Stocks, crypto, NFT’s and art have all had a great run during the past year. The housing market hasn’t been this hot since the real estate bubble which culminated in 2007. One area that has been hot is less about the new economy and much more about the old dirty economy: commodities.

The Economist commodity price index has seen soft commodities like food rise 35% in the last year while non-food agricultural and metals have risen 80% and 84% in dollar terms respectively. Goldman Sachs has even proclaimed this the start of a new commodities super-cycle, but what does that mean and how can investors take advantage of that now?

The Last Go Around

The last super-cycle was from 2000-2007 and can be characterized as the BRIC’s super-cycle. This was driven by Brazil, Russia, India and especially China’s demand for infrastructure and rapid industrialization. Apartment buildings, highways, literally entire cities were constructed at the time which saw one of the largest migrations in human history which did not take place in war time, as Chinese migrants moved from the countryside to the city for work.

Copper, iron ore and soft commodities like soy saw their prices rise. Fiscal stimulus from the US brought on by the bursting of the dot com bubble but also because of the Iraq war, drove the dollar downward. In the wake of this came stronger foreign currencies and commodity prices spiking.

The current situation promises to be similar yet different. The stimulus this time around is much more massive and is ending up in the hands of consumers, not defense companies. Given the social climate as well, the stimulus is better positioned than in past years to find its way into the hands of middle class and working class people. This alone is driving the argument that commodities could see a new heyday as these groups tend to spend more on goods than the wealthy but there are also other important reasons:

• Mean Reversion – Commodities have been in a slump since the end of the financial crisis. It’s been about 13 years since the last super-cycle which has seen mining operations close and rigs be abandoned. Supply gets constrained in these situations and when events like the pandemic and then the stimulus raise demand, prices rise and the cycle starts all over again. Taking a look at the ratio of commodities to the S&P 500 shows that they are trading at their lowest relative valuation to the index in the past 50 years. Although it can’t accurately predict when things should happen, logic says that given the valuations, there will likely eventually be an upswing in commodity prices to align things more towards a normal equilibrium.

• The Stimulus – The stimulus and the infrastructure package could create a boom in itself. There is some evidence that social spending is pro commodities as the poor tend to spend more of their money on products which require hard commodities (housing, cars etc). The growth rate of social benefits to persons seems to have a long term correlation with an equally weighted commodities index which Goldman Sachs pointed to recently (see below). Then there is the proposed $2 trillion infrastructure plan which could bump up the needs of commodities used in industrial applications for metals like copper and silver. The price of silver rose 48% last year and half of the damned was driven by industrial applications for things like solar panels, batteries and other electronics.

• Shipping Costs – One aspect of the commodities market that is often overlooked is shipping as most countries need someone to get the supplies to their market. The dry bulk index saw a spike during the tail end of the last super-cycle and a subsequent glut of ship building that produced a huge crash in rates. This bear market for shipping seems to have started to turn the course in 2016. Growth in new vessels has picked back up since then to meet higher demand for commodities. As the stimulus starts to work its way through though, investors are betting that the market will see a surge in pricing. The Dry Bulk Shipping ETF (BDRY) is up 119% this year in anticipation of increased commodity prices and demand.

Looking back even further, Janus Henderson and Stifel see an inevitable uptick in commodities as part of a historical pattern in commodities prices dating back 200 years. The blue dots below represent their estimation as to where things will head for a broad basket of both hard and soft commodities.

The Risk

Although the evidence for a commodity super-cycle seem compelling, there are some risks on the horizon that could reverse its current upward trajectory. Right now, with the “base effect” of temporarily pumped up inflation numbers, there is nervousness in the bond markets that the Fed and other central banks would be willing to deal with a bout of above trend inflation to get the longer term average back towards 2% but also to relieve some of the interest burden on indebted governments like the US.

Keep in mind that the media and market watchers play to our behavioral biz towards loss aversion, not on the upside: loser hurt more than winners feel good. It’s an innate survival instinct that has helped humans survive for hundreds of thousands of years in the wild, but works against us when it comes to modern financial markets.

If a “Goldilocks” scenario developed with low inflation yet attractive real rates in the US, capital could flow back into the US and back towards the traditional growth areas of tech. There has been a mini instance of this in the past month as tech and the S&P 500 have once again outperformed international markets despite lagging them for much of the beginning of the year.

Some commodities also remain heavily dependent on China as well. Iron ore in particular sees 58% of its demand come from China. More tepid growth there could see demand soften for certain commodities used in building materials.

How to Play This

Despite the past month’s outperformance of tech and large cap growth, I remain bullish on value and commodities. I also am hedging my US exposure through international developed markets exposure. Within the US, I still remain bullish on small and mid caps compared to large cap stocks, which have also outperformed over the past few years.

The Vanguard Materials Index Fund (VAW) is still outpacing the S&P 500 year to date rising 10.59% compared to 9.64% for the S&P. The Vanguard Small Cap Value Fund (VBR) still is outpacing both of them, rising 17.5% year to date. Yet there remain areas that still have time to get in and remain reasonable. To isolate commodity producing countries and their currencies I have exposure as well to the Emerging Markets Ex-China ETF (EMXC) as well as the Invesco DB Commodity Index (DBC) to isolate commodities themselves.

Value in general is an area that remains attractive both from the perspective of a commodities rally as well as a pickup in yield. Growth has not outperformed value for this much since the 1930’s according to JP Morgan as seen by the % drawdown in value versus growth.

The main sector weighting differences between growth and value is tech and IT versus financials, energy and utilities. Although the data below is from 2019 end, the sector weights have not shifted dramatically since then.

Financial companies have spent the past decade rebuilding their balance sheets post crisis and the low interest rate environment has not suited them well. The pickup in the long end of the yield curve offers some hope for them though. Energy companies have been one of the best performers since the lows of the pandemic and utility companies could benefit from an inflationary environment as inflation helps reduce their debt load as well as they can pass price increases into their customers due to operating as natural monopolies.

Barring the past month’s divergence, the potential for the start of a commodities super-cycle, stimulus dragging the dollar down and the high valuation of growth stocks, the case for at least some exposure to value and international equities is a strong one. As always, remaining diversified across countries, growth and value as well as small cap and large cap remains key to reducing volatility and capturing upside. It will be interesting to see how this plays out for the remainder of 2021.

The information provided by www.cashchronicles.com is for informational purposes only. It should not be considered legal or financial advice. You should consult with an attorney or other professional to determine what may be best for your individual needs. www.cashchronicles.com does not make any guarantee or other promise as to any results that may be obtained from using our content. No one should make any tax or investment decision without first consulting his or her own financial advisor or accountant and conducting his or her own research and due diligence. To the maximum extent permitted by law, www.cashchronicles.com disclaims any and all liability in the event any information, commentary, analysis, opinions, advice and/or recommendations prove to be inaccurate, incomplete or unreliable, or result in any investment or other losses. Content contained on or made available through the website is not intended to and does not constitute legal advice or investment advice and no attorney-client relationship is formed. Your use of the information on the website or materials linked from the Web is at your own risk.