Written by Ben Ross, head of commodities and Tyler Rosenlicht, Global Listed Infrastructure portfolio manager at Cohen & Steers
The world is transitioning from an era of commodity abundance to one of undersupply. We believe this shift may result in significant returns for commodities and resource producers over the next decade.
Still in the early innings, efforts to reduce global carbon dioxide (CO2) emissions are fuelling the rapid adoption of renewables and energy- efficient technologies. The green/decarbonization transition has been and will likely continue to act as an accelerant to the demand for many raw materials, including base metals, precious metals and agriculture commodities (such as sugar, corn and soybeans used to make biofuels). For instance, the amount of copper used in an electric vehicle (EV) can be as much as three times greater than what’s in a conventional auto.
Even more significant is the rapid expansion of the global middle class. The middle class is already the largest spending group in the world, accounting for one-third of the global economy. By 2030, the global middle class (also termed the “consumer class”) is expected to reach 4.8 billion people. This group’s purchasing power is expected to rise to $62 trillion annually, which would have a meaningful impact on consumption—and, consequently, demand for natural resources.
Regime shift favours inflation-linked assets
Considering the anticipated gap between strong demand and limited supply, potential issues such as labour shortages, a move towards more selective trade partnerships, and the potential for increased geopolitical uncertainty, we expect inflation to average 3% or more in the coming decade. We also believe the next decade will feature significantly higher volatility of inflation, with the potential for periodic inflationary shocks. In contrast, in the last decade, inflation was stable and averaged less than 2%.
We believe this new environment will favour real assets—asset classes that typically have high, positive sensitivity to inflation.
Commodity returns could see a marked improvement over the previous decade (Exhibit 6). This would be driven by a combination of supply/demand imbalances, higher production costs, and higher expected collateral returns. In the case of the latter, the sharp rise in short-term interest rates in the past two years (and the potential for rates to remain “higher for longer” going forward) is likely to result in greater interest income on collateral set aside for the purchase of commodity futures.
Returns in natural resource equities over the next 10 years are expected to exceed those of the broader global equity market. Greater extraction costs, increased regulation, resource scarcity and recent underinvestment are all likely to play a role. At the same time, the revenue pressures resource producers have faced in recent years have instilled greater capital discipline and a focus on profitability, which may also support valuations.
A counterbalance for traditional stock/bond portfolios
The current economic environment—marked by elevated inflation, rising interest rates, deglobalization, tight labour markets and heightened geopolitical risks—is likely to drive long-term investor interest in real assets, particularly natural resource equities and commodities. Whether as standalone investments or as part of a diversified real assets allocation, we believe natural resource equities and commodities merit permanent positions in a balanced portfolio.
Given their vital role in sustainable development and decarbonization, commodities and resource producers potentially stand to generate above average returns in the coming decade. History shows that inflation tends to be most damaging to stocks and bonds when it is unexpected. In contrast, our analysis suggests that real assets tend to experience strong returns precisely during those periods when realized inflation exceeds prior expectations.
Exhibit 7 shows the impact of unexpected inflation using a metric we call “inflation beta.” Inflation beta measures the sensitivity of returns to a 1% upside surprise in realized inflation (relative to the inflation estimate from a year before). An asset class with a positive inflation beta should generally react favourably to inflation surprises. For instance, the chart below shows that commodities historically outperformed their long-term average by 7.3% for every 1% that inflation exceeded its prior-year estimate. We believe this is a strong indicator that real assets can serve as an effective inflation hedge (though they are not dependent on inflation to produce strong returns).
Enhancing their appeal, commodities and natural resource equities’ current valuations and financial profiles are attractive compared with history (Exhibit 8). For instance, as a whole, natural resource producers today are generating significant free cash flow, have low debt-to-equity ratios and have limited capital outlays compared with past cycles.
A blended solution
Given the regime shift now underway, a diversified multi-asset-class approach to real assets offers distinct advantages from an investment perspective, historically providing:
- Outperformance in inflationary periods
- Enhanced risk-adjusted returns via portfolio diversification
- Strong total returns over full cycles
No single real assets category (including global real estate and global listed infrastructure, in addition to natural resource equities and commodities) offers a “silver bullet” solution that excels across all three criteria of prospective diversification, expected returns and potential inflation protection. However, a diversified portfolio of real assets may help investors better navigate the trade-offs of individual categories and may effectively enhance the risk/return profile of portfolios concentrated in stocks and bonds.
