Macro Minute: The Ides of June

When looking at the return of assets for the first half of the year, we find that US bonds posted their worst first half-year performance for over 100 years, while the S&P 500 declined 20.6% year-to-date, recording the worst first half of the year since 1970 and its 4th worst start on record. More broadly, the MSCI All Country World was down 20.9% for the period. Institutional investors are having one of their worst performance periods on record with the trusted 60/40 portfolio declining by 17% YTD, making it the second-worst start since the 1900s.

The month of June was marked by a sharp repricing of recession fears along with a VaR shock that led to risk reduction and high correlation across markets, providing very few opportunities for hedges and diversification. During the month, 10-year treasuries increased +16bps, with the difference between the 10 and 30-year bonds flattening by 3bps. The 2-year bond yield increased by almost +40bps for the month and jumped +54bps in two trading sessions, the largest move since 2008 when it moved +55bps. The S&P and Nasdaq were down -8.4% and -8.7%, while Energy and Materials sold off -18% and -15%, respectively. Commodities were down across the board, ranging from -10% to -40% in agriculture commodities, and -22% to -57% in industrial metals. In other words, you could not make money in June by being long.

Looking at the long-term we believe that commodity and commodity-related equities exposed to the green energy transition have an exceptional demand backdrop that arises from decarbonization initiatives that will only increase going forward while also possessing major supply challenges. As an example, the average EV consumes five to six times more copper than a combustion engine vehicle. Conservative estimates of EV production put copper demand, just from this source, increasing 20-25% over the next two decades. This does not even account for the increasing demand for copper arising from other electrification needs like batteries and cables.

This is happening against the backdrop of virtually no production increases and very low inventory levels. Mining companies learned from their mistakes in the previous CAPEX cycle of the early 2000s, and along with the more recent price declines and volatility, board members will not be in a rush to invest in capacity. Rather, they will prefer dividends and share buybacks. 

On a March 1st podcast interview with Eric Mandelblatt, he says “(…) three of the largest copper mines in the world were developed over 100 years ago. There’s been only one of the 10 largest copper mines in the world that’s been developed this century since (2001). So, you have this situation where supply in the near term is highly inelastic.”

Reflecting on the recent commodities drawdown, we put too much weight on the probability that markets would realize early that the Fed won’t be able to run the level of positive real yields required to bring down inflation to its target. Rather, when looking at prices, it appears markets are pricing the Fed outlook to perfection. We are now accounting for that and expecting that the crucible moment will occur after the Fed reaches their expectation of terminal rate, or just above, and inflation is still above target. At that moment, the Fed will either have to prove credible, or the market should then realize that the Fed will let inflation run above target for longer. It is worth pointing out that history is not on the Fed’s side. Vicent Deluard from StoneX shows that, historically, central banks only manage to bring inflation down to 3% in each of the next 5 years, following a spike above 7%, in less than 1.4% of the time. What we see today is a market that blindly believes in the Fed and prices that 1.4% probability scenario with full certainty, while completely dismissing the other scenarios. 

Also, we did not expect the market to aggressively price in a deflationary bust scenario so rapidly after a higher-than-expected inflation print and still extremely negative real rates. We expected that during this secular bull market in commodities, we would see some ups and downs in prices, but the speed and magnitude of these moves only compare to 2008, which was a massively deflationary bust period. We assign a very small probability of that scenario (for a detailed analysis on this, please see our recently published annual report), and we believe that if a recession is around the corner, it would be an inflationary bust instead. 

With the supply of commodities constrained, even a short-term decrease in demand would not fix the problem of inflation, it would only postpone it to the following part of the cycle when policies revert to accommodative to shore up demand. We know from history that during inflationary busts, commodities have two-thirds of their upward move after a recession begins. 

2022 Annual Report

We believe that 2021 marked the beginning of a secular bull market in commodities and commodity-related equities, with the usual peaks and troughs along the way. A decade of underinvestment by producers and refiners of natural resources coupled with burgeoning excess demand for those resources driven by a myriad of global initiatives including electrification, food security, and energy independence has shifted the long-term supply-demand outlook into deficit for many commodities.

Going back to the 1970s, a period where many investors are looking for clues given the recent run-up in inflation globally, commodity prices and related equities enjoyed a bull market that only ended in 1980 with the collapse of a commodity bubble. In the early 1980s, oil prices began to drop, and at the same time the Federal Reserve was credibly moving to “break the back of inflation”. Since then, we lived through a constant cycle of disinflationary forces that ended in the mid-2010s.

