Uptick, down­turn, or a plateau?

We may not yet have hit the bot­tom, but in­vestors and com­pa­nies seem to be­lieve the worst of the cy­cle has largely passed

Financial Mail - Investors Monthly - - Guest Column - Si­mon Ken­dall is a port­fo­lio man­ager at Pru­den­tial In­vest­ment Man­agers.

Where are we ex­actly in the cur­rent com­mod­ity cy­cle? At the bot­tom, as some think? Or will a whole lot more value be lost in the next few months?

Ma­jor com­mod­ity cy­cles tend to hap­pen ev­ery 25 years or so. The pat­terns are the same: com­mod­ity prices move up strongly, driven by a struc­tural shift in the de­mand curve and a pro­tracted lag in the sup­ply re­sponse. They can be a long time com­ing and a long time go­ing, es­pe­cially within the con­text of in­sti­tu­tional mem­ory among in­vestors.

The prob­lem for in­vestors is that the sig­nals of th­ese peaks and troughs are not im­me­di­ately ob­vi­ous. So pa­tience is a virtue.

While the mar­ket tends to fo­cus on sup­ply and de­mand, and the re­sult­ing sur­plus or deficit, it is in­vari­ably the slow­ing rate of de­mand growth and ris­ing rate of sup­ply growth that ac­com­pa­nies the peak in a cy­cle. And that can be dif­fi­cult to an­tic­i­pate.

Of course, sup­ply sig­nals can point to the bot­tom of the cy­cle, but you won’t find a gen­uine com­mod­ity cy­cle un­less you have an im­prov­ing de­mand trend.

It’s tricky, of course, to iden­tify the peak of the cy­cle.

Iron­i­cally, how­ever, this chal­lenge en­hances the mag­ni­tude of the cy­cle: af­ter all, if the signs were clear to all, the mar­ket would be able to pre-empt the turns and dampen the cy­cle’s size.

Changes in in­ven­to­ries are also of­ten the key to am­pli­fy­ing the cy­cle, as pan­icked buy­ers (and mo­men­tum in­vestors) build up stock when the sup­ply is weak, which am­pli­fies the ris­ing price. Con­versely, in the down­turn, just-in-time buy­ers sell their stock dur­ing pe­ri­ods when there’s a sur­plus at the same time as in­vestors liq­ui­date their po­si­tions (be­cause of an ex­pected drop in re­turns). So where are we now in this cy­cle?

To some ex­tent, the 2008 fi­nan­cial cri­sis blurred the play­ing out of the cur­rent cy­cle, but speak­ing sim­plis­ti­cally, many com­mod­ity prices peaked in US dol­lar terms in 2011 (cop­per, gold, coal, iron ore). Us­ing an­other mea­sure, com­pa­nies’ cap­i­tal ex­pen­di­ture peaked in 2012 and 2013, as com­mit­ted projects con­tin­ued to be com­pleted be­yond the top of the price cy­cle.

Even to­day, sup­plies for some com­modi­ties con­tinue to rise, as those com­pa­nies fo­cus on max­imis­ing sup­ply and cut­ting costs to op­ti­mise economies of scale. The re­sult is a flat­ten­ing off, or even a drop, in th­ese com­pa­nies’ cost curves — which only adds to the price weak­ness.

But any way you look at it, we are less than five years away from the pre­vi­ous peak — so call­ing the bot­tom of the cy­cle now feels pre­ma­ture. This is es­pe­cially so given the heights com­mod­ity prices reached, as well as the ex­tent of new cap­i­tal spend­ing in the sec­tor. How­ever, even though we may not yet have hit the bot­tom, in­vestors and com­pa­nies seem to be­lieve that the worst of the cy­cle has largely passed.

There’s cer­tainly more than a fair share of de­nial around. Some ex­ec­u­tives, for ex­am­ple, be­lieve the price down­turn will be short lived. Oth­ers are keep­ing their div­i­dend dis­tri­bu­tions rel­a­tively high, and still seem tied to a pro­gres­sive div­i­dend pol­icy. So, too, when it comes to debt: while debt lev­els are high, the cash flow to pay down the debt is fall­ing.

We be­lieve that more signs are needed be­fore we call the bot­tom of the cy­cle — in­clud­ing, sim­ply, more time.

At my com­pany, Pru­den­tial, we’re con­tin­u­ing to build our re­source ex­po­sure around the de­fen­sive, low op­er­at­ing-cost com­pa­nies with rel­a­tively low lev­els of gear­ing. At the same time, tac­ti­cally, we’re look­ing to take ad­van­tage of lower-qual­ity lag­gards, based on their at­trac­tive val­u­a­tion and the po­ten­tial that share price move­ments can ac­tu­ally pre-empt vis­i­ble signs of a turn in the cy­cle.

Since we do not know whether we’ve hit the bot­tom al­ready, it’s the most prag­matic, con­ser­va­tive ap­proach to a sec­tor that has been rocked by a plethora of bad news in re­cent months.

Any way you look at it, we are less than five years away from the pre­vi­ous peak — so call­ing the bot­tom of the cy­cle now feels pre­ma­ture

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