- After a stellar run, can commodity funds maintain their momentum?
- We assess the outlook for the sector, and possible holdings
The commodities sector has been a rare bright spot amid the recent, pervasive gloom in stock markets. Mining and resource companies have fulfilled their brief of protecting against soaring inflation, while outpacing more glamorous alternatives such as technology. However, for investors late to this particular party, there is now a question over whether it may be drawing to a close.
The contrast between the recent performance of commodities and the rest of the market is stark. While the MSCI World index is down by 10 per cent over the six months to mid-June, the MSCI ACWI Select Natural Resources Cap index has returned more than 18 per cent.
The sector has been pushed higher by vast rises in commodity prices. Over the 12 months to 15 June crude oil is up 65 per cent, natural gas is up 129 per cent and coal is up 206 per cent, Trading Economics figures show. Lithium, a key component for electric batteries, has seen its price rise 436 per cent. Agricultural commodities have also seen gains – 47 per cent for coffee, 58 per cent for wheat and 69 per cent for cotton.
Whispers of a new commodities supercycle had started even before the pandemic. It was clear that building the infrastructure necessary for a transition to low carbon fuels would create a need for specific materials – copper for electric cars, lithium for batteries and aluminium for new electricity networks. Where the last commodities supercycle was fuelled by the rise of China, this one would be created by the green revolution.
This rising demand coincided with a period of underinvestment in new supply. Mark Smith, co fund manager on the Amati Strategic Metals Fund (GB00BMD8NV62) says that many mining companies were burned by the last supercycle in commodities. As a result, investment in new mines and production has been anaemic. “Annual development capital has more than halved (from $130bn to $60bn) and exploration expenditure over the same period fell from a peak of $21bn in 2012 to $8.7bn in 2020,” he adds.
With an impetus to ‘build back better’, the pandemic brought new commitments to that green revolution. It also interrupted supply of commodities as supply chains ground to a halt in response to repeated lockdowns. As commodities struggled to get from place to place, prices start to rise. When the world economy resumed normal activity, demand outpaced supply.
Into this fragile mix, the war in Ukraine saw the supply situation worsen. In its latest economic outlook, KPMG summed up the problem: “Russia is the world’s largest exporter of natural gas, second largest exporter of oil and the third largest of coal. It is also a large exporter of titanium, uranium, aluminium, copper, nickel, and palladium. Ukraine is a significant source of global neon exports and produces components that are part of highly integrated automotive manufacturing supply chains, among others.”
The result has been structural factors, such as the need for green infrastructure and long-term underinvestment in supply, colliding with cyclical factors – rising demand as the world emerges from the pandemic – and one-off factors – the war in Ukraine. This has created a buoyant environment for commodities.
However, in the very short term, the outlook has shifted a little. Nitesh Shah, director of research at WisdomTree, says some of the cyclical elements have eroded. Rate rises from central banks and inflation have knocked growth.
One-off winners versus structural growth
Luca Paolini, chief strategist at Pictet Asset Management, says commodities tend to be the go-to asset class at a time of higher inflation, but there has been a widening gap between commodities with structural growth and those where prices have risen due to one-off factors, such as the war in Ukraine: “In general, commodities are the typical asset class when bond yields and inflation are rising. That’s the theory, but in practical terms, there may be a stagflation shock coming from Ukraine. It has been the commodities not affected directly by the war in Ukraine that have done well more recently, including areas such as lumber and copper.”
Paolini believes the outlook for the three main areas of commodities – energy, industrial metals and agriculture – is quite different. He notes: “Energy prices are vulnerable to any form of ceasefire in Ukraine, which is more likely than many people expect. Second, there could be additional production coming on stream – from Saudi Arabia or Canada, for example. It is far easier to bring oil on stream than, say, copper.”
Shah also believes the factors pushing energy markets higher are weakening: “New gas supply may come on stream from the US. Gas is considerably cheaper in the US over Europe and that gap may narrow.” He is not expecting oil prices to rise significantly from here, but neither does he see them falling.
Both agree that agricultural commodities and industrial metals may have stronger prospects ahead. Paolini says: “In agriculture, the damage of the war in Ukraine is more impactful.” Shah points to rising fertiliser costs, which are seeing it used more sparingly and may diminish yields. Agricultural systems were already straining to feed a growing world population and facing up to climate change.