Almost all crises since the 1980s were balance sheet crises, and therefore deflationary. The Japan bust, the Asian crisis, the sub-prime crash, and the Euro crisis were all balance sheet and banking crises. Those crises were deeply deflationary in an already deflationary environment. As balance sheets were negatively impacted, borrowers constrained consumption and investment to pay down debt, while at the same time banks constrained lending, which in turn negatively impacted the price of assets used to collateralize said debt, restricting banks’ ability to lend in a never-ending vicious cycle… until governments stepped in.

Global demographics served as a tailwind for labor and led to an increase in savings that got recycled into US Treasuries – colloquially known as the global savings glut. With the fall of the Berlin Wall in 1990 and China being admitted to the WTO in 2001, globalization went into overdrive as companies could tap into a global labor force, resulting in even more disinflation.

Equities and commodities have swapped market leadership in cycles averaging 18 years in length for over a century. Over time these cycles have become shorter with technological advancements, but they are still fairly consistent, predictable, and long. Commodity price bubbles tend to bust after military or economic conflicts due to the well-known “peace dividend” which drives lower commodity and input costs, better profit margins, higher equity multiples, and more leverage brought on by lower rates and a low-inflation environment. Conversely, when equity bubbles deflate, inflation resurges. Large amounts of debt that were accumulated during the expansionary phase must be reduced using a combination of inflation and defaults. When that happens, easy monetary policy follows, and military or economic conflict once again occurs, perpetuating the long-term cycle.

In the subsequent sections of this report, we examine in detail three probabilistic scenarios for what the medium- to long-term outlook in markets may be, but a summary of the analysis is as follows.

(1) Sustained growth and higher prices via re-leveraging of consumers, a renewed corporate investment cycle, and the build-up of inventories in a more inelastic supply environment. This view is anchored in the belief that the world is transitioning from slack to generally tight commodities supply. (P = 55%)

(2) Rising conflict, disruptions, and nonlinear upside price movements leading to a prolonged period of stagflation. Major wars (or other exogenous shocks like pandemics) produce high inflation, and even minor wars can interrupt trade. Conflict and inflation are intrinsically linked, especially coming out of a period of extreme money supply growth. (P = 35%)

(3) Continued price disinflation or deflation, western-dominated status quo, resumption of the technology capital expenditure boom, and prolonged strength for US equity index returns. In this scenario, the belief is that the Fed will not be as aggressive in hiking rates this cycle given the unsustainable divergence between rising debt as a percentage of US GDP and the falling nominal GDP growth derived from that debt. (P = 10%)

The above scenario analysis and applied probabilities shape our forward-looking market views and positioning. Throughout this report, we provide the economic data and analysis in support of these ideas, and a summation of the key points can be found below:

  • We believe that for at least the next few years, we are entering a new environment for inflation with consistently higher price levels. Some indicators to watch for are surging real estate prices, high money supply growth, large fiscal deficits, strong commodity prices, increasing geopolitical instability, and stretched valuations for the US dollar.
  • In that period, we also expect strong nominal GDP growth, while the outlook for real GDP growth is more uncertain given the rising risk of conflict or a central bank miscalculation.
  • Rising inflation will lead to Fed rate hikes, but the governors may have little choice but to return to an accommodative stance due to the “hangover” of past financial excesses and, potentially, war. Government roll-over rate risk is very large, with approximately two-thirds of United States federal debt maturing in the next four years.
  • We expect strong global commodity demand and commodity prices to be a central theme as well. Poor profits have discouraged investment by commodity producers since the mid-2000s, and the growth of sustainability concerns has exasperated the underinvestment.
  • With supply already in short store, producers have moved from the last decade of short duration investment – restock, destock, capex binge, balance sheet distress, capital raise, boom, and bust – to longer duration, disciplined capex cycles.
  • As a result of these dynamics, we expect commodities to outpace the S&P 500 over the next few years. Commodities become a defensive asset in commodity-driven recessions.
  • We see single-digit compound returns for the S&P over the period. The first part of the period will see negative returns and the later part low positive returns, as the focus shifts from multiple compression and falling earnings to cheaper valuations. Free cash flow generation will be key in both phases.
  • Inflation could be made significantly worse if increasing geopolitical instability leads to wars.

