point for the long-awaited mean-reversion process of wealth-to-GDP.

Could I possibly be too early?

The present inflection point looks more like the one in the mid to late-1960s than it looks like the two other inflection points, both of which were much sharper (the late 1920s and the late 1990s respectively). This raises the inevitable question: could I possibly be too early?

I provide a much more elaborate answer to this question in the research paper but, to cut a long story short, if one can stomach a fair amount of volatility, and commodity investors have indeed been confronted with plenty of it over the years, history suggests that the cost of being early in commodities is negligible, and that investors will be handsomely rewarded when the tide turns.

Final few words

Many of the observations in this month’s Absolute Return Letter are based on comments made in the most recent quarterly letter from Goehring & Rozencwajg – a letter which you can find here. I strongly recommend you read it. It is very interesting indeed.

A few days before we posted this letter, a new research paper from Goldman Sachs landed in my inbox. ”Updating our long-term return forecast for US equities to incorporate the current high level of market concentration” is the name of it and, in the paper, the research team at Goldman Sachs argue that equity returns will be much lower over the next ten years than what we have experienced since the GFC, i.e., not a conclusion too dissimilar to the one I am presenting today.

Goldman Sachs are admittedly not near-term bullish on commodities. As they say:

“We are more selective and less constructive on commodities amid softening cyclical support for the complex, with a more cautious stance on oil, copper, and other industrial metals but still bullish gold, though a potential disruption in energy supplies owing to the Middle East conflict could push oil risk premia and prices higher. Higher tariffs would likely further weigh on global commodity demand, though gold would likely find support.”

In other words, the research team at Goldman Sachs definitely think I am too early, but that’s what makes a market, I suppose.  

Niels

1 November 2024