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Will a new commodities super cycle fuel inflation?

01 April 2021

By Jai Lakhani, CFA, London UK, Investment Strategist EMEA

You’ll find a short briefing below. To read an in-depth analysis of this article, please select the ‘full article’ tab.

  • Summary

    Key takeaways

    • Commodity prices are surging, oil is rallying
    • Investors may need to adjust portfolios to counter any inflation hike
    • Oil prices have climbed past $60 a barrel
    • Gold can still be a useful diversifier.

    Many believe that we have entered a supercycle, or a period when prices are well above their long-term trend. There have been four such identifiable periods in the past century.

    Improving hopes for the recovery, driven by fiscal stimulus and the vaccine rollout, have boosted prices in the first three months of the year, especially for copper and platinum. Both metals facilitate clean energy and have garnered interest - yet supply-side constraints mean that output is struggling to keep up.

    Meanwhile, oil prices are over $60 a barrel, with demand appearing to be a function of the economic recovery and normal activity. That said, supply cuts, increased regulation and the vaccine rollout may put a floor on prices.

    With higher inflation looking likely, many may turn to gold as a hedge against inflation. Demand for the yellow metal is driven by investors, jewellers, central banks and industry; supply is generated from mining and recycling. US dollar strength is an influence – the final quarter of last year showed early signs of a pick-up, with gold rising 54% quarter on quarter.

    On the supply side, COVID-19 restrictions have also impacted production levels, with supply down 4% in 2020, and this could be a further tailwind for prices.

    In response to all of these factors, investors should consider companies with strong pricing power or those for which higher commodity prices can be a tailwind. We are wary about gold’s role as an inflation hedge – yet, it may well prove to be a valuable diversification tool.

  • Full article

    With commodities surging and oil rallying, investors might need to consider positioning their portfolios for temporary inflationary pressures. While gold has suffered due to “risk-on” investor sentiment, is now the time to reconsider the precious metal?

    Commodity prices have started the year with a bang. The commodity index has bounced this year, with platinum and copper reaching six and nine-year highs in March respectively (see chart).

    The move in raw metals has been substantial and fast paced. It is no surprise that some market participants believe that we have entered a supercycle, or a period when prices are well above their long-term trend. There have been four such identifiable periods in the past century.

    Why are commodity prices surging?

    On the demand side, expectations of a recovery driven by global fiscal stimulus and successful vaccine rollout in developed world economies have boosted prices in the first three months of the year.

    Platinum and copper saw further support due to the impact they have in facilitating clean energy. Platinum plays an important role in the conversion of green hydrogen, as well as catalytic convertors in cars. Furthermore, electric infrastructure cannot be built without copper wires and cables.

    The Biden administration’s green investment programme pledges $400bn on clean energy over the next ten years and Europe is committing to a greener world. Meanwhile, China’s January car sales are up 30% year-on-year and copper consumption accounting for around half of the world’s production. So, not only is demand driving prices higher, but the momentum could be here to stay.

    Supply-side constraints

    What’s more is that supply-side constraints mean that output is struggling to keep up. Platinum has been in a supply deficit for two years and looks set to make this a third year in a row. Outages, COVID-related disruptions and a recent energy shutdown in South Africa impeded the issue further.

    A similar story can be said for copper, with Chile and Peru (the two largest producers of the metal), both disrupted by COVID-induced shutdowns resulting in operational stresses that will take some time to recover.

    Soaring oil prices

    With oil prices soaring past $60 a barrel, it seems a lifetime ago since the commodity’s prices plummeted as the Organisation of Petroleum Exporting Countries (OPEC) struggled to come to supply cut agreements and demand collapsed.

    The rise in oil demand appears to be more a function of the economic recovery and normal activity. Weaker investment levels, tougher regulation and the OPEC+ group of oil exporters surprising expectations by committing to a tighter oil market and keeping cuts in place for April, supported prices on the supply and inventory side.

    Saudi Arabia appears to be the key advocate for this decision, with it keeping its 1m barrels per day (bpd) voluntary cut for a third consecutive month. It also made clear that the voluntary cuts may take a long time to come back into the market and that when it does, the return will be phased over several months.

    Longer term

    Looking at the oil market in the long term, supply cuts, increased regulation and the vaccine rollout are likely to put a floor on prices. With more countries expected to open up their borders for travel later on in the year, air travel is likely to increase, further underpinning oil.

    However, much higher oil prices could threaten the economic recovery as it would generate inflationary pressures that has the potential to taper demand. Another risk to consider is contagious COVID-19 mutations which could be immune to the vaccine. Should such a scenario occur, demand could falter in a similar fashion to last year.

    Also, with some estimates suggesting a 1.8mbpd deficit in the next three months, which would bring OPEC inventories back to their 2015-2019 averages by June, further upside could be limited.

    As oil continues its upward trajectory, OPEC+ members such as Russia are unlikely to be willing to stay on the sidelines for a longer period of time. Higher prices may also encourage US shale producers to return to the market.

    Overall, we remain constructive on oil prices this year, with a $66 a barrel and $62 a barrel average price forecast of Brent crude and West Texas Intermediate in 2021 respectively.

    Yellow metal’s lustre wanes

    Gold has not been part of the supercycle hype we have seen in industrial metals of late. After its best year in a decade in 2020, risk sentiment towards the precious metal is shifting and the global recovery that is gaining momentum has been unfavourable for the “safe-haven” metal.

    Gold exchange-traded funds lost 2% of their holdings in February and experienced their third monthly outflow in four months. Combined with rising bond yields, as the market adjusts for higher inflation expectations, the zero- interest bearing asset is down 11% for the quarter.

    Gold: an inflation hedge?

    With the market increasingly pricing in higher inflation, many could turn to gold as a hedge against inflation.

    Data since 1988 shows that for years when the US consumer price index exceeded or equalled 3%, gold has averaged annually 6.9%. While such a return could protect against inflationary pressures this year, the S&P 500 returned on average 13.7% in the same time (see chart).

    Fundamentals suggest some respite for the precious metal

    The price of gold is driven by supply and demand dynamics. Demand is driven by investors, jewellery, central banks and industry. Supply is generated from mining and recycling. US dollar strength is also an influence.

    An argument in favour of gold is jewellery demand. Although a risk-on environment means that investor demand could weaken, consumer demand in the form of jewellery could be strengthened. After jewellery demand had its worst year in 2020, declining 34% as a result of COVID-19 lockdowns and investor demand making gold expensive, the final quarter of last year showed early signs of a pick-up, rising 54% quarter on quarter.

    The US, China and India show signs of a “V-shaped” recovery and consumers could be poised to provide some support for the precious metal, especially as investors exiting gold ETF positions should make the price more attractive. Furthermore, central bank purchases remain supportive despite its smallest net sale on record in January.

    On the supply side, COVID-19 restrictions have also impacted production levels, with supply down 4% in 2020, and this could be a further tailwind for prices.

    Positioning

    Strong demand and supply constraints across oil and commodities such as copper and platinum more generally will likely create inflationary pressures, as input costs would rise. As such, investors should favour companies with strong pricing power or those for which higher commodity prices can be a tailwind (like in the renewables sector).

    While we are wary about gold’s role as an inflation hedge, it tends to be a useful diversification tool, despite investor demand weakening.

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Market Perspectives April 2021

Fears of higher inflation, fueled by a vaccine-driven recovery, and rising bond yields hit investor sentiment in March.

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