Navigating the Markets: Inflation and the Risks to Goldilocks
June 16, 2021
On a recent webinar, CEO Jan van Eck, Portfolio Manager Shawn Reynolds and Deputy Portfolio Manager Charlie Cameron reviewed our current Investment Outlook and the three scenarios it outlined:
- Goldilocks: the mainstream, high consensus view of rate increases pausing between 1.5% and 2%.
- Wage inflation: a hotly debated topic.
- Higher rate surprise: whereby interest rates rise above 2%.
As the inflation debate continues, our approach is to draw a distinction between wage inflation and commodity price inflation. Whether wage inflation takes hold will not be clear until we see data for next year, and with commodities rallying, some investors are questioning whether they’ve already missed the inflation trade (spoiler: no!). The following Q&A features highlights from the conversation, including what’s behind our high conviction view on commodities. The full webinar replay can be viewed here and the presentation from the webinar is available here.
Is the current commodities rally more like the 1970s cycle or the supercycle of the first decade of this century?
In comparing the performance of commodities in 2002-2007 to the past 11 months, we start to see some similarities. Over the past 11 months, there’s clearly outperformance of stocks and bonds, and we believe that a lot of the fundamental support for prices will continue.
Inflation Investments in 2000s: Returns of Real Assets vs. Stocks
12/31/2002 – 12/31/2007
Source: Bloomberg. Data as of December 31, 2007. This timeframe was selected to show performance of selected asset classes during the last period of inflation in the U.S. Commodities are measured using the Bloomberg Commodity Index; Natural Resources are measured using the S&P Global Natural Resources Index; Gold is measured using the spot price per troy ounce; U.S. Stocks are measured using the S&P 500 Index; U.S. Bonds are measured using the Bloomberg Barclays US Aggregate Bond Index. Past performance is not a guarantee of future results.
Inflation Investments in This Cycle: Returns of Real Assets vs. Stocks
6/30/2020 – 5/21/2021
Source: Bloomberg. Data as of May 21, 2021. Commodities are measured using the Bloomberg Commodity Index; Natural Resources are measured using the S&P Global Natural Resources Index; Gold is measured using the spot price per troy ounce; U.S. Stocks are measured using the S&P 500 Index; U.S. Bonds are measured using the Bloomberg Barclays US Aggregate Bond Index. Past performance is not a guarantee of future results.
The prior supercycle period was demand driven. China went from a $1.7 trillion economy to a $3.6 trillion economy, and demand across natural resources spiked. During this five-year timeframe in the chart above, China grew its economy by about $2 trillion.1
This time around, there’s some demand pressures from reopening, but consumption of most natural resources and commodities are not back at pre-pandemic levels yet. This indicates a different component is driving prices, and we see that as being supply—which we haven’t seen concern about in well over a decade.
Why will supply be an issue for a while?
In the 2000s, we saw massive increases in capital spending—in the U.S. oil exploration and production space, it grew from $40 billion in 2003 to $180 billion in 2014.2 This took oil production in the U.S. from roughly 5 million barrels a day up to a peak of about 12 million barrels a day.3
Then in November 2014 amid OPEC’s price war with U.S. shale oil, oil prices started to fall and continued to drop for the next five years. During that time, capital spending pulled back. It was about $60 billion in 2020 and estimated to be roughly $60 billion again this year.4 This may lead to a drop of about 2-2.5 million barrels a day of oil production.
That’s one reason we believe the supply response is leading to pressures on prices. A similar scenario is playing out in many other commodities, including copper, iron and gold, and even in non-headline commodities like burlap and rubber. Across many natural resources and commodities, we’re seeing similarly very high and close to historical prices.
For oil, can’t OPEC simply turn on the tap again?
This is the one commodity where that does present a risk, but we have been in this situation for the last few years. There is some spare capacity sitting out there, but the discipline we’ve seen in OPEC as well as outside of OPEC means production is coming down. In the UK, production was down about 7% in 2020 and is expected to be down another 10%-15% this year, so this is something that we’re seeing around the world.5
How long will this discipline or capital scarcity last?
The companies have gone through a number of years of operational and financial restructuring that started after the peak in capital spending, the oversupply and commodities prices falling. The miners in particular have demonstrated how financial prudence can pay off.
