WHY RESOURCES DURING A RECESSION
Over the last two months we have spent a lot of time traveling throughout North America and Europe, speaking with clients about what role natural resources investments should play in their portfolios. During our travels we were also gauging demand for our potential Undertakings Collective Investment in Transferable Securities (UCITS) fund. At these meetings, we learned first-hand what our investors worry about the most. Recession fears loom large.
Investors firmly believe inflation has gone from transitory to intractable in a few short months — something we have been predicting since 2019. Most investors believe Chairman Powell and Mme Lagarde will do whatever is necessary to stop inflation, including throwing both the United States and Europe into a sharp, deep recession. Continued geopolitical hostilities, combined with slumping investor sentiment towards commodities produced a sharp 25% pullback in commodities and natural resource equities in June.
We have never seen investors as worried as they are right now, and it is understandable: in the last six months, their world has been turned upside down. After four decades of falling interest rates and rising equity prices, the pullback in both bonds and stocks have caught most investors off guard. Equities and fixed income sold off simultaneously as investors began pricing in a period of both low growth and high inflation. The long beloved 60/40 portfolio (the industry standard in which an investor allocates 60% to equities and 40% to fixed income) experienced its worst six-month period in 40 years, wiping out trillions of dollars of value in only a few months.
It is no wonder investors are skittish about natural resource stocks. Both energy and materials are considered extremely economically sensitive. Oil has pulled back almost 30% from its June high of $120 per barrel, and Dr. Copper, the metal with a PhD in economics, suggests a global recession is looming. Natural resource investors went from asking, “Have I missed it?” to “How can we possibly allocate money to resources if we are heading into a recession?” in a matter of weeks.
These worries are not unfounded. During the Global Financial Crisis (GFC), natural resource stocks collapsed. Materials and Energy were two of the worst four sectors in the S&P 500 (along with Real Estate and Financials), falling 60% from May 2008 to March 2009. As recession fears took hold a few months ago, traders fell back on the same tactic. As the market sold off from June 8th to July 12th, materials and energy were once again amongst the hardest hit sectors, falling 15-25% in only a month.
WE STRONGLY DISCOURAGE INVESTORS FROM USING RECESSIONARY FEARS AS A REASON TO SELL COMMODITIES. COMMODITY MARKETS TODAY BEAR NO RESEMBLANCE TO 2008. INVESTORS USING THE 2008 GFC PLAYBOOK RISK SELLING COMMODITIES RIGHT AT THE BOTTOM, MISSING THE HUGE POTENTIAL RETURNS EMBEDDED IN THESE MARKETS OVER THE COMING DECADE.
When investing in natural resource equities, the commodity capital cycle is far more important than the broad economic cycle. From this perspective, 2022 is the mirror image of 2008. Our readers will recognize the following two charts. The first chart shows the relationship between the Dow Jones Industries Average and a commodity index going back to 1900. The second chart shows the weighting of energy and materials in the S&P 500. Together these two charts tell a fascinating story.
As the top chart clearly shows, commodities go through periods where they become extremely cheap relative to financial assets. At this point, they represent excellent investments and spend years in a bull market. Eventually, commodities become radically overvalued and represent poor investments. The most extreme periods of commodity undervaluation took place in 1929, 1969, 1999 and 2020.
THE FIRST THREE PERIODS WERE EXCELLENT OPPORTUNITIES TO BECOME A NATURAL RESOURCE EQUITY INVESTOR, AND WE STRONGLY BELIEVE THE LAST ONE WILL BE TOO.
It is not a coincidence that periods of commodity undervaluation are good entry points for natural resource investors, nor is it a simple story of mean reversion. Instead, periods of radical commodity undervaluation are related to the natural resource capital spending cycle, and it’s this capital spending cycle that leads to huge outperformance going forward.
A commodity price cycle usually follows a typical path. The industry might enjoy a period of very high energy or metal prices. Given their fixed cost base, the higher commodity prices fall directly to the bottom line resulting in a period of super-normal profits. High returns attract new capital and before long the industry begins a new cycle of exploration and development. Over time, increased spending leads to new supply which eventually outpaces demand growth and ushers in a period of commodity surplus.
Prices fall, causing projects that were underwritten at higher prices to become impaired and written off. Often, another industry or investment strategy falls into favor around this time and investors rush to reallocate capital towards hot new speculative areas, leaving the resource industry even more capital starved. As depletion takes hold, supply falters, demand grows, and inventory gluts eventually get worked off. The stage is set for the next bullish cycle to start.
Investing in natural resource equities when commodities are cheap relative to financial assets is important, not only from a value perspective but also because it almost always corresponds with a bottom in the natural resource capital investment cycle — a cycle that produces years of supply shortages that is fixed only after years of increased spending.
The key insight here is that the commodity capital cycle may or may not correspond with the broader business cycle (i.e., expansion and recession). Heading into the GFC, the two cycles were in near-perfect alignment. Commodity prices were extremely high relative to the stock market in early 2008. Energy and materials made up 20% of the S&P 500 – a 30-year high. Natural resource capital spending had accelerated. Driven by high prices, insatiable Chinese demand, and endless analyst calls for a commodity “super-cycle,” energy and mining capital spending in the S&P 500 surged four-fold between 2000 and 2008 from $80 bn to an all-time high of $330 bn per year.
When the recession arrived, the commodity sector was hit hard. Energy stocks fell by 50% while mining stocks fell 65%, gold stocks fell 25%, and agriculture related equities fell 40%. Natural resource equities rebounded in 2009 and into 2010, but then entered a decade-long bear market. The capital spending surge during the bull market of the middle-2000s ultimately resulted in new production of almost everything: iron ore, coal, copper, shale gas, and oil. The GFC represented a rare alignment of a bearish commodity capital spending cycle and a bearish broader business cycle.
It is no wonder that investors are skeptical of natural resource investments given the experiences of the GFC. However, we think focusing solely on one episode risks missing the point. As it relates to natural resources, the GFC was an anomaly: for most of the past 120 years, the commodity cycle and the business cycle have not been in sync at all. In fact, throughout the twentieth century, resource equities have actually been good investments during most recessions.
To illustrate our point, let’s look closely at the 1930s. The Great Depression was unrivaled in its severity. In the United States, one person out of every four in the labor force was without work. Industrial production fell 50% from peak to trough and took a full decade to regain its pre-crash high. Wholesale prices collapsed by 30%, and the stock market fell 86% from its 1929 high. Equities did not regain their pre-crash 1929 highs until 1954. Even factoring in dividends, anyone who invested in 1929 only broke even in…