Podcast: Commodities in the age of the 3D reset
John Mensack chats with fund managers Jim Luke and Malcolm Melville about the impact on commodities of decarbonisation, deglobalisation and demographics.
You can listen to the podcast by clicking the play button above. You can watch most recordings of the podcast on Schroders Youtube channel.
The full transcript of the podcast can be found below.
[00:00:07.930] - David Brett
Welcome to The Investor Download, the podcast about the themes driving markets and the economy now and in the future.
[00:00:29.450] - John Mensack
Ladies and gentlemen, do not adjust your devices. This is a sanctioned takeover of the Investor Download. My brilliant colleague David Brett has kindly offered up his seat in the presenter's chair. My name is John Mensack and I'll be your host for the next couple of podcasts. Late last year, our global Chief Investment Officer, Johanna Kirkland, co wrote a research report arguing that investors are facing a new set of financial market conditions. We're referring to it as the 3D reset, decarbonization, deglobalization and demographics. What does this all mean? Well, we think it will lead to higher inflation for longer, more active fiscal policy, a new world order challenging globalisation, a faster response to climate change and labour shortages driving technology investment. In brief, we're asking investors to consider what they've done for the last ten years and think about doing the opposite going forward. So for this podcast, we're going to focus on the impact on commodities of the 3D reset to help guide us through the possible implications, our two experts and two of my brilliant colleagues. Jim Luke.
[00:01:35.610] - Jim Luke
So I'm Jim Luke. I'm a commodities portfolio manager here in London, focused in terms of fundamental research and portfolio management on the metal space. So that includes industrial metals and precious metals.
[00:01:50.600] - John Mensack
And Malcolm Melville.
[00:01:52.040] - Malcolm Melville
Malcolm Melville here. I started my investment career way back when in the Asian crisis, 1997, and I've been investing in commodities looking at commodity markets for about 20 years now.
[00:02:05.640] - Jim Luke
I start with a question to Jim asking to what extent has central bank resolve been evident in getting on top of this current wave of inflation?
[00:02:14.050] - John Mensack
If you look in parts of the emerging market universe, as you know very, very well, John, in Brazil we have rates up about 13%, 11 to 13% in general in Latin America. Talking to Nick Brown this morning in our EMD team in London, who was saying that in Hungary now we're up at 18%. Of course, if you look at the US, also, we've had the largest and the sharpest increase in interest rates since early 1980s. 500 basis points of rate increases since the end of 2021. So it's hard to argue that central bankers have not prioritised inflation over growth. But I think for me, what's going to be interesting in terms of this debate is the extent to which that can last. Because I think between us all, we can probably agree that prioritising inflation over growth, when you have close to full employment, when you have very strong underlying economic growth dynamics, particularly in the US, but you do have inflation way above target, is not a very difficult choice. So for us, I think the big debating point is what will happen when perhaps the cyclical elements of the economy, particularly the employment picture and maybe even the financial stability picture, which we've been seeing a lot recently in the US with the regional banking issues, when those factors clash a bit more explicitly with that inflation target.
[00:03:46.010] - John Mensack
Yeah so maybe not mission accomplished, but the first leg of this, the central banks have come out of it looking pretty good.
[00:03:56.250] - Jim Luke
For me. Honestly, John, do we really think they've come out looking good? We probably have to say that the Fed made one of the biggest mistakes in history in 2021 by not tightening earlier, by continuing to run ultra loose monetary policy in the face of already full employment, full employment and a booming US economy. So you could argue, you could play devil's advocate and argue that what they've done is restore an element of the credibility that they were rapidly losing in 2021. So maybe that would be, maybe I'm being a little uncharitable there, but maybe that would be my take.
[00:04:34.420] - Malcolm Melville
No, I think that's right, Jim. And you can also argue, I think, that central banks did not see this wave of inflation coming. Absolutely. And they've been running to catch up and maybe they get some credibility now because inflation is coming down. But then, as Jim says, the question is that choice will get more difficult. And if inflation doesn't go back to target, then they'll have to choose. And in highly indebted economies, the chances are maybe they are on the side of caution and prioritise growth. And in that world, that probably is a world where inflation is stickier and commodities probably perform.
[00:05:16.630] - John Mensack
Okay, so is it fair to say then that both of you have some scepticism with respect to if developed central banks can get back to that sort of quasi 2% official inflation target range, is that right?
