by Steve Bonnyman, MBA, CFA®, Co-Head, Equity Research and Portfolio Manager, AGF Investments Inc.
The world has been in a structural cycle of declining interest rates for the better part of four decades now, so perhaps it’s not surprising if the widespread impact of central bank tightening this year catches some investors off guard. After all, most are simply not old enough to remember what happens when monetary policymakers start pulling money off the economic table. These days, however, they are seeing it in high resolution, and it’s a picture made even starker by war in Europe and the continuing effects of the COVID-19 pandemic. Bonds, which had enjoyed a 30-year-plus bull market, and equities, which had been reaching all-time highs as recently as last December, have both been hammered. Yet there is a rare bright spot, and it’s emanating from an asset class that had been on a downward trend for more than a decade: commodities and other real assets.
In the first four months of 2022, the Commodity Research Bureau (CRB) Index, which provides a rough measure of global prices for energy, agricultural goods and base/industrial metals, rose by more than 40%, according to Trading Economics. The short-term causes are obvious and significant, but they do not tell the whole story. Clearly, commodity prices have climbed sharply as the Russia-Ukraine conflict constrained access to Russian oil (~10% of world production, according to the International Energy Agency) and a significant share of global grain exports from the rest of the world, while further disrupting supply chains that pandemic conditions had already rendered fragile. Yet while the war in Ukraine has been the catalyst, a longer-term driver is at play here, and it has to do with the interest rate cycle.
For the past several decades, low rates have meant that capital was cheap and plentiful. The accommodative and relatively stable rate environment favoured longer-duration assets like bonds and high growth equities, and one could argue it led to over-investment in these classes. In contrast, capital intensive, shorter-duration assets like commodities have generally experienced a lack of investment, both in markets and in the real world. The result: capacity to produce and transport more stuff became tight. Now, the stressors of war, supply chain disruptions and resurgent late-pandemic demand for goods have brought those constraints to a critical inflection point. Any excess capacity that had existed before has quickly been used up, limiting the production and delivery of vital energy and metals. And so prices have risen sharply.
It is a situation sparked by short-term events, but it was also years in the making. Now, for companies in the real assets space – which largely comprises commodities, but also includes other capital-intensive, lower-growth assets like real estate, utilities, infrastructure and telecommunications – we can expect a sharper focus on putting their profits to use through re-investment. That would entail not only increasing production capacity, but also expanding the infrastructure that supports it. And long-term sectoral trends – like the transition to a greener economy – could provide a tailwind to the mission of re-energizing and re-focusing investment.
That is the macroeconomic backdrop to the commodities rally, and it highlights the continuing opportunities for investors. Yet those will also be determined by more sector- and company-specific factors, of course.
For example, the largest impact of the Ukraine war has been on energy markets – the straw that broke the camel’s back after years of under-investment in production capacity, which began with the price collapse of 2015. Today, oil prices are already testing generational highs, but they should be considered in the context of capacity use and costs of production. Consider that the price per barrel is over US$100 while much of China is in lockdown and the European economy has slowed, and then think about how high it could go if and when the world gets back into full growth.
Meanwhile, the likelihood is not high that Russian oil exports will resume to prior levels anytime soon. Russia will probably remain a pariah state even if the Ukraine conflict is resolved; production and transport will likely be impaired for months or even years to come. With the driving season approaching (and likely to be even busier than normal, given the lifting of pandemic restrictions), oil could well move back into the US$120-$130 per barrel level this summer, and gasoline prices could remain crushingly high. For investors, this shorter-term outlook makes valuations for oil company equities look attractive even at or below current prices for benchmark crude, as they are realizing significant boosts to their cash flow. Despite re-investment of that windfall into production, energy capacity cannot be expanded quickly and is likely to remain tight. And supply chain disruptions – which impact oil and natural gas, as well as everything from steel and coal to fertilizer and labour – will probably persist for some time.
Beyond energy, however, the outlook for real assets equities is more mixed. In real estate and infrastructure, rising rates will likely present a significant challenge, as these sectors rely heavily on debt. Building anything, from radio towers and power transmission lines to toll roads, is becoming more expensive, not only because of borrowing costs but also due to inflation in wages, materials and transportation. On the other hand, utilities typically have some flexibility to pass along higher costs to consumers – insulating their margins and their investors from inflation – and the reopening of the global economy should benefit transportation infrastructure like airports and ports over the short-to-medium term. And over the longer run, the “green transition” to lower fossil-fuel consumption and global-warming-resilient infrastructure should create demand for capital across the spectrum of real assets – and opportunities for investors.
Predictably, market volatility has been high, as a rebounding global economy and strong corporate earnings run face first into elevated geopolitical risk, supply chain disruptions, inflation and tighter monetary conditions. And over the longer term, we still do not know whether the sectoral trend of lower rates has well and truly come to a close. In uncertain times like these, it can be difficult to act strategically rather than tactically. Yet, in our view, the outlook for real assets – driven both by longer-term trends and recent events whose impact is likely to persist – will present opportunities for strategic investors, if they can see through the noise, look at the structures underlying earnings power, and tolerate the volatility that is almost certain to occur through the rest of the year.
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The views expressed in this blog are those of the authors and do not necessarily represent the opinions of AGF, its subsidiaries or any of its affiliated companies, funds, or investment strategies.
The commentaries contained herein are provided as a general source of information based on information available as of May 19, 2022 and are not intended to be comprehensive investment advice applicable to the circumstances of the individual. Every effort has been made to ensure accuracy in these commentaries at the time of publication, however, accuracy cannot be guaranteed. Market conditions may change and AGF Investments accepts no responsibility for individual investment decisions arising from the use or reliance on the information contained here.
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