Given this outlook, we have built positions across the commodity complex, the core ones being in industrial metals – namely copper, aluminium, and cobalt – emission allowances, and grains. Alongside those positions, we have further built upon the theme through equity allocations to global energy refiners investing in renewable fuels (e.g., sustainable aviation fuel, renewable diesel), miners and refiners of industrial metals who lead in low carbon intensity production, and industrial companies exposed to the renewable revolution with large market share and pricing power. We expect the supply-demand fundamentals facing commodity markets to persist for many years, pressuring prices and having a negative impact on prevailing market sentiment, with a particular emphasis on long-duration assets. We will be hedging a portion of our equities exposure by betting against indices we find to be richly valued given our probability-weighted scenarios. We expect interest rates, especially in the developed world, to make higher highs and higher lows over the next few years, a quasi-mirror image of the lower highs and lower lows of the deflationary past few decades. Lastly, we believe that the currencies of commodity-exporting nations will benefit greatly from this scenario.

To arrive at these views, we have done extensive research that involves proprietary information and third-party data. If you are interested in a full copy of the report, please contact ir@norburypartners.com.

Macro Minute: The Russian Gambit

Last week, the European Union announced plans to ban Russian crude oil over the next six months and refined fuels by the end of the year as part of the sixth round of sanctions. Over the weekend, the proposed ban on its vessels transporting Russian oil to third-party countries was dropped, but the EU will retain a plan to prohibit insuring those shipments. Bloomberg reports that about 95% of the world’s tanker liability cover is arranged through a London-based organization that must heed European law. Without such insurance, Russia and its customers would have to find alternatives for risks, including oil spills and mishaps at sea, that can quickly run into multi-billion-dollar claims. (For more on the commodity trading business and how insurance impacts commodity flows, listen to “Javier Blas Explains How Commodity Trading Shops Really Work” on the Odd Lots Podcast).

The pain to European consumers is clear. The region last year got 27% of its oil imports and approximately 40% of gas from Russia (paying $104 billion for supplies of fossil fuels). Economists estimate a full embargo on Russian oil and gas reduces the area activity from 4% (Barclays) to 2% (Bundesbank), while some analysts have argued that the impact would be lower than that. Germany’s vice-chancellor Robert Habeck said his nation has already cut its reliance enough to make at least a full oil embargo manageable with the share of Russian crude in German imports falling to about 12% since the invasion.

For Russia, an oil embargo would limit the inflow of foreign currency and make difficult spending cuts necessary. Russia’s Finance Ministry expects its GDP to shrink as much as 12% this year, on par with the turmoil seen in the early 1990s, when the Soviet Union ultimately dissolved. On Monday, Russia said it expects its oil production to rise in May, and that it is seeing new buyers for its crude, including in Asia. But how much of this is true and how much of it is just posturing?

Changing oil shipping routes from Europe to Asia is not as trivial as Russia would lead us to believe. Different vessels are required to efficiently transport oil on different sea routes. When done properly, transport of crude oil by tankers is second only to pipelines in terms of efficiency, with the average cost of transport at $0.02 to $0.03 per gallon. When transporting oil, there are three main types of vessels: Very Large Crude Carriers / Ultra Large Crude Carriers, Suezmax, and Aframax vessels. There are about 800 VLCCs/ULCCs in the world used for long-haul routes and they carry around 2 million barrels each. There are about 700 Suezmax vessels capable of passing through the Suez Canal in a laden condition, and they can carry around 1 million barrels on long-haul routes. Lastly, there are about 600 Aframax carriers in the world, known as “go-fast boats,” moving about 600,000 barrels on short-haul routes.

Zoltan Pozsar of Credit Suisse estimates that roughly 1.3 million barrels of oil get shipped from Primorsk and Ust Luga to Europe on Aframax carriers and these journeys take a week or two to complete. Russia does not have pipelines to Asia so the only way to sell its product to new buyers is by using sea routes. However, it is uneconomical to transport crude on long-haul voyages on Aframax carriers and they would need more VLCCs/ULCCs to make that happen. Because Russian ports are not deep enough to dock VLCCs/ULCCs, they would first need to use Aframax vessels to get to a port to then transfer the crude to larger vessels. This transfer itself can takes weeks. After the transfer, the larger vessel would then take about 70 days to get to Asia, unload, and take a similar amount of time to return. This compares with just a couple of weeks when shipping to Europe. This would cause a sharp slowdown in Russia’s economic activity. The world would also need an extra 80 VLCCs/ULCCs to accommodate that change which represents 10% of the current global capacity of those vessels. Additionally, this only accounts for the re-routing of one product, oil, but Russia exports every major commodity.

