Art by Irene Servillo

Commodities: Will they be such stuff as dreams are made of, or merely a brief reverie? While Shakespeare isn’t a hot topic on Wall Street, the duration of the current commodities bull market is.

There’s speculation about a new years-long supercycle ahead for commodities—a diverse group that ranges from agriculture to metals to energy. If that prediction comes true, many institutional investors, leery of the asset class because of its storied volatility, could be missing out. 

The S&P GSCI Commodity Index has been on a tear since late April 2020, when investors took heart that the pandemic wasn’t going to destroy the world’s economy, as Washington and other nations’ governments injected trillions in monetary and fiscal rescue efforts into the system. Commodities, after crashing early last year, began an upward march that as of Friday logged a 121% appreciation. That’s a better showing than stocks: The S&P 500, since its nadir a month earlier, has gone up 97%.

Nonetheless, most pension plans and other institutions thus far have been reluctant to put much money into commodities. Just 1.7% of US public plan portfolios are allocated to them, and that’s been the case for the past two decades, according to Public Plans Data. That period happened to overlap the last supercycle, which began in 1998, then peaked right before the 2008 financial crisis, and ended in 2015. In other words, a lot of plans missed out.

Classically, professional money managers view commodities as a good hedge against inflation. Pension giant California State Teachers’ Retirement System (CalSTRS), for example, has only a small amount in commodities, slightly less than 1%. It sits in a catch-all category, which includes Treasury inflation-protected securities (TIPS), designed to offset Consumer Price Index (CPI) increases.

Institutions, unless being tactical on their own, tend to consider “a smaller sliver of their portfolios in passive long-only commodities due to their volatility,” said Ed Egilinsky, Direxion’s head of alternative investments.

But investing in commodities during supercycles has proven they can produce handsome returns, as well. That could explain why, lately, a handful of the cautious asset allocators are looking at commodities as a possibility.

“They have been hesitant,” said Matt Lloyd, chief investment strategist at Advisors Asset Management (AAM). “They want to see how it develops” this time.

No doubt, commodities are risky propositions. Quick-changing macroeconomic conditions and the ever-surprising weather can up-end a tidy investment in raw materials.

Numerous investors in them “got sick and tired of losing money,” said Tim Rudderow, CEO of Mount Lucas Management, which has an institutional clientele. “It was like hitting your head with a hammer. It felt so good when you stopped.” The more sophisticated strategy toward commodities is not to buy and hold, he said, but to trade in and out of them.

To Jonathan Glidden, CIO of Delta Air Lines, it makes sense for commodities to be a part of an asset allocator’s growth portfolio. Certainly, he acknowledges that the erratic nature of commodity prices gives many pause. “The high volatility makes it so only the strongest governance structures can handle the inevitable busts,” he said, referring to top management’s degree of patience with investment dips. 

A diversified private portfolio could smooth out the severity of the declines, added Glidden, who has 5% of his portfolio in public traded commodities and 3% in private ones.

Certain asset allocators have been gung-ho about commodities for some time. In May, for example, the Indiana Public Retirement System (INPRS) pushed up its commodities target allocation to 10% from 8% of its defined benefit (DB) portfolio.

Another long-time institutional fan of commodities, as well as of other so-called alternative investments, is Yale’s endowment, which has 4.5% of its holdings in them (most recently, in timberland, agriculture, and oil and gas). Over the past 20 years, this has generated an average annual return of 13.6%. As Yale strategists explained in their recent annual report, these commodities “share common risk and return characteristics: protection against unanticipated inflation, high and visible current cash flow, and opportunities to exploit inefficiencies.”

Supercycle, or Not?

So, could the past 14-month commodities jump be, to quote the old song, the start of something big? As with much in finance, divining whether recent developments are the beginning of a trend is hard to determine definitively at the outset.

Commodity supercycles appear when a basic change in economic dynamics occurs, which affects consumers significantly. Although no agreed-upon definition exists for a supercycle, the term customarily is invoked whenever commodity prices levitate above their long-term trend for a decade or more. This upswing eventually is followed by a slump of similar duration as supply catches up with demand.

The first recorded US supercycle began in the 1890s, as the nation rapidly expanded its industrial output and urban areas bulged with new arrivals, mainly immigrants. It ended with World War I, when the economic focus shifted to the military. The next cycle kicked off in the 1950s, amid the re-industrialization of war-torn Germany and Japan, which resurrected themselves as major players on the world scene. That period, marked by increasing inflation, stretched through the 1970s.

The last supercycle was China-driven: With its turn toward private enterprise, the enormous communist nation catapulted from a primitive, rural society to a fast-growing, urbanized colossus that now threatens US hegemony. China developed a gargantuan appetite for all manner of raw materials as it built out its factories, housing, and infrastructure. The 2008 financial crisis almost squelched the supercycle, but the Chinese regime kept it going through massive spending, much like what the Trump and Biden administrations have done over the past year-plus for the US.

The previous cycle eventually petered out in 2015, however, because China retreated from its spending splurge and the world became awash in oil. The oil glut resulted from American shale developers’ manic pumping, and the Organization of the Petroleum Exporting Countries (OPEC)’s decision to increase output and squeeze the upstart US rivals. Too much oil and too little Chinese demand for other raw materials ushered in a commodity price rout.

