This week I write about a favourite topic and one that I believe will fundamentally drive investment markets over the next decade. We’ve all seen the headlines around electric vehicles, rare-earths and commodities heading higher more broadly, some of us have seen ourselves get a little ‘richer’ as a result. But let me delve a little deeper, why I’m personally invested and where I see this market heading.
Let me begin with the macro picture. We’ve seen some immense price-action in everything from precious metals to the esteemed economist Dr. Copper. While it might seem irrational, could there possibly be some semblance of logic and reason behind this? More importantly, I will make a bold claim; that we are in the beginnings of quite possibly a multi-decade secular bull cycle in commodities. But why do I believe so?
I won’t bore the readership with details about inflation and the behaviour of certain commodities in an inflationary environment. But, to put it simply, in my view the answer lies in supply and no, not the supply of materials but the supply of money. Through Covid, the immense amounts of monetary and fiscal stimulus that we have seen has resulted in some previously unfathomable numbers. The supply of USD into global markets has increased by 25% since the beginning of Covid (i.e. broad money), the Japanese Yen by close to 10%, the Euro and AUD are seeing similar trends (9% on average). And yes, it is true that many market pundits have previously entertained doomsday scenarios of runaway inflation during the first round of QE with the advent of the GFC, this time however it really is different. We are not seeing just growth in bank reserves but when the central banks and treasuries guarantee credit principle and, in some instances, force the financial sector to lend directly to the market, this is true money created into the real economy.
More recently we have seen the RBA expand its own balance sheet, given the issuance of new treasuries, while at the same time all but ruling out a change in monetary policy for the foreseeable future. So, is it any wonder we have been seeing precious metals reach toward the sky or even the price action in crypto? This is a flight to scarcity in whatever form, everything from metals to bitcoin to Pokemon or sports trading cards. So what does this have to do with commodities then?
The implications are twofold. The first being that, by the laws of supply and demand, it should mean that, all things equal, if the supply of money increases then, unless the supply of commodities is increased in a similar fashion, we are likely to see upward pressure upon certain goods. If I increase the supply of the USD by 25% and expect this supply to keep increasing rapidly, then is it any wonder that (on a relative basis) the price of copper increases in proportion? Especially if the supply of said commodity cannot increase in a similar manner due to long lead times and capex. The second implication being that much of the fiscal stimulus is thankfully going towards industries and investment into infrastructure, much of which includes green energy (renewables), energy security and the next generation of industries like electric vehicles. This is the second catalyst, not only has recent fiscal policy created real money supply, it has also targeted and created scenarios where demand is likely to increase over the coming years.
These two macro-variables have created a tremendous opportunity. So with that context let's explore one area that is likely to see continued growth. That of rare earths.
As a point of fact, this creation of dangerous byproducts is nothing new for rare earths. The creation of the gas mantle lamps developed by Carl Auer von Welsbach in the latter 19th century, and in use up till the 1930s, used rare earths and created piles of waste and left production that became fire hazards to deal with for decades to come.
In the initial years much of the global supply of ore came from Brazil and India, creating one of the first global supply chains in rare earths. Through much of the early 20th century the manufacturing of the final components and the production of rare earths was situated in the US as a result of favourable policy and trade agreements, not to mention the arms race and the Cold War. The opening up of trade barriers in the later half, as well as, the advent of labour arbitrage enabled companies to outsource this part of the production. Initially, this was to Japan (which had an immense thirst for raw materials during reconstruction) and later the Asian Tigers.
After the Asian Tigers, in the way of the flying geese model for the economists amongst you, it was China’s turn. The CCP under then leader Deng Xiaoping, targeted rare earths as a high priority. Successive governments continued to enable a scenario where production grew at a rapid 40% p.a. between 1978 to 1995. Along with this, Chinese companies continued to buy up their counterparts around the world with the last remaining major player Magnequench being sold to a Chinese consortium in 1995 and, although there was a requirement to keep production in the US for five years, operations were stopped at the end of those five years and shifted from Indiana to China.