The increasing competition for selling oil in Asia would have an impact on one of the Middle East’s biggest consumers. It is then no surprise that Saudi Arabia cut oil prices for Asia buyers over the weekend. This will not make Russia’s situation any easier. China benefits when Russia becomes weaker and more isolated and hence more dependent on Chinese goodwill. Let’s not forget that during Russia’s invasion of Crimea in 2014, China got Russia to agree to build (and possibly pay for) a dedicated pipeline at lower prices than it sells to Germany, even when the cost of gas from the new field is higher.

The cost of banning Russian oil might be large for Europe, but it can be even larger for Russia. This should increase the impact of sanctions and diminish the possibility of a unilateral cut in supply in the near future. 

Macro Minute: A Phoenix From the Ashes

While we normally use this section to discuss macroeconomic concepts that help frame our top-down asset allocation views, or to present bottom-up macro asset analysis, today we are highlighting a company that stands out in a world of higher commodity prices.

At present, there is much discussion on how legacy companies, particularly in the commodity space, must change how they do business to adapt to a sustainability-focused world. There is currently a plethora of negative attention on fossil fuel companies as CEOs go before Congress, but today we’re focused on a company that is seven years removed from an activist campaign and fresh off an upgrade from high yield to investment grade last December.

Alcoa is the fifth largest aluminum “pure player” globally, and the largest upstream producer in the Western world. Its operations are geographically diverse, with an integrated aluminum production business from bauxite and alumina procurement and processing, to smelting.

Aluminum is a critical input to virtually every aspect of the forthcoming renewable energy complex and is often referred to as solid electricity given the sheer amount of power (and carbon intensity) required to process the metal.

By our estimates, global aluminum balances are expected to persist in deficit for at least the next 2-3 years, which is already being reflected on exchanges; LME aluminum inventories are running 40% below their five-year average. 

75% of Alcoa’s smelting capacity is powered by renewable energy, which positions the company as one of the least emitting players in a highly energy-intensive sector.

Alcoa is naturally leveraged to aluminum prices and has been consistently delivering on cash flow generation due to a disciplined capital allocation strategy focused on rationalizing its asset base and deleveraging. The company has also been quick to target green growth initiatives with an emphasis on low-carbon aluminum products, helping to differentiate the company from its peers. Some analysts believe that one such peer, Rusal, is expected to see aluminum production go to zero in 2022 due to Russian sanctions precluding the import of bauxite and alumina, which should have a positive impact on Alcoa’s market share.

In our view, Alcoa is a good example of a legacy company from an old-fashioned industry that has increasingly gained investor interest, not only due to the quality of the company’s management but also from a positive industry backdrop (e.g., green transition, supply imbalance).

Macro Minute: Commodities in 2022

After a strong year, we believe 2022 is shaping up to be another good year for commodities. The theme across most sectors in the asset class is consistent – a fundamental mismatch between supply and demand is driving prices higher. Prices are being further pressured by increasing costs of capital for some (e.g., energy producers), higher input costs for others (e.g., fertilizer for agricultural products), and/or after a decade of underinvestment, a lack of new projects ready to boost supply (e.g., base metals mines). Any weakness in a historically strong USD will further the dollar-denominated sector’s move higher.

Looking across the asset class, one finds inventories of many commodities well below their 5-year averages entering 2022.

Concurrently, JP Morgan projects global investment in commodity sectors to be the lowest across all sectors this year. This comes at a time where the forces of ESG have driven costs of capital higher, leading major producers of commodities to hold off on investing until higher prices are sustained for a longer period.

Fundamentally, physical assets are driven by volumetric levels rather than expectations, which fuel financial assets. When supply cannot meet demand, and inventories cannot bridge that gap, only the highest bidders get access to a specific commodity. This process is called “demand destruction” and can produce parabolic price movements.

