Commodities: a geopolitical hedge in an uncertain world? – Podcast highlights

The full podcast is available here. 

John Mensack: The Covid-19 pandemic, rising tensions between the US and China and the war in Ukraine have caused many nations and companies to reconsider their supply chains and strategic partners. We're going to speak today about the potential to use commodities as a geopolitical hedge in your portfolio. But before we get to that, let's go back and start at the beginning. Jim, Malcolm, what did globalization provide the world?  

Jim Luke: What really made a big impression on me was this notion that between, say, 1980 and 2010, in a globalizing marketplace, you saw close to a threefold increase in the global working age population that could be accessed by a footloose or a cost optimizing manufacturer. The working age population grew from about 700 million people in 1980 to 2 billion people by 2010 via the accession of China into the WTO in 2001. Other factors were the expansion of the EU in the post-Soviet period into the Eastern bloc, a huge source of labor supply into the broad developed economies of Europe and the increased role of India and the Indian subcontinent.  

What the globalization period demonstrates is it was an exception that probably proves the rule because it was one of the periods, particularly in the early 2000s, when you saw very strong increases in commodity prices but also developed market headline inflation that was still rather tame. But what was happening structurally behind the scenes in terms of labor supply was, from my perspective, an unrepeatable and historically unprecedented increase in the global labor supply, which was significantly suppressing labor in the lower deciles of the income spectrum.  

Malcolm Melville: One of the key tenets of globalization was just-in-time time delivery. The focus globally of all corporations was, Where can we produce on a global basis at the lowest possible cost? Security of supply was a minor consideration. I think the disinflationary impact of that just-in-time delivery, i.e., finding the cheapest place anywhere in the world to produce your goods, was key to globalization. Clearly the world has changed now and globalization is under threat. Now security of supply likely ranks alongside cost as a primary driver when companies think about their production cycles. 

John Mensack: I guess one of the downsides we had through globalization, certainly in the US, was fewer union jobs as some of those jobs were shipped overseas. 

Malcolm Melville: I think that's right. If you look at the BLS data on union membership in the US, you went from the 1960s when it averaged 35% and in the 2020s it has been down to 10%. You had a very big change in the structure of labor markets, particularly in the US. But there were some challenges to globalization and two kinds of vulnerabilities were exposed. One is the lack of diversification in supply and the second is exposure to globalization where you get those stress points because those relationships with your supply have been weak. On the diversification element, I think it was highlighted most vividly in Europe where buyers went to the cheapest supplier of energy because the primary motivation was price, not security of supply. Europe found itself very tied up with Russia because of its energy needs. The end result was huge spikes in gas prices globally and particularly centred in Europe.  

And if you're very reliant on one area for supply, then as those relationships change through time, stress builds if relationships aren’t solid. The globalization theme delivered lower prices in an era of lower inflation but it had vulnerabilities, which have been exposed during the last few years.   

John Mensack: We're living through the most significant geopolitical realignment since the fall of the Berlin Wall and before that, probably the end of World War II. These realignments tend to last for decades so we're in the beginning of all of this now, in a multipolar rising environment. Let's break down the three poles as we see them and start with the Western powers: the US, Western Europe and Australia. What do they want? What are they trying to achieve? 

Jim Luke: I think the US wants to retain its primacy within traditional spheres of influence, which includes Asia Pacific. I think more broadly, governments in Europe and governments in North America in particular, and maybe including Australasia, will be thinking hard about the security of supply chains. I think if the broad assumption is that the direction of travel in US-Chinese relations is not great, then given the reliance for some critical industries on Chinese supply and that goes down to renewables but also in terms of critical minerals and refined production, there needs to be much more attention paid to supply chain security. We’re seeing this to an extent but there is likely more room to grow. There is great potential for disruption. 

John Mensack: On the other end of that tug-of-war rope, we have a strengthened relationship between China and Russia, a marriage of convenience. What do they seek from each other? 

Malcolm Melville: There are clearly mutual benefits to having closer cooperation. Russia is a key energy supplier producing 10% of the world's oil and ever increasing amounts of gas and has direct pipeline access to China. China is eternally energy hungry and seizes the possibility of getting cheaper energy. Russian oil trades at a meaningful discount to international prices. So if China can secure cheap energy from Russia, that is going to help suppress inflation and help its economic growth. The other element is that because of Russia's actions in Ukraine and the international reaction to it, Russia has been forced into a position where it needs to seek allies wherever it can. And in China it has a partner.  

Saudi Arabia and the Middle East clearly need and want to maintain their strong relationship with the US but ties to the petrodollar system are weakening. And they too see the strategic benefits of building partnerships with China. Cooperation with Russia in the OPEC+ framework continues to be strong. 

