16th of June, 2021 - by Mathias Maurer & Simon Tobler, torck capital management AG
The following article is based on the research work of SIM Research
Why invest in commodities now?
As we indicated in our last piece, we are at the dawn of a new commodity super cycle. That this cycle is about to play out over the next few years in full force, is not mere coincidence though. There is more to it than just happenstance – an entire cycle theory if you will.
We are of the belief that our world is moving in smaller as well as larger cycles. Said differently: The world proceeds cyclical, going through various different phases that keep on returning. As the saying goes: History might not outright repeat itself, but it rhymes.
Productivity Phase kicking off a cycle
Usually a capital cycle has a duration of about 100 years and starts with a productive period. Capital is scarce, and opportunities abound, which gives an economy a lot of room to grow. In this build-up phase, economic returns are driven by economic productivity growth. The current capital cycle started after World War 2 and was kicked off by a postwar recovery boom. Decade over decade, this capital cycle has been unfolding.
With creasing economic productivity growth, an economy’s capital stock is accumulating. This increases valuation through the entire economy not least because ever increasing productive capacity allows for an abundance of capital which translates into low-interest rates. A continuous fall in interest rates was only kicking in after the early 1980ties though. The decade before marked somewhat of a deviation from the post-war economic boom phase. This was due to fact that the US went off the gold standard in 1971, leading to a devaluation of the US dollar, because it was no longer backed by gold. This led to runaway inflation which could only be brought under control again by massive increases in interest rate by the FED. After having reach a top at 19.1% in June 1981, FED fund rates began a 40-year decline, taking global interest rates down with them and supporting the economic growth of the last 40 years.
Turning into a debt cycle
Towards the end of the productive phase, a saturation of real productive capacity kicks in. As a consequence, capital increasingly finds its way into financial assets. The capital cycle turns into a debt cycle as the financial system leverages up and financialisation of the economy is in full swing. This transformation for the capital into the debt cycle started around the 1970-ies and coincided with the closing of the gold window.
Typical for this phase is the fact that the strongest driver for investment returns are coming from a change of the money supply or debt creation. Real assets, like commodities remain rather flat while financial assets are going from high to high. Fueled by falling refinancing costs, debt levels across all indicators are pushed to new highs and share buybacks are intensified. All of these things are signs of a maturing debt cycle and we have seen them consistently throughout the last several years.
The end – or better the point of no return – of any debt cycle is theoretically marked by reaching a total debt to GDP ratio of about 300% to 350%. This is the time, when financialised capital is no longer sufficiently supported by real economic productivity. The financial economy has decoupled from the real economy at large and valuation are out of sync. Greater and greater instability follows, and anything can break the system.
As a matter of fact, at the end of 2019 economists at the Institute of International Finance (IIF) calculated that world’s debt when compared against its total output hit another all-time high of over 322% in the third quarter of 2019. Then in 2020 the Corona virus hit, economies all around the world were shut down and unprecedented monetary as well as fiscal interventions by central banks and governments ensued. As a consequence of this, global total debt today stands at $289 trillion, which amounts a total debt to GDP ratio of over 365%. Financial asset prices would have collapsed entirely, and the system would have readjusted if it were not for the interventions that were taken. As cycle theory predicts adequately, things unfolded pretty much the way they should have: The end of the debt cycle was artificially pushed out by all means possible.
A correction is inevitable
But we should no longer be in denial: What has been happening in recent months has marked the beginning of the end of the debt cycle. Covid and the ensuing interventions have surely prolonged and aggravated the debt cycle. Although governments will keep on trying to sustain the system, a readjustment period will be coming our way. In the end, procrastination will only lead to a greater correction, while this correction is not preventable at all.
For now, current governmental initiatives like infrastructure projects, helicopter money as well as social support will give another boost to financial assets. At the same time, real assets like commodities will be in demand as well, uplifting their valuation in the process. This is what we have been seeing playing out over the last few months. Therefore, commodity stocks are seeing a double return at the moment, as tailwinds from generally higher equity prices as well as real economic demand are adding to a positive valuation adjustment of commodity-linked stocks.
At some point in the foreseeable future though, we expect that the proverbial jug has to break. In our view, there are basically two ways the readjustment phase can play out: We either experience a significant correction of all financial assets while real assets stay more or less stable or financial assets will be trapped in a deadlock for a very long time while real assets surge massively in nominal terms.
The first scenario would give us a depression-like situation that could be quite chaotic. The classical historical example is that of the Great Depression in the US. Back around 1929 debt default lead to a collapse in financial asset prices and things got tough. The depression lasted until the late 1930s and marked the longest, deepest and most widespread depression the world ever experienced so far.
Were the second scenario to play out, things would either develop into a painful but rapid hyperinflation or into what can be called stagflation that would provide for a slow but gentle rather than an abrupt but hard death of nominal assets. With stagflation, higher prices are the consequences of changes within the real economy. If trust in a government currency is completely lost, hyperinflation is the result.
A historic example would be what happened to Germany in the first part of the 20th century. Back then, Germany’s total debt to GDP ratio was over 350% and financialisation at its max. In a short period of time, the country experienced a hyperinflation and quite a severe readjustment of nominal values. While the Reichsmark got wiped out completely, people who invested in real values at that time managed to get through this period a lot better.
No matter what: Commodities will outperform
No matter the scenario we will see, we consider the following as certain: On relative terms, real assets like commodities will massively outperform financial assets going forward. Once the adjustment period is over and the deleveraging process of financial asset in favor of real assets is done, economic growth will come back. This growth will most likely be driven by the green energy revolution we already hinted at in our last article. In that case, the respective commodities would experience a further extended boom environment.
Rest assured, that we at torck capital management will launch products accordingly to let our investors benefit from these upcoming developments.
 Makroökonomische Feldtheorie, Heribert Genreith with further research conducted by SIM Research