[00:05:32.110] - Jim Luke
Yes. Personally, I doubt we'll get there. If we do get there, I think we'll be there momentarily, very briefly, depending on how strong the cyclical downdraft is in coming quarters in the US and in the EU in particular. And it goes back to exactly that point that Malcolm just made. Because ultimately, if the other part of the Fed's dual mandate, employment, is absolutely fine and you continue to see disinflation, then of course we will get to target, no problem at all. But it seems very unlikely, given the early signs of stress in the US economy, the early signs of stress in the labour market, that by the time headline inflation gets down to anywhere near that 2% target, you won't already have pronounced increases in unemployment and the knock on effect of that into the broader policy picture. For us, I think it's a very, very narrow window. And the probability is that by the point the Fed has to act in order to make sure it's getting anywhere near meeting the other part of its mandate, probably inflation won't be back at target.
[00:06:50.520] - John Mensack
I think there's another dynamic too coming out of COVID Right? And we're going to get to Gold in a second here, but certainly the developed market fiscal response was more than robust. And relative to emerging markets, I mean it was many fold times more aggressive. At this point how tempted do you think developed central banks will be to just literally accept a somewhat higher level of structural inflation going forward in order to help monetise their elevated levels of debt?
[00:07:27.070] - Jim Luke
I think for me the way I look at it personally is I don't really think the Fed or central bankers in general in other developed markets are having kind of behind the scenes discussions with political leaders or fiscal leaders or their relevant ministries of finance or in the US the treasury in order to come up with some kind of compact that ultimately they need structurally higher inflation to bring debt to GDP down. For me, I believe at face value, people like for example Neel Kashkari who at various town halls has been asked that question directly and has said very clearly look, when it comes to the Fed, the Fed has a dual mandate. The mandate is full employment and inflation. The debt issues, the fiscal issues that are clearly very prominent and I think are an absolutely huge issue in the, in the states are secondary and they, they are the concern of, of Congress, their concern of, of the White House and ultimately it is up to the treasury how those fiscal issues are contended with. So I don't really believe that the central banks themselves are actively or consciously thinking about that as a target.
[00:08:49.760] - Jim Luke
But what I really do think is that ultimately they're not going to really have a choice because the negative impact of having such high debt and running such high deficits is that by the time you get to a cyclical downturn and by the time deficits have widened materially from, say, the 5% they're at today in the United States domestically or in recessionary scenarios to 8 to 9%, the absolutely inevitable consequence of that is that treasury issuance will have to massively increase to fill that gap. And which raises the question of who ultimately will buy that issuance? And the Fed has ultimately to guarantee the financial stability and implicitly, if not ever explicitly, the solvency of the treasury. So in answer to that rhetorical question, who would actually end up buying that, providing that liquidity? I think the answer ultimately will be the Fed. So I think yes, clearly the Fed is going to be looser than they would like to be just based on their inflationary mandate earlier because of some of these debt and deficit dynamics that are in play in the US economy currently.
[00:10:08.420] - John Mensack
What does this all mean for gold then? And let's just use gold as a proxy for commodities in general and say if we're going to be running at a somewhat higher level of inflation what does that mean for the gold brick?
[00:10:24.290] - Jim Luke
I think for gold, if you look at the relationship between gold and core macro financial variables in the post 2008 world, the two strongest by far have been US real interest rates, number one, and then number two, the US dollar. But really real interest rates have been the most powerful driver. But I think that the question. You can frame the question to the extent that if you are going to see central banks forced to loosen earlier than they would in previous cycles, and you're going to see inflation more entrenched structurally, then from our perspective, you should expect to see lower real interest rates, which should be positive for gold. But to be honest, that's a very kind of academic way, quite a rigid way to view the gold market. And to an extent, the price action in gold in 2022, where real rates in the US went from negative 100 to positive 150 on the ten year, and gold actually performed pretty resiliently, kind of suggests that even there, some of those relationships are changing. So for us, I think that the better way to frame the argument for gold, when you come at it purely from a macroeconomic perspective, is more just through the lens of normalisation, true normalisation.
[00:11:49.530] - Jim Luke
So if, John, for example, you believe all of your faith lies with the Federal Reserve, you genuinely believe that they're masters of the universe, they have this under control, and they can engineer a true normalisation of monetary policy and a return to the world, a return to a world where you know, normal business cycles are just regulated by monetary policy and there are no negative side effects onto employment or financial stability, then I think that's not a particularly rosy outlook for gold. But if you think like we do that fundamentally, as we just discussed, some of those macro pressures that stand behind current policymakers, particularly the current state of US fiscal affairs, particularly the elevated levels of debt across both in terms of public debt, but also in terms of entrenched required entitlement spending. If you think that those factors really push policymakers away from a normal policy response and actually push them back towards unconventional policy responses, either direct monetisation of debt, the resumption of quantitative easing, ultimately in a downturn potentially the resumption of kind of fiscal programmes, direct fiscal programmes, then I think that is an environment that is potentially much, much more explosive for gold.
