Commodities have had a rough ride for past few years, hit by falling demand from China as its economy slows.
In its “Thundering Word” note, Bank of America Merrill Lynch argues that all of this has led to a “humiliation” for the sector.
As the bank points out, annualised returns for commodities are at their lowest since the Great Depression in the early 1930s, and that makes them, as an asset, the current “humiliated” class. Here’s the chart showing just how bad the situation is:
That may be terrible news to an industry that has seen a wave of big defaults in recent months, and crashing share prices, but BAML argues that the “humiliation” of commodities is actually the “most bullish argument” for the sector.
Here’s what BAML’s Michael Hartnett and Brian Leung have to say (emphasis ours):
The most bullish argument for commodities today is “humiliation”. Similar to stocks in 2009, the rolling return from commodities is currently at a multi-decade low, indeed the lowest since 1933. And commodity producers and Emerging Markets at least offer the potential for lower rates and higher EPS over the mediumterm. The secular upside for commodities is thus greater than downside. We like gold.
But great, historic bull markets tend to start with humiliation and a famous catalyst.
The bank then goes on to detail four so-called market humiliations and the catalysts that have sparked a major bull market.
- The bond bull market from 1981 to 2016, catalysed by the “Volcker shock” and the ascension of Ronald Reagan and Margaret Thatcher to power in the USA and UK — something BAML calls a “capitalist regime change”.
- The equity bull market between 1990 and 2000, which was spurred by the fall of the Berlin Wall.
- Commodities enjoyed a rampant bull market between 2001 and 2008, and were shocked into action by the 9/11 terrorist attacks, and China joining the WTO in December of 2001.
- The current equity bull market, which was shocked in 2009 by the introduction of quantitative easing globally.
Essentially, BAML argues, while the sector is being humiliated right now, things will only improve if there is a big secular shock to spur a bull market. That could come from inflation (emphasis ours):
Sustained commodity outperformance thus requires a secular catalyst and today that would need to be an inflation-shock (energy was the best performing equity sector, and only value stocks & small cap stocks outperformed commodities during inflation/stagflation of the 1970s.
Inflation could rise in coming years should a fickle Fed pursue policies to encourage wage inflation and/or we see a broad socialist shift in global economic policy.
While an inflationary shock to the upside could help the woes of the commodity sector, Bank of America urges caution, saying that we’re currently in the midst of “the formidable deflationary forces of debt, deleveraging, demographics & technological disruption.” The bank closes by saying that “A secular rise in inflation is unlikely.”