This past year, we saw an example of “demand destruction” price action in European natural gas (TTF). Weather seasonality impacted a very inelastic demand while shifting energy priorities related to net-zero goals, and regional geopolitics caused a shift on the supply side.

We expect to see more demand destruction across the commodities complex in 2022.

Macro Minute: Cross-Asset Views for 2022

Rather than provide a classic “Here are 10 things to watch” list that will more than likely be stale by the time you hear from us next, we’ll share quick views across different markets for 2022.

Equities

At a $3 trillion market cap, Apple is worth more than two years of Brazilian GDP or about equal to the United Kingdom’s GDP in 2020. Put simply, equities (particularly in the US) screen expensive by almost any metric. There are still opportunities to be had here, especially in companies levered to commodities, but with rates rising and Fed QT on the horizon, we are cautious on the asset class.

Commodities

The 2022 Norbury Partners Annual Report will be focused on commodities and a regime shift from an equity-driven market to one driven by commodities, but in brief, we think that decades of underinvestment across the complex, coupled with an increase in demand ex-China will be a boon for commodity prices. Commodities are essential to human life in a way incomparable to other financial assets. There is a strong case to be made that the sector will be a key piece of the geopolitical framework this decade (e.g., Russia, Kazakhstan, China).

Rates

We continue to monitor US interest rates with the view that they should persist moving higher from here and that the curve should steepen. While less clear on the number or pace of rate hikes this year, this paper from the Kansas City Fed (published October 2021) sheds some insight into how the Fed is thinking about policy normalization this time around.

Fewer hikes coupled with a bigger unwind of the balance sheet would in theory not only steepen the yield curve, but also allow banks (who borrow at the short-end and lend at the long-end) to continue making loans to maintain growth in the economy. A steepening yield curve would also help to cap the sharp rise in housing prices we’ve seen in the past year, a key goal for those looking to address wealth and asset inequality in the system.

Currencies

FX volatility screens as the cheapest among all asset classes, and we have been using this to hedge some of our high conviction positions in Equities and Rates.

Divestment Is Not The Answer: An Easy Way Out Of A Complex Problem

Divestment, the act of removing and or excluding particular sectors or segments of the market from investment portfolios, was all the rage at the beginning of the last decade in the face of climate change. Based on my perspective, however, the results of such action by institutions and portfolio managers have been uninspiring.

For citizens of a democracy, voting is the most important action one can take toward shaping the future path of economic and social policy in his or her municipalities, states and nations. George Nathan, an American editor in the early- to mid-1900s, has been credited with saying, “Bad officials are elected by good citizens who do not vote.”

A case can be made that the same level of responsibility held by voters in a democracy sits with the market when it comes to shaping a company’s business decisions. Shareholders, irrespective of size, are typically entitled “to vote in elections for the board of directors and on proposed operational alterations such as shifts of corporate aims and goals or fundamental structural changes,” according to Investopedia. When you consider the democratic tradition of voting to make a change, particularly in American culture, it is hard to “square the circle” when it comes to supporting divestment.

However, recently, the trend seems to be shifting. This year, shortly before Memorial Day, the board at Exxon “conceded defeat” to impact investment firm Engine No. 1, which drummed up (and won) a proxy fight by alleging the company was being disingenuous with its emissions targets and not taking its impact on climate change seriously enough. Through a combination of publicity and engaging with large shareholders, the newly launched firm used activism to, against the recommendation of Exxon’s executives, elect three candidates to the company’s board who are committed to pushing the company’s business model away from fossil fuels and toward renewable energy.

As an investor, one should strive to understand as many of the components of risk that will impact a company’s (or country’s) future rate of growth and ability to operate efficiently. We founded Norbury Partners, a sustainable macro fund, on the premise that it is impossible to make informed investment decisions without considering changing consumer preferences, as well as changes in the regulatory and policy environment arising from climate change mitigation and adaptation and access to basic services. However broad, certain sustainability information can be material to better understand macroeconomic variables and the idiosyncratic risks associated with countries and the future cash flows of corporations.

From severe flooding in low-lying cities caused by mega-storms to drought-stricken commodity harvests, and everything in between, it has become increasingly clear that fundamental data found on company 10-Ks, or in periodic sovereign data, does not always wholly paint a picture of the future. Like people and their voting habits, companies and countries change with the times. Look at the past six months: the United States rejoined the Paris Climate Agreement and the largest economies in the world committed to net-zero targets within the next 40 years.

