The Commodities Quandary

"We abuse land because we regard it as a commodity belonging to us. When we see land as a community to which we belong, we may begin to use it with love and respect." -Aldo Leopold


Welcome to the new, slimmer format of the Absolute Return Letter. As I mentioned last month, going forward, the monthly letter will be noticeably shorter. In the past, my self-imposed guideline has been 2,500-3,500 words per letter, which typically adds up to 8-10 pages including 5-10 charts. From this month, I will limit myself to about 1,000 words per letter. I will instead spend most of my time on the forthcoming launch of our first climate change fund and the research associated with that. As you may already be aware, all our research, whether linked to one of 'our' six megatrends or not, is made available to subscribers of ARP+ which you can find on our website here.

Why a quandary?

Long-only investors use the information ratio as a proxy for the risk-adjusted return and, as you can see in Exhibit 1 below, commodities often deliver negative information ratios (i.e. poor risk-adjusted returns) when inflation is high and decelerating. In other words, although commodities do well when inflation is accelerating, once central banks decide to go to war against it, you do not want to hold too many commodities in your portfolio. That has at least been the case historically.

The predicament investors are up against at present is that the current commodities cycle is unlike anything we have ever seen before because of the ongoing transition to green energy forms. It is therefore not unreasonable to expect certain commodities to behave rather differently this time around.

Exhibit 1: Commodity information ratios in different inflation regimes

Source: PGIM Wadhwani

Demand for those commodities used when producing EVs and battery storage solutions will be particularly strong, but there are other investment opportunities too. For example, the electricity grid will have to expand to provide the energy required, and wind and solar’s share of total energy supplies will continue to increase (Exhibit 2).

Exhibit 2: Demand for green metals and minerals

Sources: New York Times, International Energy Agency