[00:13:16.910] - Jim Luke
And to that extent, you could make the point that to some extent, when viewed through that lens of normalisation, gold is to some extent a barometer of the credibility of those institutions. The lower the credibility of the Fed goes, the more extreme the policy responses come from monetary and fiscal policymakers, I think the stronger the case for gold grows against that. When we go back to that idea of normalisation, it is becoming apparent that the expansion of central bank balance sheets, particularly the Fed, is not a temporary measure. We go back to 2008, 2009, and Bernanke was absolutely explicit this was a temporary measure and would be normalised. This is some $9 trillion later. How temporary do we think it is now? What do we think would happen to that balance sheet in the event of another downturn? What just happened to the balance sheet a month ago in response to a regional banking crisis? It went straight back up again. There are underlying systemic stresses here that really make some of these short term issues a complete sideshow, the debt ceiling being the most obvious one. That's the way we think about it. John.
[00:14:36.360] - Jim Luke
If you think things are going to be fine, we're going back to a kind of a normalised monetary policy regime that we had through the great moderation, then don't worry about gold. If you're slightly more sceptical like we are, then gold definitely has a place, as does the broader commodity complex.
[00:14:51.270] - John Mensack
It sounds like it's the triumph of hope over experience is what we're looking for here. As they say.
[00:15:05.210] - Anouncement
On Apple podcasts, Spotify, or wherever you get your podcasts, you're listening to The Investor Download.
[00:15:14.010] - John Mensack
The rise of the petrodollar in the 1970s was based upon implicit US security guarantees in the Mideast. That seems to be wavering a little bit right now. What developments are challenging this?
[00:15:26.930] - Malcolm Melville
John, I think it's a very interesting debate that the role of that system is going to play going forward, which has been in place for the last 40 years. So if we take a step back, that system really came in post the Yom Kippur war in October 73. And as you say, is that kind of the guarantee where the US would provide security to those in the Middle East in return for oil being priced in dollars, and then those dollars would then get recycled into US assets, whether it be fixed income or equities and help fund US deficits. But I think there's a number of reasons to think that that relationship and that kind of system where oil was primarily priced in dollars is going to be challenged going forward. And I think firstly, from the US perspective, the US need for this system, which has been in place for the last 40 years, is reduced somewhat, given the US is now the number one producer of oil in the world as we stand at the moment, it's still important to the US. But less so. I think the second reason I would highlight really, is that from the suppliers point of view, from the Middle East point of view, they want to build strategic relationships with India and China.
[00:16:41.020] - Malcolm Melville
If you think about the growth of those economies over the last 20 years, they are very important now in the global context, and having strategic partnerships with those is increasingly important to many in the Middle East. And you see that particularly from Saudi Arabia. And then thirdly, you have Russia. Now, Russia clearly wants to avoid, especially post the invasion of Ukraine. They want to avoid anything to do with the dollar. And Russia is roughly 10% of global oil supply as we stand at the moment. And the pressure for Russia to deal and transact in oil in any currency but the dollar is there. And that really feeds into that narrative of countries moving away from using dollars in the commodity space. And finally, I'd probably point to China, really. So China now consumes 15, 16 million barrels a day, 15% of global oil. And they want to make their currency more international. So they are pushing for oil to be priced where they can in renminbi. And we saw that come in last year for the first time. So there's a number of different factors at work. It's still important. It's still important to the US.
[00:17:58.500] - Malcolm Melville
It's still important to the Middle East, but it's just much less important than it was. And I think we can see that petrodollar system generally being eroded in years going forward and oil trading in other currencies apart from just the US Dollar.
[00:18:13.100] - Malcolm Melville
What is very clear, I think, in the last year or so is many of the key producers, and I would put Saudi Arabia at the forefront of this, will very much do what is in their own interests. It's kind of OPEC plus first. And this is really driven by their very aggressive domestic agendas. If you think of the Saudi Vision 2030 plan, which is all around reducing dependency on oil, increasing the health system, increasing the education system, increasing tourism, that is incredibly expensive. It's estimated that the break even for this year in the Saudi budget is about 80, $81 a barrel. And that really puts them on pressure to really focus on what policy is best for Saudi Arabia in a way that before the primary consideration, one could argue with what would be best for our strategic partners such as the US. And I think that's a dramatic shift we're seeing. So the influence that the US have on the price of oil is being diminished. And you see that with the criticism laid by the Biden administration at the door of OPEC recently following those recent cuts. That's not what the west wanted in an era when inflation is deemed as too high.
