Commodity Supercycle Unlikely

Asset Allocation – Market Cycle & Portfolio Positioning

• Say what you will about the equity markets, some of which appear overvalued and are pricing in a lot of good news (mainly theU.S. equity market). You could even say there are some small bubbles out there. But one thing is for certain: the economic outlook for 2021 is looking pretty good and has a lot of momentum.

• The global COVID-19 case counts are coming down, unprecedented stimulus remains largely in place, economies are re-opening, and there is pent-up demand by citizens to spend some of those savings –all good for the economy. With this kind of momentum, even with some softening of late, has the probability of a recession in the next 12-months down to 5%. For comparison, this gauge from the NY Federal Reserve was rising at an accelerating pace during 2019 into early 2020 –an accurate alarm bell for the last recession. Typically, 5% is the lower bound for this index, implying a very low likelihood of a recession anytime soon. (Chart 3).

• Even if we do see a pullback in equities, which we would argue is overdue, this would be a buying opportunity given the low probably of a recession. Historically, pretty much any material drawdown in the equity market is a buying opportunity as long as it isn’t coinciding with a recession. Unfortunately, we don’t know a recession has started until months after the fact, but safe to say there isn’t one in the works today. 

• Supporting this ‘low recession probability reading’ is our Market Cycle indicators. We did see a slight dip from last month, 30 to 29 bullish, but this is still very high and elevated (Chart 4).The vast majority of economic indicators remain bullish of a continuation of the market cycle. The only negatives remaining are valuations in the equity market, emerging market momentum and energy demand.  

• Our portfolio recommended positioning has not changed over the past month. We remain market equity to a tiny overweight in equities, underweight in bonds and overweight in cash. The cash balance is earmarked as opportunistic capital if / when the market corrective phase hits. (Chart 5).

• Within equities we have a market weight in both Canada and the U.S. with an overweight International. We are more cautious for the U.S. market and have this capital tilted towards value / dividend payers and less exposed to the megacaptech. International markets, and Canada, are not cheap by historical standards but are still not overly expensive. Relative to the U.S. market, international is cheap on a relative basis, providing a buffer on a pullback and upside potential should this historically high spread narrow. 

• We remain constructive on the market cycle looking out a year+. However, given the advance we have seen this year, we would encourage some profit-taking to raise cash for the potential pullback, as well as taking advantage of the highly valued Canadian dollar to do some non-Canadian buying. 
  

Fixed Income – GICs, a better alternative to short-term bonds today

• Although the past few months have been characterized by rising long-term yields, short-term yields continued to be anchored close to zero by central bank policy.

• Credit spreads also remain narrow, resulting in low yields on short-term corporate bonds –the weighted average yield to maturity on the underlying holdings iShares Core Canadian Short Term Corporate Bond Index ETF is currently just 1.22%.

• Guaranteed Investment Certificates (GICs) have many similarities to corporate bonds. They are deposits that represent a term loan to the financial institution, with a guaranteed rate of return. 

• The benefit of a GIC over a corporate bond is Canadian Deposit Insurance Corporation (CDIC) insurance –CDIC is a federal crown corporation and effectively this provides a 100% federal guarantee on the investment.

• Optically, always priced at par in accounts, they also convey a sense of safety.

• Historically, GIC rates have been lower than yields on corporate bonds in wholesale markets. This has resulted in superior long-term returns from corporate bonds, mutual funds, and ETFs.

• Today however, yields on GICs are superior to what we see in wholesale markets. By comparison, a 5-year fully CDIC insured GIC ladder today provides a greater rate of return than an A/BBB rated corporate bond ladder would.

• This is also notable for investors looking to park cash –cashable GICs and high-interest savings account rates are much higher than that on Bankers Acceptances and wholesale term deposits.

• Although we don’t look for this to be a permanent change in the investment landscape, investors who are underweight fixed income and duration in expectation of higher yields ahead should note and take advantage of this current phenomenon.
  

A not so ‘super’ cycle

• Broadly speaking, all commodities have overcome pre-pandemic levels by a large degree. Chart 7 defines various commodity types, and the respective period returns over the past year. It’s no wonder that inflation concerns are creeping into the market narrative given this much price appreciation. 

• With some commodities at, or near, all-time highs, we’re not surprised with the growing chatter of a commodity supercycle. Supercyclesare rare and long lasting, and historically share a few common characteristics. Supercycles require a sizable and sustained rally in commodity prices from a fundamental shift in demand overtaking supply that is too slow to respond. Going back the past 130 years, there have been about 4 supercyclesas detailed in Chart 8. 

• The upswing phase in supercycles results from a lag between unexpected, persistent and positive shocks to commodity demand in conjunction with a slow-moving supply response. Current demand is being driven by the cyclical recovery of the economy following the vaccine rollout, increased infrastructure spending in many countries as well as shifts in environmental policy.Importantly, the deceleration in China’s “old economy” will also prove to be a strong counterforce to offset the acceleration in industrial production in developed economies. The sustainability of the current demand upswing is also in question, given an expected shift in consumer demand for services rather than ‘hard’ goods. Economic re-opening does not equal a multi-year sustained increase in commodity demand, a prerequisite for a commodity supercycle.