John Mensack: Furthermore we have a block of countries called the Global South, which are southern Asia, parts of the Middle East and Latin America—very resource rich countries. They understand this is their moment with respect to the imminent major spend on climate change mitigation. 

Jim Luke: It certainly puts them in a very strong position given the competing power blocks of the US, potentially Europe and then Russia and China. In terms of the ability to benefit from the need for resources, particularly if you look at parts of Africa and then Latin America, you would think they'll be doing everything to maximize their own benefits. But it does put certain parts of that bucket into very difficult positions between the US and China. Some of those regions may ultimately be forced to choose which block they align themselves to. It will be interesting to see the extent to which you can play both sides off each other or whether there's more tension that comes from that. 

Malcolm Melville: And globalization is not dead, however, the players come from different perspectives. Take the agricultural sector, where countries are quick to impose tariffs or export restrictions, whether it be Australia and barley or Argentina with wheat or palm oil from Indonesia. Agriculture does seem to be the sector that is most susceptible. And I don't think that's going to change going forward because a government’s primary responsibility is always going to be to look after its domestic population. Ensuring food security is absolutely the number one priority. That can have significant implications for agricultural prices at times if you have poor harvests or increases in demand or shifting eating habits, as you're seeing in many parts of Asia and particularly in China. 

John Mensack: I think the most prominent story that we've seen so far in the last 18 months while tectonic plates have been shifting has been tanks rolling into Ukraine in February 2022. In April, 3,200 miles away in Mumbai, India, Prime Minister Modi famously declared that India would feed the world because it had a phenomenal wheat harvest in a La Nina year due to a great monsoon season. Yet four weeks later there was a subsequent pronouncement from Mumbai that India was instituting a near total export ban on wheat. Is this the new normal in terms of other commodities? 

Malcolm Melville: I think food and commodity security, whether it be for the energy transition or agricultural products to depress inflation, are going to be key. When you have higher inflation and pressure on governments, high food prices and commodity prices can be detrimental. You saw that reaction in the US when it tapped the Strategic Petroleum Reserve (SPR), the world’s largest supply of emergency crude, because of the spike in gasoline prices. Governments will do all they can, whether it be export bans or tax relief or tapping reserves, to cushion those effects on the population and economy. 

John Mensack: It’s not just agriculture. There is also the Chips and Science Act in the US, which blocks China from sophisticated technology and entails a claw back provision that bans a partner from expanding in China if it exploits the Act. The lines are being drawn here; both companies and countries must strike a delicate balance. Commodities tend to work as an inflationary hedge and they're an important asset class in a time of elevated inflation. Supply chain disruptions, hoarding, food hoarding and critical supply hoarding will be ensue randomly making them impossible to predict.  

Jim Luke: I think it's a question of is the probability of a geopolitical shock or supply disruption higher given the stresses between, say, the US and China, and more broadly, in terms of this global bifurcation or trifurcation? Can you say that the probability of that kind of rupture has increased because of some of the fiscal stresses and debt stresses? I think you can and it's the same point for geopolitics. It’s clear that times when commodities have massively outperformed were often amidst geopolitical events, particularly disruptions to Middle Eastern oil supply. 

John Mensack: Past events—proxy wars, embargoes—typically hinged on ideology. Oil was at the center and gold was the common hedge. It seems now that the potential list of items in scope for this fabric fraying and conflict is quite large, given the major spend on metals occurring in the climate transition. 

Jim Luke: If you define a strategic commodity as essential to the smooth functioning of the economy, then you can broaden the definition of potential commodity beneficiaries of this kind of stress wider than the gold market and metals into agriculture. Energy security is absolutely vital given how large energy markets are relative to GDP and how large they are relative to other commodity subsectors. 

John Mensack: With all the inherent instability and uncertainty, it seems that what had been a tactical trade of commodities now seems to make a decent case for a structural element in a portfolio for at least the next decade.  

Malcolm Melville: The starting point also is important. If you think about a typical portfolio, on average an allocation to commodities is low. The past three or four years have been very good for commodities but previously there was a very savage ten-year bear market in commodities. We have seen investors periodically over the last three or four years allocate to commodities but it has been a tactical allocation. There haven’t been many people who have said, We really want to take that five-, 10- or 15-year view because there are structural changes transpiring in the geopolitical landscape and we need to have a structural allocation to commodities. So if your starting allocation to commodities is either zero or very low, then reflect on it. If you believe in these risks, then you might want some small allocation, depending on what suits the portfolio.  

Jim Luke: The question is, What kind of world, and with what kind of priorities and strategic tensions, do we think we're entering? If it's one in which priorities remain around climate mitigation and strategic tensions are high and building, I think the case for commodities is enhanced. 

John Mensack: Jim, Malcom, thank you for your time. 

The full podcast is available here.