Commodity super-cycle fever is here but shorter-term considerations should drive investment decisions

There were many reasons for strong performance across commodity markets in 2020, albeit equities showed better returns versus commodity indices. There are also good reasons for continued commodity support in 2021, but super-cycle fever may be premature. The chart below is just one example of how some analysts have posed the super-cycle argument.

 

Recoveries in commodity prices offer investment opportunities but these upward price trend may not be the same as a super-cycle. Commodity super-cycles are actually longer than the normal business cycle and are caused by a combination of events:

• Weak investment in production especially for extraction commodities which cannot be easily reversed in the short-run;
• Excesses in demand caused by long-term secular trends in growth that usually involve demographic shift such as the ascent of China as an economic engine or the overall growth in emerging markets;
• Shocks that disrupt shorter-term global supply chains but also have impact across more than one growing season; 
• Loose credit conditions for an extended period as signified by a declining dollar and the desire by investors to hold real assets as inflation protection. 

Commodity markets, at this time, look more like the strong price reversal after the GFC. The commodity index reversal after the crisis never reached the pre-GFC highs. In the GFC case, commodity markets fell significantly in 2008 only to reverse with strong gains in 2009 on lower rates and a rebound in growth. However, the market then fell into the long down cycle that may have only shown a recent bottom. 

The four conditions for a super-cycle are pointed higher, but business cycle considerations are still paramount. Credit conditions are easy and inflation expectations are growing albeit not showing excesses relative to old targets. Investment in extraction firms has fallen but production constraints have not tightened. The China - EM story is still strong however growth will be lower although on a larger base. The demand wild card is continued unprecedented fiscal expansion in developed markets. Finally, supply shocks were present which makes for some demand/supply deficits for selected commodities   

A super-cycle is good opportunity for the long-only passive commodity investor with a long investment horizon but mixed for the trend-follower who will often make trading decisions based on a few weeks of data. The trend-follower can ride a super-cycle wave but more importantly should focus on the business cycle supply/demand shock opportunities.