Paolini says that the pandemic and the war in Ukraine have cemented the energy transition and, as such, industrial metals remain an interesting area. These areas have significant supply constraints and it has proved difficult to bring on new production. Chile, for example, has not managed to bring on any new copper supply in more than a decade.
Smith says that in the end, it is demand that will power these new technologies: “The shift to decarbonise the global energy supply and replace hydrocarbons with renewable energy will be very metal intensive. The demand annuity will be for most metals over the coming decades, but the acute projected shortages will be in the ‘tech-battery’ metals: lithium, nickel, cobalt, rare earths, graphite, vanadium, manganese.”
He believes a gap is opening up between supply and demand, with policymakers facing the unwelcome choice of tapering global climate ambitions or adjusting to an inflationary commodity environment. If the world is to limit global temperature rises to 1.5°C, a five-fold increase in base metal supply is needed by 2040. He believes this is likely to create a fertile backdrop for investors, including plenty of aggressive merger and acquisition activity.
He says: “The mining industry is not currently prepared to respond to the green ambitions of politicians. Renewable energy technology will have to improve and adapt to thrift out some key metals to ensure a sustainable supply-demand balance. Metal demand for decarbonisation will have to take precedent over other discretionary demand sectors.”
There are plenty of options for investors interested in commodities in all its forms. Diversified commodities exchange traded funds (ETFs) include the L&G All Commodities UCITS ETF (BCOG), the iShares Diversified Commodity Swap UCITS ETF (COMM) and the WisdomTree Enhanced Commodity UCITS ETF (WCOG). There are progressively more granular options, including WisdomTree Industrial Metals ETC (AIGI) or the widely followed thematic equity play iShares Global Clean Energy UCITS ETF (INRG). There are now battery technology ETFs and even a specific lithium ETF, that sit alongside specialist oil and gas ETFs.
ETFs won’t give investors the spot price for commodities. Instead many will use derivatives, usually futures, to replicate the price as closely as possible. Gavin Haynes, investment consultant at Fairview Investing, says: “These ETFs can provide exposure to the underlying commodities, but it is not direct exposure. They will reflect the complexities of commodities pricing in the futures market.” Some ETF providers, including WisdomTree, aim to optimise the futures exposure, depending on market conditions.
For those who are willing to take equity risk, individual mining companies or active funds will be an option. Mining companies won’t directly mirror the commodities price and investors will need to consider the operational strength of the company itself, but there will be a strong relationship. The right time to invest in a commodity versus a mining company will depend on the market environment. Shah says that direct investment in commodities has tended to provide better inflation protection, while Smith says that the leverage on investment return will be higher for mining companies than investing directly in the metal and investors gain exposure to any merger and acquisition activity.
Active funds should be able to navigate the dynamics of different commodities markets. Haynes likes BlackRock World Mining Trust (BRWM), which is run by an experienced team under Evy Hambro. He also likes the Amati Strategic Metals Fund. “This is not just looking at short-term pricing, but looking at the move to clean energy and the infrastructure needed to capture that,” he adds.
Paolini likes the mining companies, saying they are directly linked to reflation in China: “Valuations are also pretty attractive, particularly in Europe, and it is a sector that is generating a lot of cash. We take exposure via some commodity currencies too, mostly in emerging markets.” The economies of Brazil or Australia, for example, are closely linked to commodities prices.
The UK market also provides some exposure to mining and resource companies for those who prefer a domestic tilt. The FTSE 100, for example, has an 11.3 per cent weighting to energy and another 8 per cent in basic resources. It has benefited from the recent rally and this is part of the reason it is modestly up over the year to 16 June, compared with a 15 per cent fall in the mid-cap FTSE 250 index.
However, it should be noted that investors are largely getting exposure to energy markets through BP (BP.) and Shell (SHEL), rather than more exciting areas such as agriculture or green energy.
Shah believes commodities remain one of the best hedges for inflation: “They provide protection against expected and unexpected inflation, but particularly unexpected inflation. No other asset class offers that.” Haynes says that a lot of the good news for commodities is now in the price, but prices are likely to remain at historic highs. Supply is restricted and China’s zero Covid policy continues to cause blockages.
However, investors may want to take a more nuanced approach, focusing on those areas with longer-term structural demand, rather than just a short-term supply crunch. Agricultural commodities and those areas supporting the energy transition are less reliant on the ebb and flow of economic growth and the outcome of the war in Ukraine to drive prices.