• Buy the cycle or the commodity? – Divergence of commodity prices;
  • The quarter that was;
  • Current positioning and looking ahead

Buy the cycle or the commodity? – Divergence of commodity prices

Obsidian Capital has always believed in the importance of correctly calling the global economic cycle as the primary driver for commodity prices. Historically, prices of various commodities have always been well correlated to one another and have moved in line with the global economic cycle. As a rule, synchronised accelerating global growth is traditionally the fuel that drives commodity prices while decelerating growth cools commodity markets. However, many of these correlations in commodity prices have broken down this quarter, as various commodities have been driven by their own idiosyncratic fundamentals, rather than reacting to the same global economic cycle.

Chart 1 shows that despite the Obsidian economic indicator remaining at elevated levels, iron ore and platinum group metals plummeted during the quarter, while most commodities, including coal, oil and base metals have continued to soar over the same period.

1) Obsidian economic indicator & commodity prices

The Power Crunch

While South Africa may have pioneered the concept of load shedding, rolling blackouts are now something that other countries like China, the world’s largest producer of goods, have had to deal with. The post-Covid boom in global demand for goods has pushed Chinese factory production and power demand to record levels. Meanwhile, electricity supply has not kept up with demand.

A lack of investment into “dirty” coal mines and fossil fuel-powered power stations due to environmental concerns has meant that China is now facing a severe shortage of the key power-making commodities. Sanctioning of Australian coal and Covid-related closure of borders to Mongolia, another key coal producer, have further compounded China’s coal shortage and constrained electricity supply. Chart 2 shows that Chinese power supply has sharply decelerated while power consumption is outgrowing generation.

2) Chinese power production & power consumption

This power crunch has sent energy-related commodity prices, such as coal and natural gas, soaring over the period. The price of aluminum, which requires a huge amount of electricity to produce, has also surged on the back of rising electricity prices.

Steel cuts

Chinese regulation has been a theme across a range of sectors this year. We have seen new regulations implemented in the housing, education, gaming, gambling and internet sectors recently. These regulations now seem to be impacting the commodity sector too. China has identified property development as an area of excess speculation and have escalated attempts to cool that market. Furthermore, the Chinese government want to pivot the economy away from a fixed asset investment-driven growth model.

In pursuit of these objectives, combined with the added pressure of alleviating power shortages and reducing emissions, Chinese authorities have capped the country’s annual steel output at a level equal to last year’s output. As steel production in the first half far exceeded production of the same period a year earlier, drastic cuts to Chinese steel production are required in the second half for that goal to be achieved. Chart 3 shows the cuts to Chinese steel production which have already occurred in the first couple of months of the second half.

3) Chinese steel production

Our estimate is that approximately 90 million tons per month of steel production will have to be cut in the second half. With approximately 1.6 tons of iron ore required for every ton of steel produced, this translates to a reduction of approximately 150 million tons per month in iron ore demand. This sharp drop in demand has sent iron ore prices reeling.

The Beijing Olympics in February 2022 is an event for which China is aiming to have clear skies and no pollution. Therefore, in the short term we expect regulatory pressures on Chinese steel production to persist, at least until this showcase event.

However, looking into the medium to long term, we think that China’s demand for steel should continue to increase. With China’s urbanisation rate in the low 60’s, compared to 85% of other industrialised nations such as Japan, we still see significant scope for growth in Chinese construction and steel demand.

Chart 4 illustrates that, compared to Japan, China is still relatively early in its urbanisation journey which is supportive of growing construction activity going forward. Therefore, while headwinds to steel production may persist in the short term, we believe that looking into the long term, Chinese steel production is still yet to peak.

4) Chinese urbanisation & residential construction compared to Japan

Can PGM’s have one last Hurrah?

The largest source of demand for PGM’s such as platinum, palladium and rhodium come from vehicle manufacturers. Following the Covid-induced contraction in 2020, we entered 2021 expecting new car sales to recover from depressed levels towards the levels of 2018/19 at around 90 million cars. This growth in demand, together with limited supply of the metals, was expected to maintain the large PGM deficit which has caused the elevated pricing environment over the last few years. However, this has not played out as the global chip shortage has negatively impacted vehicle manufacturing.

The average car is packed with 1,400 semiconductor chips that control everything from airbags to the engine. The unavailability of chips has resulted in major cuts to vehicle production over the course of the year. Chart 5 illustrates how lost vehicle production had worsened across all major manufacturers in Q3.

