Is there room to run in the commodities cycle?

It has been a bumper time for commodities as the global economy recovers and infrastructure programmes support demand, but - says Olivia Markham, Co-Manager of the BlackRock World Mining Trust plc - there is still plenty of scope for growth.

­­­­2020 was a good year for the commodities sector and mining equities. The sector has seen a significant step up in demand, as governments begin vast infrastructure investment programmes, but has also benefitted from growing confidence in economic recovery. Mining companies themselves are in good health, with strong balance sheets and buoyant margins.

The question for every investor in the sector today is whether this strength can last. Some are asking us whether they have missed the boat, or whether the good news is already in the price of shares. Mining is cyclical - is the cycle turning? We believe that we are only in the foothills of this recovery in the mining sector.

For many commodities, supply and demand dynamics are extremely favourable. Co-ordinated infrastructure spending from China, US and Europe has only happened a handful of times: in the late 1990s, coming out of financial crisis and today. This is a good environment for commodities as a whole, but in particular benefits a number of the ‘greener’ commodities such as copper and those involved in the manufacture of electric car batteries such as lithium, cobalt or nickel.

We see this in the pricing of copper, but also in metals such as iron ore, which continues to see strong demand from China at a time when supply is low because of production disruption during the pandemic. This infrastructure building is likely to be a multi-decade theme. Countries have set themselves ambitious net zero targets, notably from China, and the transition to a low carbon future cannot occur without the necessary commodities.

We believe that we are only in the foothills of this recovery in the mining sector.

Mining companies

Commodity demand isn’t enough in itself. Companies need to be in a position to take advantage. Mining companies have learnt their lesson from the last crisis. We have seen eight years when companies haven’t invested in new supply, avoiding the profligacy that created problems of over-supply in the last cycle. We don’t see this changing in the short term; the cost of production is increasing in many cases and it can take as long as a decade to bring on new projects. In the meantime, inventories are being drawn down.

Companies have shown strong capital discipline and have low debt. This means that they have relatively few demands on their cash. Payout levels have been high as a result, at 50-60% for many mining companies. Low debt levels also helped them during the pandemic.

At the same time, input inflation is still under control. Central banks have made it clear that they will tolerate higher inflation temporarily and we are seeing some cost inflation coming through, given the significant moves in key input materials such as steel, lumber or plastic. As such, it is a risk we are monitoring, but inflation remains modest relative to earnings.

Early cycle?

Even after the recent stronger run for the mining sector, valuations remain attractive to broader market and their own history. When we compare the performance of mining equities to other cycles in the past, we believe it is still very early on in the mining recovery. Our research suggests a typical mining cycle lasts around three years and so far, this has lasted less than a year.

In previous cycles, a key contributor to over-heating in commodities markets has been financial demand. As such, it is an important factor for us to understand. Today, we see demand from financial investors substantially below that in previous cycles. This also suggests that the cycle has further to run.

Equally, we are optimistic that the global economic recovery can continue. Much of the economic data we are seeing points to a rapid recovery in many industries on the back of the vaccine rollout. Commodities tend to do well in a climate of economic expansion. Spending plans announced by governments are encouraging for the sector, both from a fiscal stimulus point of view and from rising commodity demand as the global economy looks to transition to low carbon.

We are also conscious of the risks. The pandemic is not 100% behind us and there are potential pitfalls in the vaccine rollout and economic recovery. However, overall, we believe that the commodities cycle still has further to run. Valuations – both of commodities and of mining companies – do not look inflated, while demand looks set to hold up as the economy recovers and infrastructure building begins in earnest. This suggests the cycle is still in its infancy.

This material is not intended to be relied upon as a forecast, research or investment advice and is not a recommendation, offer or solicitation to buy or sell any securities or financial product or to adopt any investment strategy. The opinions expressed are from BlackRock as of May 2021 and may change as subsequent conditions vary.