Right now, the major sea change that could make this commodity advance into a supercycle is the pandemic. The coronavirus scourge surely has altered the fabric of economic life worldwide, various market watchers believe. Alessandro Sanos, a strategic director at data firm Refinitiv, surmised in a research paper that, while the global plague’s economic impact has had a short-lived effect on commodities, it also could be “the start of something more substantial.”

Today, several specific conditions are present that helped stoke the last supercycle. “We do have the ingredients,” AAM’s Lloyd said.

A weaker dollar is a big factor. Commodities are usually priced in US currency, which means that raw material producers must adjust prices upward to offset their higher costs in local money. At the same time, a cheaper dollar stokes demand because commodities now are less expensive for an importing nation, thus prompting it to buy more. Along with that, interest rates are low, thus making borrowing easier to purchase commodities.

Another supercycle hallmark is burgeoning consumer demand, thanks to the pandemic, which fueled largescale purchasing of things such as homes. “People have more cash than liabilities” these days, Lloyd observed. Plus, there’s the new push for so-called “green growth”—that is, expanding industries such as electric vehicles and solar energy. These businesses devour minerals like lithium, used in batteries.

And yet another sign of the swelling post-lockdown demand is the emergence of “backwardation,” a phenomenon that Goldman Sachs noted in a report. This is a situation where the current, or spot, prices of commodities are higher than those in the futures market. In other words, present demand is surging faster than the conventional wisdom expected.

Of course, many forces are at work in the commodities arena that can thwart price hikes, among them geopolitics. Chinese authorities have announced they will tighten their control of commodity pricing, with the objective of smothering what they called “unreasonable” increases. That news led to a downdraft in commodity pricing in May, although prices since have more than recovered.

The Big Market Basket

The disparate commodities covered by indexes each have their own special dynamics. “They’ve moved at different speeds” in the current up-cycle, Direxion’s Egilinsky pointed out. “Energy and grains led, then came steel, copper, and lumber, with precious metals lagging.” Such disparities make commodity indexes helpful, if over-broad, approximations of the overall trend.

Indeed, investors have their choice of exchange-traded funds (ETFs) to capture commodity price movements. And not all of these vehicles are slavish copies of the indexes. Egilinsky’s firm sponsors one, called Direxion Auspice Broad Commodity Strategy ETF, which has a rules-based flexibility sporting such features as an ability to go to cash with an individual commodity when it shows a downward price trend, thus potentially lessening some of the downside risk associated with indexes. In 2021, as of last Friday, it is up 20.8%, and over the past three years, is ahead 8.2% annually, according to Morningstar. A prominent ETF that tracks the S&P index, the iShares S&P GSCI Commodity-Indexed Trust, has risen 30.2% this year, but is down almost 2% per annum over three years.

A sampling of individual commodities performances demonstrates their distinctive characteristics, and speaks to the challenges confronting investors:

Oil. The goo that provides much of the world’s energy has surged fourfold in price since its April 2020 pandemic trough. Recently, the geopolitical waves touched off by OPEC Plus (the original group, which Saudi Arabia leads, with the addition of Russia and its allied producers) show how volatile commodities can be. On July 18, this group decided to boost output by 400,000 barrels daily. That sent oil prices tumbling 6.1%. But then, perhaps owing to the overall up-trend of commodities and the economy, oil has since recovered almost all its losses.  

Petroleum cost more than $100 per barrel in 2014, at the end of the last supercycle. It plunged to a $33 low in 2016 and slowly inched back to stay in the $50 to $65 range—with the exception of the dive to $18 at the pandemic’s outset. Now it sits at about $72.

Wheat. The torrid drought afflicting a large chunk of US farmland, in addition to high demand, has ballooned the price per bushel by 40% since its 2020 low, to $6.78. In this country, 89% of the spring growing areas are afflicted. Spring wheat is the variety most often used for human consumption, as opposed to the lower-grade type meant for animal feed. The heat wave and the lack of rainfall is expected to last into October, says the National Weather Service. Hence, no let-up for wheat prices.

Copper. After trading in a band of about $6,000 per metric ton for several years, and taking its early-pandemic plunge, the metal’s price has elevated to just over $9,400 lately. Copper, used in housing and electronics, is closely linked to global growth. The question up ahead is production capacity, or rather the projected lack of it. As a result, Goldman Sachs forecasts that copper will ascend to $12,000 in two years.

S&P Global Platts’ research indicates that, over the past three decades, 224 large copper deposits have been discovered. Alas, just 16 of those have come in the last 10 years and only one since 2015. In recent years, copper miners have trimmed their exploration budgets. Now, they are scrambling to ramp up again.

Lumber. This, the key component of home building, is the epitome of swinging commodity prices. In pre-pandemic February 2020, lumber’s price stood at $454 per 1,000 board feet, and a month later, as COVID-19 blighted the globe, that fell to $304. The lockdown sparked a sudden interest in home purchases, under the theory that if folks were housebound, they at least should have their ideal home.

Trouble was, residential construction had lagged since the housing crisis that triggered the Great Recession. Many sawmills had closed, and virus anxiety kept workforces down at the remaining sites. As housing construction accelerated, lumber shortages proved vexing, and prices exploded, reaching a high of $1,544 two months ago. Then came the next stage: Supply revved up to meet demand. Lumber descended to $644, back to where it stood at the end of last year.

Despite the mind-spinning gyrations, does everything here add up to a new supercycle? It’s likely. “We have a lot of liquidity chasing goods,” AAM’s Lloyd declared. If that keeps going, look for many years of increases.

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