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The big picture: Equities priced against inflation and commodities
Summary: Global equities have corrected hard over the past 15 months against commodities, and if we are right about that we will find ourselves in a new commodity super cycle over the next decade, then investors must understand asset allocation and get an overweight exposure to commodities. It is easy to get caught up in the short-term noise of war, earnings releases and price moves, but the bigger picture suggests that equities will experience a dramatic repricing against inflation and commodities in the years to come.
The pendulum swings again
European equities rallied yesterday on news out of Istanbul that there had been a breakthrough in the peace negotiations between Ukraine and Russia. Comments from Russia that it would scale back activity in Kyiv and that there was an opening for a meeting between Zelensky and Putin fueled sentiment. While equities behaved like joyful cows seeing grass after a long winter the commodity market initially sold off, but oil and natural gas have since sent the clear signal that there is no breakthrough. Already last night data suggested that Russia had done little changes to troop formation north of Kyiv and today Kremlin is saying that there is no breakthrough in peace talk with much work to do; in other words, Putin is still not getting a deal good enough for him to spin a victory or win to his population.
As a result, European equities are down 0.9% today and commodities are bouncing back. To underscore the risks in Europe, Germany announced this morning that it is going into crisis mode over natural gas supplies following Russia’s demand to be paid in RUB which is not something the EU wants to do. If Russia escalates cutting gas supplies to Europe, it could mean days with disruptions to heating and industrial processes in Germany. Part of Germany’s solution to lower dependence is creating new partnerships such as recently with Qatar, and massive LNG investments in Tanzania, and today the deal between Fortescue and E.ON to get green hydrogen to cover a third of Germany’s current natural gas consumption. While green hydrogen is expensive it has become feasible due to national security needs, but also ultra-high natural gas prices in Europe, and as we recently wrote in an equity note, hydrogen is a key pillar in the future and the existing natural gas infrastructure can easily be modified to deal with hydrogen.
Equities without commodities is a dangerous game for investors
Investors often get trapped by short-term noise forgetting the big picture. Even before the war in Ukraine, the world had smashed into the racing court wall in the sense that the physical world was too small to support the enormous demand created during the pandemic. Years of underinvestment in energy and metals had finally caught up. The war in Ukraine amplified the move in commodities , but the recent weeks of rally in equities and their response to potential peace yesterday does not square with reality.
Global equities are in a 15 months drawdown against commodities as of February 2022 with global equities underperforming by 24% against commodities. This is the biggest relative repricing of equities since 2008. But more importantly if look at equities vs commodities in the bigger picture since 1969, then we have had two periods of equities being repriced dramatically against the physical world and those were the periods of the 1970s and 2000s which both encapsulated the two previous commodity super cycles. The epic outperformance of equities vs commodities from 2009-2020 was a historic period in which the largest profit engines of the world were doing it with little commodity input. The excess wealth creation starved off the world for investments in the physical world setting the economy up for a massive supply constraint shock. This next 10 years will be all about the next commodity super cycle and the underperformance of equities relative to the physical world. Equities might be flat or going slightly higher as in the 1970s, but priced against inflation or commodities equities will underperform.
It is therefore of paramount importance that investors that have been playing the 100% equity portfolio game the past 12 years begin to understand commodities and asset allocation. Otherwise, these investors may end up with a lost decade.
The main themes to be overweight in the current regime are still logistics, cyber security, commodity sector, defence, and green transformation. On a macro level inflation assets such as inflation-protected bonds and commodities will outperform nominal bonds and equities.