Rather than divest, rational investors seeking to maximize their returns should look for companies in the early or interim stages of change that will create outsized value in a changing world energy paradigm. Often by the time companies mature, becoming renowned for their sustainability practices and stalwarts in environmental, social and corporate governance (ESG)-focused portfolios, the excess value created when a company managed its downsides and built upside has already been priced into the stock.

Furthermore, what industry is going to see a more significant shift in the changing world paradigm? Someone will have to provide the innovation and energy required to power a growing, more technology-centric world. By participating in a company that has long been called for divestment, Engine No. 1 has demonstrated that investors have a better chance of shaping the future and capturing upside for themselves as active shareholders than they do as spectators in the market.

Finally, the nature of markets guarantees that by divesting, particularly on a large scale, prices will be pushed down with more sellers than buyers. This, in turn, increases the expected return for divested company shares where business will continue as usual, bringing non-ESG-focused investors into the fold who are less likely to make the required changes (or vote along those lines) for a sustainable future.

By last fall, more than 1,200 institutional investors, with more than $14 trillion in assets, had made commitments to the divestment of fossil fuel holdings. Yet, the way I see it, the movement has failed to bring about the change it has been lauded to produce.

As citizens of a democracy, it is our right and our duty to exercise our vote in order to institute change. As investors, we should be looking for the upside to be found in energy companies transitioning to technologies more suitable for the future that policymakers have committed to. And as students of markets, we must recognize that by divesting shares and pushing prices down, we increase a stock’s expected return, thereby inviting marginal investors less committed to ESG and a sustainable future as shareholders, and creating a feedback loop of “more of the same,” with little prospects of advancing toward our goal.

Voting should not be something we talk about every four years. Utilize your ability to be an active market participant to drive the change you want to see.

Article also submitted to Forbes

Macro Minute: Commodity Inventories

A quick note on commodities… Historically tight inventories have led to all six base metals (Aluminum, Copper, Nickel, Lead, Tin, Zinc) listed on the London Metals Exchange to trade in backwardation for the first time since 2007.

Of those six, some of the tightest markets are in Aluminum, Copper and, especially, Nickel, which has the largest deficit in its history. Using the average daily production of each metal and aggregate inventories across Shanghai, London, and United States metal exchanges, we estimate global aluminum inventories to be approximately 5.8 days of production, copper at 2.2 days of production, and nickel at just under 13 days of production. Actual daily draws from exchange are variable, but this illustration speaks to the level of tightness in the market.

All but tin have upside to the levels reached in the last period of backwardation across the sector, after adjusting metal prices for inflation.

Bear in mind that while the price run-up in 2007 was also the result of a supply shock, albeit for different reasons, there was a sharp decline in demand caused by the bursting of the housing bubble and onset of the Great Financial Crisis, just as more supply began to come to market. The setup this time appears to be different. Persistent underinvestment in commodity extraction over the past decade, coupled with increased demand driven by government net-zero goals rather than private industry (e.g., homebuilders), suggest that this rally could be much tighter for much longer. With EV penetration increasing around the world, including in China, where nearly 20% of new car sales are electric, and the fact that those vehicles require between 5-6x more metal than internal combustion engines, we could see pressures drive prices past 2007 levels.

Special Report – A Changing Paradigm

As an investment philosophy, we believe that the best way to deliver above-market returns is to find something cheap, take a position, and hold it for the long term. We tend to avoid market timing and “short-term” investments.

Looking across asset classes, we find that many equities are overpriced on a historic basis by virtually every metric and expect future returns to be much lower than in the past decade, save for a couple of undervalued sectors like energy and materials. When the stock market is on fire, as it has been almost non-stop since 2008, investors ignore companies that specialize in raw materials and other goods. With investors too distracted by their ever-increasing portfolio of technology companies, there was a loss of interest in investing any money in increasing the productive capacity of raw materials, agricultural products, and other hard assets.

In real estate, housing around the world is already too expensive to represent a compelling investment. In the US alone, the S&P Case-Shiller Home Price Index sits a lofty 26 percent above its 2006 peak, with a 17 percent increase year-over-year for the nine US Census divisions. To put this in context, housing prices have been rising more than 5 percent above inflation for the past decade.