[00:19:27.150] - Malcolm Melville
But OPEC plus led by Saudi Arabia, did it anyhow because it is in their interest to do so.
[00:19:33.620] - John Mensack
So, 15 months ago, Malcolm, when Putin's tanks rolled into Ukraine, there was some speculation that Russia would have a real problem exporting its oil. And I confess, I was one of those people. I was in that camp. But that ended up being a little bit of a naive viewpoint, is it not?
[00:19:53.600] - Malcolm Melville
Yeah, John, I was in that camp too. I really did think that Russia would struggle to find a home for its all when all those sanctions came in from the west. And the reality is that hasn't been the case. The main buyers we've seen is India and China. And I think the primary motivation, really, and the thing that we got wrong, and many in the market also got wrong, was Russian oil traded a $25 discount to international oil. And cheap oil, cheap energy for India, for China, for many countries is really too good to miss. So they really have taken that advantage of those lower prices. And if you look at the Western sanctions regime, it is actually set up with exactly this goal in mind, the twin goal of reducing the flow of dollars of capital back to Russia, but at the same time ensuring Russian oil flows onto the market to depress, keep inflation. The last thing the west wanted through the sanctioned regime on Russia was to restrict oil supply and see inflation and energy prices spike. And you have to say, through all the scepticism that I was sceptical about whether this system would work, it is working incredibly well.
[00:21:10.400] - Malcolm Melville
Russia's oil trades at a $25, $30 discount, but it continues to flow pretty much at exactly the same rates we were. And that really has put a cap on the cap on oil prices so far. And I think it explains some of the weakness we've seen in the oil price over the last twelve months or so.
[00:21:28.760] - Jim Luke
So they're making revenue, they're not making a tonne of profit because of that, is that correct?
[00:21:33.980] - Malcolm Melville
[00:21:35.830] - Jim Luke
To your point that's what the west wanted was for the flow to the taps. Keep the taps on, but keep the profits down. Don't fund the war machine. What do those recent OPEC Plus production cuts mean for crude's risk premium going forward?
[00:21:50.490] - Malcolm Melville
I think they mean two things. I think that the price you see on the screen of oil should have a risk premium in the sense that OPEC Plus is a major supplier, the major dominant supplier, really, to the oil market. And their cut, which was an intrameting cut, it wasn't at their regular framework, really suggests that they have the ability to change the supply of an absolute key commodity as and when they see fit. And that is very difficult to predict. I don't think there's anyone really outside that core group who has any visibility on that, and therefore the price of oil should reflect that risk premium. And the second point, I think really, which highlighted by those OPEC cuts is in my mind, it really puts a floor under the oil price. We talked earlier about those fiscal constraints that Saudi Arabia have, which are shared by many OPEC members. And I really think if oil prices would fall materially below where we are with kind of low-to-mid 70s at the moment, if they were to get into the 60s, then you would see another supply response. So I think that policy statement, that cutting of that supply really shows it really puts a floor in the oil price.
[00:23:02.470] - Malcolm Melville
So you should have a bit of a premium now, but it really means that downside in oil price, you've got to think, is limited from where we are.
[00:23:10.230] - Anouncement
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[00:23:22.390] - John Mensack
When it comes to climate transition, all roads lead through commodities. I think that's pretty obvious. And we're going to focus specifically on copper, which is a key metal in energy transition. And Jim Luke, it's been said that copper is actually the key metal to energy transition. How so?
[00:23:41.710] - Jim Luke
Because of its role as an irreplaceable conductor of electricity, which basically leads to, as we've pretty much all heard many times now, increased usage per unit. So increased intensity of usage in things like electric vehicles, but also increased intensity of usage per megawatts of installed capacity. If you compare, for example, solar plants or offshore onshore wind plants, in terms of copper intensity versus conventional power sources, they just use a lot more metal. And that really is why, from an energy transition perspective, even, for example, if you were to shift around with battery cathodes and EV, so you to use a bit more manganese, a bit less nickel, for example, still you're not going to be able to get away from using quite a significant amount of copper in that vehicle. So I think, really, that's where a lot of the excitement comes from.
[00:24:45.730] - John Mensack
Now, we've heard a lot this year about recent supply disruptions. Can you give us a sense of whether this is to be expected going forward, or have we seen the worst of things?
