Has the pandemic induced a new commodity super cycle?
Since COVID-19-related lockdowns became widespread globally in Q1 2020, bottlenecks have developed in various supply chains, including most commodity markets, to varying degrees. This, together with rising concern around inflationary risks driven by the combination of highly stimulative monetary and fiscal policies working together for the first time since the 1970s, has raised the question whether we have entered a new commodity super cycle.
- Supply chain bottlenecks have increased given global lockdowns, affecting the extraction and refined supply of many commodities.
- Inflationary fears have risen on realisation that excessive money printing could cause excess demand for goods and services above available supply. Also, hedging inflation risk using commodities, further squeezes tight markets.
- Decarbonisation efforts and related energy transmission infrastructure changes may trigger super cycle conditions for certain commodities, but are unlikely to do so for the asset class as a whole.
The high degree of uncertainty around both supply and, more importantly, medium- to longer-term demand for most major commodities, makes it very difficult to conclude with high conviction that we have entered a new commodity super cycle. However, it is clear that the world has reached an inflexion point in combating climate change. Long-term stringent carbon emission reduction targets set by the world’s largest governments will have a material impact on many industries, making it highly probable that certain commodities will experience super cycle conditions over the next decade or two.
Commodity super cycles are generally demand-driven
It is generally accepted that commodity price super cycle bull markets are extended periods during which commodity prices are well above their long-run trend. The main drivers of super cycle bull markets since the late 1800s included:
- US industrialisation in the early 1900s.
- Reindustrialisation and reconstruction of Europe and Japan, following the Second World War, drove the 1950s and 1960s cycle.
- China’s acceleration of both industrialisation and urbanisation beginning in the early 2000s.
This illustrates that a commodity super cycle is likely to need a specific medium-term demand driver that distinguishes it from normal demand growth. Today, we potentially have two key recent developments that could generate a potential super cycle:
- Decarbonisation brought on by increasing climate change. Governments have set long-term carbon emissions reduction targets, which help to grow the supply of renewable energy sources like wind and solar (and therefore materially adjust energy infrastructure). There are also consumer-driven behaviour changes such as the choice of electric vehicles (EVs) over internal combustion engine (ICE) vehicles. This shift is often incentivised by governments, such as through tax credits for buying EVs or penalties for auto manufacturers that do not improve the oil consumption efficiency of their new models.
- Globally, central banks are using monetary policy to effectively fund fiscal policy, which includes the previously discussed increase in renewable investments, as well as direct stimulus payments to both corporates and households. These payments may change the disinflationary forces of the past 40 years, as governments and central banks understand the necessity of generating inflation to assist in paying down record-high debt levels.
Decarbonisation is a potential game changer for some major commodities
Given its excessive carbon emissions, the transition of the energy sector is likely to include:
- For primary energy consumption, moving away from fossil fuels, such as coal and oil, towards renewables like wind and solar.
- For transportation, moving away from oil used in ICE vehicles to EVs, which includes the need for lithium-ion batteries and significantly more copper, including for increased EV charging stations.
- While the global ICE vehicle fleet is likely to decline gradually in the long run, platinum group metals (PGMs) will remain in high demand, as a key input for the autocatalytic converters that reduce ICE vehicle carbon emissions.
- The expanded transmission infrastructure linked to less carbon-intensive, renewable energy sources. Batteries and copper will also be needed in energy storage, which will play an important role in the deployment of renewable sources like wind and solar that only supply energy at certain times of the day.
Inflation risk is highest in decades
A fundamental change was made by the US Federal Reserve last year in the way it tackles its key mandate of price stability and full employment. Changing to average inflation targeting and focusing on the low end of the employment spectrum has effectively changed the way it tries to pre-empt overheating in the US economy. This means that going forward, it will allow the economy and, by design, inflation, to run much hotter than any time since the 1970s.
Global investors concerned about the rising inflation risk often hedge by buying commodities. The chart below clearly shows that commodity investment is currently even higher than the peak reached in the China-driven super cycle. However, relative to the trillions of US dollars of COVID-19 monetary and fiscal stimulus and the size of other risk asset classes, total commodity investment of less than $700 billion is small and could increase materially if inflation risks continue to rise.
Another important issue related to inflation expectations is their close correlation to the oil price. This is unsurprising, given its direct and indirect impact on most industry supply chain costs. Linked to this, is the question whether new renewable power generation sources and infrastructure can rise at the appropriate rate to replace the falling supply of fossil fuels, like oil and coal. Mismatches in this transition could potentially cause shortages and price spikes in years to come, despite a declining demand profile for fossil fuels. Such energy price spikes are likely to stoke inflation fears, thereby continuing to support hedging demand.
Challenges to a broader commodity super cycle
While decarbonisation and average inflation targeting are compelling tailwinds for certain commodities, it is difficult to envisage a broad-based commodity super cycle, because of various long-term headwinds, including:
- Carbon emission targets are not set in stone: China’s plans, which drive a significant global portion, lack firm commitment.
- The US dollar may not be destined for extinction: While the US dollar is an easy target at the moment, given the extent of America’s rising twin deficits (fiscal and trade), relative demographic profiles and potential growth rates do not place the US at a major disadvantage to other large currencies in the medium term.
- Uncertain global growth after the 2021 unlock rebound: Record annual growth rate numbers in many countries in 2021, will mostly be driven by the base effect of the fall during 2020’s lockdown-induced recessions and the associated large monetary and fiscal response. Many factors impact longer-term growth trends.
- China’s high level of global commodity consumption is set to wane as its GDP growth mix evolves.
A potential commodity super cycle generally requires a meaningful and sustainable above-trend growth driver. While the supply chain problems and short-term growth rebound linked to the COVID-19 lockdowns globally have pushed certain prices above marginal costs and some into super cycle territory, these are unlikely to drive a sustainable, longer-term, broad-based commodity super cycle.
We do, however, believe that it is plausible to have ‘super cycles’ in specific commodities that encounter above-trend demand growth conditions. Uncertainties around inflation driven by the continued combination of novel and aggressive monetary and fiscal policies in the US and other major economies, will underpin significant investment demand in commodities. Such tailwinds, together with impending decarbonisation policies in all the world’s major economies, can drive supply deficits in commodities such as copper, lithium, PGMs and perhaps ironically, oil. The extent and persistence of these deficits will depend on government commitment, speed of adoption and continuity of decarbonisation policy initiatives.