Commitment To Financial Prudence Paying Off:
“Big 6” Mining Capital Return and Dividend Yield
The reader should not assume that an investment in the securities identified was or will be profitable. Not a recommendation to buy or sell a security. Source: VanEck, Bloomberg. Data as of September 2020. “Big 6” mining companies include Anglo American, BHP, Glencore, Rio Tinto, Teck Resources and Vale. Past performance is not a guarantee of future results.
Early on in the last decade, dividends rose and reached a peak, and then prices dropped. Dividends were slashed in 2016 and 2017, but then operational and financial restructuring came through, as seen in the rebound in yields in 2018 and 2019. And again, miners are ahead of other industries in this, but there’s a similar story in lots of different industries. We are seeing capital discipline making its way through to distributions and yield strategies as well as public business strategies around prudence and not overspending, so we believe this discipline is sustainable.
Besides this discipline, what else do you see driving this industry?
What we really think is going to be a multi-decade impact on the demand of commodities is the resource transition and environmental sustainability trends that are taking off. The International Renewable Energy Agency (IRENA) estimates that the resource transition could total $110 trillion over the next 30 years, which provides us a sense of how large this market and potential growth opportunities may be. Thinking about the investment objectives of our VanEck Global Resources Strategy, we believe the energy transition story fits neatly into that—providing inflation protection and leverage to global growth.
Who will be the main beneficiaries of this transition?
In particular, we believe “green” metals—such as copper, nickel, cobalt and lithium—will be a major player in the transition. In a way, we can say that our economy is going from a fossil fuel based economy to a minerals or metals based economy. The amount of minerals and metals that go into an electric car is significantly larger than in a conventional car. These metals are also used in clean energy technologies like wind and solar in significantly higher amounts than traditional natural gas and fossil fuel technologies.
Looking at potential supply issues, the U.S. is one of the largest producers of natural gas and crude oil and among the top processors of oil and liquefied natural gas exports. However, when it comes to the green metals, the U.S. is not among the leaders—with the exception of rare earth extraction—and the processing of these materials is dominated by China.
Top 3 Producing Countries of Selected Minerals and Fossil Fuels (2019)
Source: IEA. Data as of May 2021.
There is a movement happening around the world to onshore the extraction and processing of materials, but this will take some time and will be costly. This is one of the greatest pressure on prices that we have seen in several decades, and we believe we are already starting to see the impact. Vestas, one of the largest wind turbine manufacturers globally, announced in their Q1 2021 earnings call that their average selling price has to go up because of increases to raw material and supply chain costs.
Do you see the inflation spike as episodic in nature or persistent for the next few years?
Short-term, we believe macro trends are supportive for resources. Over the medium-term, we look to how individual companies and industries have restructured—the changes to their financial policies and their discipline—which is going to impact supply over multiple years. Then over the long term, we believe the resource transition and environmental sustainability trend will be in play over decades.
What role will oil refiners be able to play in the energy transition?
We believe the key word in energy transition is “transition,” so fossil fuels will be consumed for many years to come. Traditional refiners will continue to play an important role, and they have spent a number of years fixing their balance sheets. Another interesting aspect is that some of these companies, such as Valero in the U.S. and Neste in Finland, are making a move towards renewable diesel, as well as renewable aviation fuels and renewable plastics.6 We think this movement may continue.
What do you make of the current valuations of energy stocks?
Across the resource space right now—not just energy—there’s the macro tailwind that we’ve discussed as well as the restructuring and discipline that are leading to a supply response and high commodity prices. Then to top that off, investors don't have to pay for it right now. Valuations have come down across all the commodity industries that we're focused on. As opposed to paying a premium of maybe 10 times EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) five years ago for an oil exploration and production company, investors are now getting a discount and paying about four times EBITDA.7 In many cases, in addition to being a discount to the market, these stocks are trading below their 10-year averages and even, in some cases, at their 10-year lows.
For more information, listen to the full webinar replay: Navigating the Markets: Inflation and the Risks to Goldilocks.
1 Source: The World Bank.
2 Source: Evercore ISI.
3 Source: U.S. Energy Information Administration.
4 Source: Evercore ISI.
5 Source: S&P Global Platts.
6 Valero and Neste company data.
7 VanEck research.
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