All this led to two outcomes. Firstly, the prices for rare earths declined rapidly through much of the last few decades while, at the same time, their centrality to the global supply chain and the economy increased. Think smart phones, electric cars and every conceivable piece of electronic equipment you might have. In fact, as of 2019 China produced roughly 85% of the world’s rare earth oxides and approximately 90% of rare earth metals, alloys, and permanent magnets. A situation that is now becoming a headache as the world heads to a new stage in global relations. The first glimpse of this was in 2010, when a dispute over territorial waters resulted in an embargo of rare earths supply to Japan, putting a rocket on prices for the short-run before the dispute was resolved under the auspices of the WTO.
So with that little walk down history lane and a bit of context, let’s come back to the present. What do rare-earths have to do with the coming commodities bull cycle that I posited?
Think for a moment about what the ambitions of large portions of the recent stimulus packages announced by the EU and the US entail. Covid-19 was effectively the catalyst for the wide ranging ambitions termed the Green New Deal stateside and the EU’s ambitions towards energy efficiency and the next generation of industries. In fact, recent market darling VUL.ASX (Vulcan Energy Sources) derives its now lofty valuation in no small part thanks to its location and its own supply chain (all EU based). Or indeed Lynas’s recent win of Pentagon funding to build its manufacturing facilities in the US.
What we are now seeing is the beginning of new spheres of influence created, that firstly constrain supply while placing huge pressure in terms of the demand side of the equation through the building up of everything from wind farms to the move towards de-fossilization as part of the zero-emissions targets that many governments have embarked upon. Whether you agree with it or not, this is the world we live in and it will continue to be the case. By the way, for the older generation, the world has seen this before, the unipolar world we now take for granted is a rather new phenomena (i.e. Cold War, British Empire etc. etc.).
So the sky-rocketing share price of Lynas during the period following Sino-Japanese tensions might’ve been a little unwarranted given that those particular tensions were sorted out in ‘a much ado about nothing’ sort of fashion. This time around, it is a little different. The Trump administration's final big policy initiative was to create a strategic uranium stockpile to maintain energy security and the new administration will undoubtedly stay the course, given the rhetoric coming out of Washington, especially given that the question of China is one that there is broad consensus upon (a rather ‘rare’ commodity).
The coming growth in renewables and infrastructure should not only drive demand for broad based commodities such as copper but also for rare earths such as neodymium and dysprosium. The move towards electric vehicles increases demand for rare earths magnets to batteries (including commodities such as cobalt and lithium). All this at a time where money supply is increasingly sky-rocketing to levels that have not been seen in the modern era (dare we say even during the days of post-Versailles and the Weimar Republic).
Where is the Opportunity Set?
I spoke briefly in previous article that the creation of artificial barriers and spheres influence which, while not ideal from a consumer standpoint, is neither here nor there for the discerning investor as this will create what is effectively economic rent-seeking, where the companies that are profitable neither have to be best of breed or offer the lowest price. Lynas and Vulcan might not have to be the lowest cost producers but certainly their risk will be somewhat mitigated in a non-discriminating market (though they might if management pays its cards right).
Other opportunities like ATC.ASX (Altech Chemicals), Northern Minerals (NTU.ASX), Arafura Resources (ARU.ASX), Alkane (ALK.ASX), Hastings Technology Metals (HAS.ASX), Peak Resources (PEK.ASX) are all worth doing some research on. Technology companies such as Novonix (NVX.ASX), which this particular author used to own but no longer does in the name of full disclosure, and Vulcan are also interesting plays though I missed the opportunity on that one.
For the more conservative, that do have some commodities exposure, one suggestion is to pay special attention to the by-products when you read your next assay. For example, copper players typically have some component of commodities like molybdenum which can be alloyed to create any number of things, like stainless steel and can support everything from military armor to light bulbs.
Food for thought!
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TAMIM Asset Management provides general information to help you understand our investment approach. Any financial information we provide is not advice, has not considered your personal circumstances and may not be suitable for you.