Why the commodity supercycle narrative is overblown.
Stockpiling by China a major factor
It has been surprising to see just how far commodity prices have soared beyond what could be considered real economic growth. Much of the rebound has been a result of the base effects from the pandemic plunge, but there are other factors at play as well. The largest is China’s stockpiling efforts, which seem to have peaked in most commodities. But there are secular changes to consider, including the greening of infrastructure, that could indeed result in strong bull markets for select commodities such as copper.
As a reminder, in past boom/bust cycles for the highly volatile commodities sector, we typically see bear markets bottom out when the Commodity Research Bureau index hits -15 per cent year over year, while bull markets peak around 24 per cent. In this highly distorted pandemic-induced supply crunch, the CRB index is more than double that historic benchmark, having surged 52 per cent year over year to the end of April.
The primary reason is that a year ago, in the face of global lockdowns shuttering wide swaths of economic activity, the index had collapsed to its lowest point since May 2009, so a sharp yearly swing to the upside was inevitable off that base. However, as per Wall Street legend Bob Farrell’s timeless investing rule No. 4, we know this won’t correct by moving sideways.
Indeed, the macro outlook, though improving in some pockets of the world, remains highly uncertain. We are a far cry from the synchronized growth story that was pervasive in 2018/19; divergent growth is the way forward as the virus continues to surge in many emerging markets where vaccines are less available and fiscal capacity is more limited. This is hardly the recipe for a sustainable commodity boom.
Even China, the key driver of commodity demand for decades, is looking at more subdued growth ahead. The Communist Party of China’s new five-year plan calls for a shift toward “quality” rather than “quantity” in reference to its growth strategy, with a focus on building domestic demand and capacity for higher-value manufacturing (for example, semiconductors) and relying more on services rather than manufacturing overall.
At the same time, the government is prioritizing de-leveraging after years of debt-fuelled development that has resulted in increased concerns about financial risk and stability (though the country came out of the pandemic early, China’s debt burden grew by 30 per cent in 2020, primarily among state-owned enterprises and local governments). All this to say that growth will be weaker than in the past and is expected to average 5.3 per cent per year over the next five years, compared to 9.8 per cent in the five years after entry into the World Trade Organization and 8.7 per cent in the five years after the Great Financial Crisis.
China’s overall demand for commodities may moderate in the next few years, particularly following its aggressive buying spree in 2020 and early 2021. China took advantage of its appreciating currency last year to ramp up its stockpiling of resources. We can’t know the total stock held in the country as it isn’t disclosed, but the sheer volume of imports suggests that demand may be met for some time: unwrought copper (up 34 per cent year over year), steel and iron products (64 per cent), unwrought aluminum (319 per cent), crude oil (seven per cent), grain (28 per cent) and cobalt (45 per cent).
Part of the stockpiling is related to geopolitical risks as tensions persist with the United States. But there is also a growing global demand for key components of the green revolution underway as governments pledge to “build back better” with sustainable infrastructure projects. Commodities such as copper, cobalt, lithium, rare earth metals, nickel and silver all fall into the category of key metals and minerals that will see a boom from these initiatives for quite some time.
China is securing its supplies early, which is a smart strategic decision considering that certain commodities are facing supply crunches. For example, underinvestment in the copper mining industry has led to predictions of a market deficit in the red metal out to 2030, something that could greatly curtail the electrification ambitions of U.S. President Joe Biden and allies in Europe and Canada.
We continue to believe that the supercycle narrative is overblown, but there appears to be demand pressures ahead for certain strategic commodities and China has taken the lead in amassing a critical supply. But as the country de-leverages and focuses inward, and as the full picture of a divergent economic recovery becomes clear globally (once fiscal measures subside), the overall commodity space will likely fall down from the stratosphere.