• Many of the most dramatic commodity prices increases are due to a combination of both higher-than-expected demand and supply issues. A prime example is the oil embargo in the 1970s. The current logistical mishaps, whether they be too few sawmills, shipping constraints or boats getting stuck in a canal, appear rather transient. Time will cure them, bottlenecks just slowed things down a bit. Inventories for many commodities remain healthy, with plenty of product available.

• Past commodity cycles have also benefited from a depreciation of the U.S. dollar. Is this a prerequisite? Not necessarily, but it certainly helps. For the cycle to continue in a meaningful way, you likely need the U.S. dollar to continue to lose value. This also drives inflation risks and together with it rising bond yields, which beget a potential shift in monetary policy that could quickly derail the commodity comeback. 

• The story for each commodity is rather nuanced and idiosyncratic. Copper is one example of a metal that could be a more durable bull market, but the rationale behind the popularity of Dr. Copper has nothing to do with lumber prices or the price of tea in China. No doubt it’s been a good time for commodity exposure and a healthy home country bias, but we’d question characterizing it as a supercycle to endure for years to come. The critical aspect is that the demand surprise may not be as enduring as some expect and we expect the supply issues to resolve over the course of the year. We still like commodity exposure given the potent structural backdrop for real assets, but more in a tactical sense. 

Charts are sourced to Bloomberg L.P. unless otherwise noted.

The contents of this publication were researched, written and produced by Richardson Wealth Limited and are used herein under a non-exclusive license by Echelon Wealth Partners Inc. (“Echelon”) for information purposes only. The statements and statistics contained herein are based on material believed to be reliable but there is no guarantee they are accurate or complete. Particular investments or trading strategies should be evaluated relative to each individual's objectives in consultation with their Echelon representative. 

Forward Looking Statements

Forward-looking statements are based on current expectations, estimates, forecasts and projections based on beliefs and assumptions made by author. These statements involve risks and uncertainties and are not guarantees of future performance or results and no assurance can be given that these estimates and expectations will prove to have been correct, and actual outcomes and results may differ materially from what is expressed, implied or projected in such forward-looking statements.

The opinions expressed in this report are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Echelon Wealth Partners Inc. or its affiliates. Assumptions, opinions and estimates constitute the author’s judgment as of the date of this material and are subject to change without notice. We do not warrant the completeness or accuracy of this material, and it should not be relied upon as such. Before acting on any recommendation, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Past performance is not indicative of future results. These estimates and expectations involve risks and uncertainties and are not guarantees of future performance or results and no assurance can be given that these estimates and expectations will prove to have been correct, and actual outcomes and results may differ materially from what is expressed, implied or projected in such forward-looking statements.

The particulars contained herein were obtained from sources which we believe are reliable, but are not guaranteed by us and may be incomplete. The information contained has not been approved by and are not those of Echelon Wealth Partners Inc. (“Echelon”), its subsidiaries, affiliates, or divisions including but not limited to Chevron Wealth Preservation Inc. This is not an official publication or research report of Echelon, the author is not an Echelon research analyst and this is not to be used as a solicitation in a jurisdiction where this Echelon representative is not registered.

The opinions expressed in this report are the opinions of its author, Richardson Wealth Limited (“Richardson”), used under a non-exclusive license and readers should not assume they reflect the opinions or recommendations of Echelon Wealth Partners Inc. (“Echelon”) or its affiliates.

This is not an official publication or research report of Echelon, the author is not an Echelon research analyst and this is not to be used as a solicitation in a jurisdiction where this Echelon representative is not registered. The information contained has not been approved by and are not those of Echelon, its subsidiaries, affiliates, or divisions including but not limited to Chevron Wealth Preservation Inc. The particulars contained herein were obtained from sources which we believe are reliable, but are not guaranteed by us and may be incomplete.

Assumptions, opinions and estimates constitute the author’s judgment as of the date of this material and are subject to change without notice. Echelon and Richardson do not warrant the completeness or accuracy of this material, and it should not be relied upon as such. Before acting on any recommendation, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Past performance is not indicative of future results. These estimates and expectations involve risks and uncertainties and are not guarantees of future performance or results and no assurance can be given that these estimates and expectations will prove to have been correct, and actual outcomes and results may differ materially from what is expressed, implied or projected in such forward-looking statements.

Forward-looking statements are based on current expectations, estimates, forecasts and projections based on beliefs and assumptions made by author. These statements involve risks and uncertainties and are not guarantees of future performance or results and no assurance can be given that these estimates and expectations will prove to have been correct, and actual outcomes and results may differ materially from what is expressed, implied or projected in such forward-looking statements.