May 28, 2021 | 12:43
The Commodity Cycle: Super or Short-and-Sweet?
After the briefest of lulls, the broad commodity complex regained momentum this week, this time led by heavyweight oil. Most major indexes have more than doubled from the extreme lows of last spring, and are also well up from pre-pandemic levels. To pick but one example, the Bank of Canada’s commodity price index is now up nearly 40% from its January 2020 average, with gains across the board. Oil had been a relative laggard to the fiery conditions for some other resources, but has now pressed above US$67 for the first time since 2018. Weighing in at nearly half of the BoC’s index, the renewed upswing in crude carries the potential to drive a serious second leg to the commodity cycle. What makes this 13-month rally in commodities particularly amazing is that it comes hard on the heels of the deepest global downturn in the post-war era.
The broad-based strength in commodity prices is giving Canada its day in the sun. Supported also by solid Q2 bank earnings, a robust resource sector helped push the TSX to a steady string of all-time highs this week, with the index now within reach of the 20,000 mark. Its 13.4% year-to-date rise as of Thursday is a world leader—and would already be its third best full-year return in the past decade (if we stopped the clock today). At the same time, the Canadian dollar is at the top of the leaderboard this year as well, even with a tiny step back this week. The loonie is now up just over 5% in 2021, even as the trade-weighted U.S. dollar has largely churned sideways this year. The combination of a world-topping equity market and a world-leading currency means that foreign investors have absolutely thrived being in Canadian assets in 2021. For example, an unhedged Japanese investor would have seen a 27% rise in their Canadian equity holdings in yen terms so far this year.
Rollicking resources have been the big driver of the loonie’s outperformance in recent months, after mostly just following the pack against the mega swings in the U.S. dollar in 2020. However, the currency has also caught a tailwind from a relatively hawkish Bank of Canada. While the Fed dances around the possibility of thinking about beginning to think about discussing the possibility of one day considering talking about possibly thinking about tapering, the Bank has just done the deed in one fell swoop. And the market remains convinced that the BoC will be many months ahead of the Fed on the rate-hike timeline as well. Given the U.S. is many months ahead on re-opening its economy, and also appears to have more of an inflation issue on its hands, it’s not at all obvious that the Fed will in fact be far behind the Bank of Canada when it actually comes time to hike rates. Ultimately, we don’t believe there will be significant daylight between the central banks on the rate-hike front, and less than the market currently has priced in.
Even so, we remain constructive on the Canadian dollar in the year ahead, with solid underlying resource prices the big driver. In addition, the quickening pace of vaccinations in Canada and a recent slide in new cases are setting the stage for a partial re-opening in many parts of the country in coming weeks. As we detail in this week’s Focus Feature, this should help the Canadian economy play catch-up in the second half of the year, after a stalling in Q2 growth. While a secondary factor, that sunnier second-half outlook is likely also providing some support for the recent run in domestic equities.
While Canada is looking forward to a better second half, the U.S. economy is looking forward to a better Memorial Day weekend. This week’s heavy slate of economic data didn’t feature any star attractions, but still carried some important messages. After a bit of an April sidestep—as highlighted by the soggy jobs and retail sales data—early indications for May look solid. Jobless claims are coming down fast as more sectors re-open, and consumers are increasingly upbeat on current conditions (at least according to the Conference Board). And, the April income and spending data revealed, yet again, just how high the wall of excess savings has grown. Even with a big pullback after round III of stimulus payments, disposable income was still up a towering 13% from pre-pandemic levels in April, while the saving rate punched in at 14.9%, or double the 2019 pace. Spending on services continues to recover, but it still has plenty of room to run (down 2% from Feb/20, or roughly 6-7% below trend). A comeback here will almost certainly fuel solid overall growth in both Q2 and Q3. Indeed, we have bumped up our call on GDP in both quarters, and now expect 7% for the full year (up from 6.5% previously).
A notable wrinkle in the April U.S. spending data was a small shift from goods to services, a reversal of the unusual skew the other way over the past year. Prior to the pandemic, the ratio of U.S. consumer spending on services to goods was 2.25; that ratio plunged to 1.83 in March before nudging up last month. While outlays on services are still down 2% from pre-pandemic levels, goods spending has leapt nearly 20%, even with a dip in April. And, of course, it’s this heavy emphasis on goods that has played a big role in the stunning rebound in commodity prices through this unique cycle.
But as economies gradually re-open, and consumers redirect spending back towards services again, will this translate into a big pullback in goods spending, and in turn abruptly end the commodity run? The short answer is no. The prodigious buildup of savings suggests that households, especially U.S. households, have the wherewithal to power up services spending without sharply cutting back on goods outlays (especially since the latter are relatively smaller). However, even a small tilt away from goods will take some of the steam out of the hottest sectors, and we’ve already seen some cooling in red-hot housing.
For commodities broadly, we suspect that prices can stay strong for longer, especially as the global economy recovers over the next 18 months. A serious U.S. infrastructure package could add another leg of support, with public sector demand for resources stepping in as consumer demand fades slightly. While the final deal may still fall short of President Biden’s $1.7 trillion counter-offer, even the Republicans are proposing nearly $1 trillion in outlays. But a big push on this front is unlikely to support a long-lasting commodity cycle. After the global economy is able to fully repair from last year’s deep damage, it’s likely to re-emerge with a similar sluggish underlying growth rate of pre-pandemic trends of around 3%. While each commodity has its own story—and a case can be made for a supercycle in a few specific names (say, copper)—demand for many will fade, while supply will eventually respond, in most cases. Overall, we thus believe that these are not the early days of a supercycle, as impressive as the commodity run has been in the past year.