Commodity Supercycles, Conjecture and Speculation

Stocks aren’t the only asset that surged after last winter’s lockdown panic. Metal prices (e.g., copper and iron ore) also boomed, helping Materials stocks—particularly Metals and Mining firms—outperform over the full year.^[i] For a while it was one of the year’s more underappreciated success stories, but now it is gaining notice, with talk of a new, years-long commodities “supercycle” growing by the day. Now, we expect metals prices to be strong in 2021 as developed world economies rebound from the pandemic, benefiting growth-oriented Materials stocks. But we caution against looking much beyond that.

Many see last year’s run as a down payment on years of rising commodity prices and impressive gains as fiscal stimulus boosts infrastructure spending and countries accelerate a shift to renewable energy. Both endeavors are quite metal-intensive, leading pundits to believe years of booming prices for copper, lithium and more lie ahead. But in our view, not only are long-term forecasts a fool’s errand, but citing what the world might look like in 15 years as reason to buy is generally a sign of creeping euphoria. Instead of putting these arguments in your reasons to be bullish file, we suggest taking note of the burgeoning optimism and staying alert for more arguments like this. The more you see, the closer we probably are to a market peak.

It generally is true that metals prices tend to move in long, grinding cycles. This is largely because supply is very slow moving. A typical cycle goes something like this: Demand rises, lifting prices. Those higher prices incent companies to invest in new mines—an endeavor with high up-front costs. But constructing a new mine can take years, keeping prices elevated for a long while if demand stays strong—spurring more investment in new mines. Eventually, mine development overshoots, and as the new mines start producing, a supply glut ensues. That, too, can last quite a while as companies keep production up in order to get the revenues needed to service debt—a similar phenomenon to what we have seen among US shale oil producers in the last couple of years. Eventually production does ease, and the cycle begins anew.

What we haven’t seen in any of the arguments for a metals boom is a detailed analysis of future supply—all are focused on demand, presuming they know exactly how governments will spend over the next several years. Politicians are touting green investments, and renewable power plants are metal-intensive. The Biden administration is talking up big infrastructure spending, creating lofty visions of America’s old airports and highways finally getting an upgrade—supposedly a turbocharged version of China’s infrastructure boom in the early 2000s. Some pundits envision governments in Europe and the Middle East jumping on the construction bandwagon. The common problem is that all of these things are possible. But not necessarily probable. Politicians have a long history of abandoning or watering down loose proposals like this, making them seem like a poor investment thesis to us.

None of this is reason to be down on metals today. Demand for iron ore, copper and others is recovering nicely, with China leading the way. Copper production fell a smidge last year, according to the International Copper Supply Group’s (ICSG) estimates, and several key iron ore producers reduced their 2020 production guidance as the year wore on. So the near-term economic recovery plus temporarily constrained supply should bolster prices. That bodes well for Materials companies, whose earnings are price-sensitive. We think growth oriented ones with big gross operating profit margins should have a nice ride. But the ICSG also expects production to rebound this year, which clouds the outlook beyond 2021. Maybe demand does stay as strong as everyone seems to expect, but that is far too early to know now.

The broader implication here is what this all says about investor sentiment. This is just one more instance of pundits presuming we are very early in the economic cycle, which they expect to last many years. Problem is, that presumes last year’s economic contraction was a traditional recession, which resets the economic and market cycle. Typically, companies work off excess and get lean and mean. Based on our reading of the data, that didn’t happen. This was an induced contraction—a forced cessation of economic activity. When officials allowed life to resume, it was largely back to business as usual. Inventories, manufacturing and business investment didn’t register the lengthy declines you would expect if businesses were working off froth. That tells us excess is probably building now. The fact that everyone seems to expect a long demand-driven commodity boom tells us the world has blinders to that building excess, making it a key thing to monitor as 2021 unfolds.

We don’t think we are at a euphoric peak now. For all the cheer building in the Materials world (sorry), there are still pockets of skepticism elsewhere. But the long-term metals thesis is reminiscent of some things we saw at stocks’ last euphoric peak, in 2000. Oodles of articles and books back then argued investors should be bullish because of this, that or the other trend that was going to revolutionize the world by 2015. The Internet, fiber optics, you name it. The world in 2015 wasn’t a good investment thesis then, and we don’t think the world in 2035 will work out much better this time when it gains wide traction. So yes, stay bullish for now, but keep watch for more far-fetched bullishness.