5) Lost vehicle production in 2021

Global vehicle production is now running well behind expectations at a run rate of only 75 million units for the year, eradicating the PGM deficits. Currently the situation in terms of chip supply remains extremely opaque; in the words of the Volvo purchasing manager, “I feel like I’m driving a ship in the fog with no radar.”

Ultimately the chip shortage will correct itself, and at some point, in 2022 vehicle production will recover. There are already encouraging signs of recovering chip supply from Malaysia, an integral part of the semi-conductor supply chain, with factories operating near 100% again following a devastating 3rd Covid wave.

Chart 6 shows how the expansion in German manufacturing has been restrained by lower vehicle production. In contrast to vehicle production, German production of electronics has surged, confirming the exceptionally strong global demand. We expect that as the semi-conductor shortage eases, vehicle production should catch up to electronics production. This would provide a boost for PGM demand; however, the timing is quite uncertain.

6) German total industrial, vehicle & electronics production

Looking into the long term, the substitution of combustible engine vehicles with electric vehicles, which do not consume PGM’s to the same extent, is a significant risk to PGM demand. In fact, electric vehicle adoption has been accelerated by the chip shortage. In the long term, this will create a major drop in PGM demand that the PGM industry will have to navigate.

The Quarter that was

Global economic indicators remain at elevated levels, which should continue to support risk assets for now. However, in Q3 global equities gave back some of their strong year to date performance, with the MSCI world index falling by 1% during the quarter. The S&P 500 index was flat for the quarter, Japan’s Nikkei index was up 1% and emerging market equities underperformed.

The JSE All Share index fell by 3%, but there was significant dispersion between sectors. The resources sector retreated by 8%, Naspers and Prosus retreated by 17% and 15% respectively, while the domestic shares outperformed, with the banking sector gaining 14%. Our reduced resources exposure and our overweight domestic equities contributed to our strong performance for the quarter.

Towards the end of the quarter, US bond yields recovered, with the US 10 year yield closing the quarter at 1.5. This in response to a renewal of the reopening of the economy as Covid cases in the US waned, as well an anticipation that US Fed will begin the tapering of its asset purchasing program.

South African bond yields were also higher for the period, with the SA 10 year yield closing the quarter at 9.62. The Rand was 6% weaker, finishing the quarter at 15.07. As shown in the chart 7, despite a weaker Rand and higher SA bond yields, domestic equities such as banks still outperformed.

7) JSE Banks vs the rand

Current Positioning

Significant portfolio transactions for the period included the following

  • Reduced South African net equity in order to increase our offshore exposure
  • Within South African equity, we significantly lowered our resources exposure, with a focus on reducing our exposure in iron ore and PGM’s
  • Domestically, we have also reduced our holdings in retailers after a very strong quarter. We have maintained our high exposure to banks in anticipation of another strong half of earnings growth.
  • Following a reduction in the holding company discounts, we reduced our holdings in Naspers and Prosus, opting to rather own direct Chinese IT exposures in Tencent, Netease and JD.com.
  • We have increased our offshore exposure to developed markets in the form of Japanese equities and currency
  • Our bonds position has increased slightly

We still favour equities as our preferred asset class. We think that the ultra-low interest rates, particularly in developed markets, will continue to provide support to corporate earnings and equity valuations in the short to medium term. We think developed market bonds are still overvalued at current yields and continue to prefer equities.

However, as we move into the final quarter of the year, we are cognisant of the risks that lurk. As chart 8 shows, the Obsidian economic indicator remains at extremely elevated levels. We expect this index to eventually fall and growth to moderate but remain strong. This view has resulted in a slightly reduced domestic equity exposure and an increased developed market exposure.

8) Obsidian economic indicator

Our resources exposures have been slashed, particularly in iron ore and PGM’s for the reason outlined previously, but also because of excess (and hence unstainable) profitability. Within Resources, our preference is for Energy counters as their earnings recovery has lagged that of the rest of the sector.

We continue to like Financials and expect them to maintain strong earnings growth for another period. Offshore we see rising bond yields as welcome upside to banks’ net interest margins. Domestically we think that banks will have another strong period of earnings growth, driven by improved credit charges. We also think domestic insurers can grow earning significantly off bases that contain substantial provisions for Covid losses.

In summary, we acknowledge that we are now deeper into the recovery and global growth will decelerate in the final quarter. We have therefore added some protection to the portfolio in the form of increased offshore allocation and reduced resources. However, both the undervaluation and earnings momentum of our selected exposure keep these equities as compelling investment cases.