[00:24:57.510] - John Mensack
I think in 2023, the disruptions that we saw starting in late Q4 and running through Q1 got up just about to record levels. So we're talking 7, 8% of global mine supply being disrupted at a given point. And that compares to a kind of typical disruption rate on an annual basis, say four to five. So for 2023, I think probably things will get better from here. But I think structurally, that question of disruption, to an extent, dovetails with the subject of our next podcast in terms of geopolitical stability and regional stability in areas where copper is produced, particularly Latin America. But then particularly it will come down to the political situations in places like Peru, in places like Chile, both in terms of national politics and in terms of some of the community issues that miners often face in those regions.
[00:25:59.060] - John Mensack
Is there enough copper available to satisfy the needs of the energy transition plans of all the countries?
[00:26:06.230] - John Mensack
I think you can confidently say that yes, there is enough copper. The great arbitrator of copper supply and demand, as in any commodity, is always price. If you spent a while looking at commodity markets, or copper in particular, it can get a little bit frustrating to hear some of the hype that gets pushed out, particularly around the copper market, from some major producers, some major promoters, but also some academics. I think what history shows is that at a given price, there will always be a way for the market to balance. And we can go back to the early 2000s and prove over and over again that the theoretical peak in copper supply is always two to three years out. And that is no different today than it was in 2010 or 2015. The question then is how healthy is that supply pipeline that we have in front of us? And what type of copper price would we need to actually incentivize producers to bring that stuff to market against a backdrop of very, very significant ESG constraints, geopolitical constraints, grade constraints, geologic constraints? And I think there you can make a very rational case that if you even believe that the compound average growth rate of copper demand can be 1.5-2% going forward, backed up by a raft of global climate mitigation policies.
[00:27:48.660] - Jim Luke
Then I think there is a very credible argument to be made that copper prices need to be substantially higher in order to incentivise that supply into the market. But are we going to be facing a critical shortage or a geopolitically destabilising shortage of copper? Which I think was a quote from S and P Global a couple of weeks ago, on that sense, I would stay a bit cynical. So I would call myself a cynical bull when it comes to copper supply.
[00:28:20.870] - John Mensack
The best kind of bull for sure. So I guess these comments on copper, any of these energy transition metals, they kind of fall in along the same lines, is that correct?
[00:28:37.790] - Jim Luke
The supply picture varies by metal, the bottlenecks in different places. But broadly speaking, I guess one contrast you could make would be that the production, particularly the refined production of some metals, is more concentrated than others. So for example, rare earth materials, 95% plus of that is still processed and refined in China. Then the number for lithium remains very high. So there are clearly some strategic issues there. But more broadly, I mean, you can see with the raft of legislation from both the EU and with the Inflation Reduction Act in the US, that this is something that is becoming much more highly prioritised as the global geopolitical situation becomes more fraught.
[00:29:32.090] - John Mensack
Okay, excellent. And always a chance for certain countries to strategically stockpile inventories and it's just not going to be as smooth a world going forward as we've seen in the past. Is that correct?
[00:29:45.730] - Jim Luke
I mean, you would think so.
[00:29:47.000] - Jim Luke
You would think that if you had your eyes on the future and you had the view that US. China relations were going to get worse, then you would hope that policymakers would look at the supply of things like rare earths and some of these base metals and think it would probably do me good both from an industrial complex perspective and from the military industrial complex perspective to have a decent buffer on hand. So I wouldn't be surprised to see governments move in that direction at all and I would be slightly worried if they don't from a security perspective.
[00:30:19.540] - Malcolm Melville
Okay, so, Malcolm Melville, Jim Luke, that's going to do it for this podcast. I thank you for your time and obviously your great insights. And to the listener, we certainly hope that it was time well spent for you. I do invite you to listen into our commodities as a Geopolitical Hedge podcast coming out very soon. Thanks so much. Have a great day.
[00:30:40.050] - David Brett
Well, that was a show. We very much hope you enjoyed it. If you want to find out more, check out our website schroders.com/theinvestordownload. You can also get in contact with us about anything in the show or ideas for future shows at firstname.lastname@example.org. Please remember to subscribe to us at Apple Podcasts, Spotify, Google or wherever you get your podcasts. And don't forget to leave a review. We're now doing one show a week, which will be available every Thursday from 05:00 p.m. UK time. Thanks very much for listening, but above all, keep safe and go well.
[00:31:16.190] - David Brett
[00:31:17.250] - Speaker 6
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