Macro-Economic Environment
Much has been written of late about the “Magnificent 7” and their outsized and historical influence on returns to the S&P 500. Never in history has such a narrow group of names made up such a large percentage of the index’s weighting, leading some to wonder whether the future prospects of the other 493 are simply not that great. While we disagree with this premise completely, we think that the unbalanced nature of capital flows highlights exactly why we are selectively bullish on commodities despite some predicting we are on the precipice of a recession.
While it is true that commodities are highly cyclical, and generally underperform during periods of broad economic weakness, we take issue with those that are currently lowering their respective ratings on this sector. We are advocating an allocation to commodities for three main reasons:
We are not convinced that the global economy is necessarily close to a broad slowdown. Nothing in the PMI prints or current leading indicators have convinced us to believe that we are on the verge of a significant slowdown;
The narrowness of capital flows into Tech and AI is indicative of a continued dearth of capital being allocated to the broader industrial economy. The inadequacy of this was highlighted during the pandemic where we saw shortages and supply lines pushed beyond their capacity;
The pre-emptive flows into alternative energy and other “non-commodity” commodities have been a disaster. The massive amounts of capital that has been incinerated over just the last year in wind and solar, as well as in the BEV space, has been highly instructive. One of the lessons learned is that paradigm shifts take time and are not driven by government mandate.
While the lack of targeted CAPEX is one substantial underpinning for the natural resource/commodity sector, we would also point to the misperceptions surrounding the largest buyer: China. There is no denying that China has been the largest single buyer of nearly every commodity you could name over the last several decades. Therefore, any signs that economic growth is slowing will immediately be reflected in commodity demand.
It is our contention that the China slowdown story is “old news”, and reflected in the steep selloff of Chinese equities over the last 18 months. Conversely, the commodities complex has held up on a relative basis quite well. In our estimation, the commodity markets have largely already re-priced and are looking past this slowdown.
Perhaps this associated chart sums up the relative value of commodities best. If you take the S&P 500 as a proxy for the broader U.S. economy (we know that this is flawed somewhat) and the Chinese Stock Market as a proxy for the Chinese economy, we are seeing a broad divergence between the technology driven, consumer-led U.S. economy and the industrially driven, commodity-dependent Chinese economy.
Takeaways: It is sometimes easy to forget that the purpose of equity markets is to efficiently allocate growth capital. The massive outperformance of seven companies reminds us that this process is anything but efficient. Furthermore, outsized allocation leads to vacuums in other parts of the capital markets, which is precisely the situation we are in today with respect to most of the “old line” industries directly tied to commodity markets.
Commodities/Energy
As the U.S. marches toward record oil production, questions are naturally raised regarding an OPEC+ reaction. The EIA forecasts 13.2MM and >13.4MM barrels per day of U.S. oil production in 2024 and 2025, respectively. Iran and Venezuela production levels are also at multi-year highs. With the Saudis in charge of managing swing production (cuts) in order to maintain a reasonably balanced global market, it is fair to ponder whether their patience will eventually run out leading to another 2020-esque targeting of U.S. shale.
There are several factors making that outcome more remote in our view. The increased number of U.S. upstream mergers/acquisitions is one. A number of higher production-growth E&Ps with (largely) Permian exposure are now under the umbrella of industry heavyweights, including Exxon, Chevron, Conoco, Oxy, etc. This consolidation significantly insulates the domestic upstream industry from OPEC+-led market share and price wars. This isn’t to say oil prices won’t slide under such a scenario - they most certainly would. Rather, these companies that now possess fortress balance sheets are positioned much better than they were in 2020. Thus, any attempt by OPEC to meaningfully flush out U.S. shale by adding to global supply is unlikely to do much other than depress the prices received by all, without removing any meaningful capacity.
With the taps pretty much open everywhere, it may be time to consider some potential reduction in flow. Oil prices have remained incredibly stable amid some of the largest Middle East threats in years. Despite U.S. pressure, Israel has continued their Hamas extermination mission in Gaza, increasingly clashed with Hezbollah on their northern border with Lebanon and now (reportedly) have publicly stated that Iran is a “legitimate target” of missile attacks. In some form, Syria, Iran, Iraq, Pakistan, Yemen, Israel, Lebanon and the U.S. (amongst several others) are deeply involved in military conflict. Possessing upside optionality in oily names that are trading at (or near) yearly lows and throwing off attractive dividends isn’t a bad place to be.
Takeaways: We believe the rotation to value, hence “stuff”, will provide excellent risk-adjusted returns in 2024. This tide doesn’t lift all boats however as we’re seeing with initial Q4 2023 earnings reports.