Riding a Reflation Wave
#Market Strategy — 06.04.2021

Reflation: Riding Commodity Inflation

Our 2021 Updated Investment Themes

Edmund Shing, Global Chief Investment Officer

Vaccines, recovery and reflation

Reflation: riding commodity inflation

Short-term, high risk

  • While current global inflation rates remain well contained, the combination of huge monetary and fiscal stimulus as well as widespread supply constraints could drive substantial increases in good inflation in 2021 and beyond.
  • Commodity prices have already started to reflect these pressures; but we believe that we are still at the beginning of this new commodities bull market cycle, with further gains ahead.
  • We favour exposure to industrial metals, such as copper, nickel and tin; precious metals such as silver and platinum; inflation hedge funds/products and global miners.

At the dawn of a new commodity supercycle

As the left-hand chart above shows, medium-term expected inflation rates have risen in the US as market participants start to price in the risk of higher US consumer inflation, driven by a combination of the strong economic recovery plus the inflationary effects of bottlenecks in logistics and the supply of goods, such as semiconductors and industrial metals.

The US Federal Reserve (the Fed) has been clear in its public pronouncements that it will not pull back its exceptionally easy monetary policy until US core inflation has exceeded 2.5% for an extended period. In December 2020, the US core personal consumption deflator (the Fed’s preferred inflation measure) stood 1% below this threshold at just 1.5%.

Historically, rising US inflation expectations have coincided with substantial rises in commodity prices. Thus far, the rally in the Refinitiv commodities index since 2020 has been relatively modest. Low inventories, the lack of investment in new mining production and rising demand are a heady cocktail for commodities, in particular industrial metals like copper, tin, aluminium and nickel.

The FTSE 30-year TIPS (Treasury-rate hedged) index has gained 29% since end-March 2020, highlighting the benefits of investing in products geared to rising US inflation expectations. 

The huge projected increase in spending on renewable energy infrastructure and electric vehicles is an additional structural growth driver for copper, lithium, nickel, aluminium and tin, as well as silver. Wind turbines and solar panels should drive 250-300% growth for copper, nickel, aluminium, zinc and silver to 2050, according to the World Bank.

Global mining companies are very well placed to benefit from this combination of rising demand, low inventories and constrained global mining production. The normal mantra in commodities is: “the cure for high prices is high prices”, i.e. high commodity prices encourage investment in new production, which will increase supply and thus drive prices back down.

However, compared with previous commodity cycles, we now see a far more consolidated global mining industry worldwide, with greater oligopoly power today in a number of industrial commodities such as copper, nickel, tin, aluminium and iron ore. Global miners are thus more likely to maintain current production and enjoy rising profitability from the growing gap between selling prices and the cost of production, than to pour money into heavy new investments. Yet global mining stocks (STOXX Europe Basic Resources sector)  remain way off 2008 and 2011 price peaks, offer very attractive sector valuations of 6x EV/EBITDA and a dividend yield of nearly 5%, and 54% estimated 2021e EBITDA growth. It is thus one of our preferred equity sectors.

A new opportunity: the commodity-rolling yield

  • The term structure of the Brent futures is now in backwardation (prices decline as maturity dates increase)
  • The rolling yield of the Brent futures is above 8% per year
  • In general, the rolling yield of the commodity complex is increasing
  • Commodity investors should consider both the price outlook and the rolling yields

Generating high yields from commodities

Brent prices have risen 40% since 30 September to more than $60 per barrel on the back of the OPEC+ decision to restrict its production led by Saudi Arabia which unilaterally cut its own production by 1 million barrel per day in February and March, bringing the total output restrictions to 8.1 mb/d.

Given the huge excess capacities and the fragility of the OPEC+ agreement, we do not see much upside potential from here in the coming months.  Our forecast for H2 2021 is $50-60/b.

We are, however, more upbeat for the coming years due to the lack of investments in traditional oil fields since the oil price collapsed at the end of 2014. New investments will be harder to finance as their long-term profitability is challenged by the energy transition. Oil majors will also divert part of their investments to green energy and decarbonisation, leaving less resources for fossil fuels.

What does it means for oil ETFs? In the short term, the Brent is overbought and there is a correction risk. What should investors do? This is not a straight-forward question, the short- term outlook is uncertain but i) the medium-term outlook looks bright, and ii) the oil futures rolling yield is now above 8% per year.

Last year it was the opposite scenario: forward prices were in strong contango, making the price to roll futures very expensive.

Backwardation:  occurs when the prices for future delivery decline as the maturity of the contracts lengthen further into the future.

Contango is the opposite scenario: prices for future delivery increase according to the maturity of the contracts.

Rolling yield: commodity funds and ETFs invest via the futures market, and as they do not want to take delivery of the commodities they “roll the contracts” i.e. sell the contracts that are about to mature to buy new ones with a longer maturity. If they buy them at a cheaper price, they make a gain when the contract approaches maturity (nothing else changes), they have a positive rolling yield. In a contango situation, the rolling yield is negative.

Final users are usually prepared to pay a higher price for immediate delivery. When supply is constrained and demand increases, backwardation tends to increase. On the contrary, excess supply tends to lead to contango.

A new super cycle for commodities would most likely mean a positive rolling yield on top of the price evolution.

It is possible to take advantage of the commodity rolling yield, without taking a directional bet on the commodities themselves, via funds and ETFs which hedge the price risks.