Products like copper and lumber seem expensive but as an asset class, commodities are the cheapest. When you factor in inflation, even after the recent run up in prices, most commodities are trading closer to their historical lows. We will further explore this asset class in detail in future reports.

Figure 1: Inflation-Adjusted Commodity Prices

Bonds have never been this expensive in history and are clearly in a bubble. As we write this letter, 10-year real yields in the United States are at their historical lows of -1.2 percent. With the Fed’s new inflation targeting policy of slightly above 2 percent, real rates could still theoretically go down to somewhere slightly below negative 2 percent, assuming the Fed cannot reduce nominal interest rates meaningfully below zero. However, for that to be true one needs to accept that we are living through some type of global secular stagnation[1] process, from the demand or the supply side.

Herein, we hope to show that such a scenario is extremely unlikely. First, we believe it highly probable that the environment of slower growth and inflation from the past few decades has more to do with a series of temporary “headwinds” arising mostly from consecutive deleveraging processes caused by the fact that almost all recent crises were balance sheet crises, and therefore deflationary. Secondly, we argue that even if we were living through secular stagnation before, we are not anymore. The underlying forces in play for the past few decades began reversing around 2015, and the Covid crisis created a catalyst for an acceleration of these forces.

If you wish to receive a full copy of this report, including our directional views across asset classes, please contact ir@norburypartners.com.


[1] Secular stagnation is defined as a prolonged period of low growth. While prolonged and low are not further specified, many economists define low as an average annual real output growth rate of no more than one to 1.5%, and prolonged as covering at least several business cycles. The term secular does not require stagnation to persist forever.

2021 Annual Report

When observing macroeconomic trends, we separate our thinking between short-term credit cycles and the impulses impacting them versus slower-moving, long-term credit cycles and the prevailing policy drivers for their behavior. A tertiary layer that has been gaining steam for the better part of the past decade and is now firmly entrenched as a key driver of economic activity, market behavior, and our investment theses is sustainability. As we look ahead into 2021, we believe that we are at, or very near, a rare inflection point involving each of the three aforementioned factors that will reshape the landscape for investors globally. In the subsequent sections, we will discuss at length our views on each of these three pillars, but a summation of the key points can be found below:

  • The coronavirus pandemic caused the sharpest contraction of United States GDP and rise in unemployment of any recession since the Second World War, which resulted in an unprecedented level of fiscal and monetary support in most developed markets.
  • A combination of vaccination rates and the effects of the policy response has created an environment where cyclicals and services could benefit from the large increase in excess household savings and the most pent-up demand since the 1920s.
  • Commodities will play an important role in all of our investment horizons. In the short-term, supply-demand mismatch and supply chain disruption could provide upward pressure on the asset class, while rising oil prices might stymie consumers ability to spend on goods and services. In the medium-term, large increases in money supply used to finance government deficit spending could cause inflationary pressure to further increase commodity prices and in the long-term, government net-zero policies might result in higher carbon costs, which could raise soft commodity prices, as well as greatly increase demand for a new set of commodities integral to developing a clean energy complex.
  • Globalization has been driven by global demographic trends and trade policies since the 1980s that are slowly reversing due primarily to the working age population in China peaking last decade.
  • Labor market integration caused lower wage inflation which led to lower inflation globally. Central banks responded by progressively lowering interest rates, driving asset prices higher and causing balance sheets to expand rapidly relative to income.
  • Economic inequality across generations as voting demographics change in developed markets could lead to a redirection of capital and will influence the rate at which balance sheet issues are resolved.
  • Recent growth in sustainable and responsible investing strategies has been parabolic but encompasses a wide range of implementations. Limiting one’s investable universe through exclusion or negative screening reduces potential Sharpe ratios, while integrating material sustainability information as part of a holistic analysis of individual companies, countries, and commodities boosts them.
  • Given current government positioning, climate change mitigation and adaptation will likely be a key driver of secular trends for the coming decade. Large investments will be required to increase end-use efficiency and electrification of transportation and buildings, generate and transmit renewable energy, develop bioenergy and other carbon-free fuels, capture and store carbon dioxide, reduce emissions, and increase land sinks. Each of these verticals can shape the future path of equity, credit, and real asset prices if net-zero goals are to be met.

To arrive at these views, we have done extensive research that involves proprietary information and third-party data. If you are interested in a full copy of the report, please contact ir@norburypartners.com.