Over the past few months we have spent a lot of time traveling throughout North America and Europe, speaking with clients about what role natural resources investments should play in their portfolios. At these meetings, we learned first-hand what our investors worry about the most. Recession fears loom large. Investors firmly believe inflation has gone from transitory to intractable in a few short months — something we have been predicting since 2019.
We have never seen investors as worried as they are right now, and it is understandable: in the last six months, their world has been turned upside down. After four decades of falling interest rates and rising equity prices, the pullback in both bonds and stocks have caught most investors off guard. Equities and fixed income sold off simultaneously as investors began pricing in a period of both low growth and high inflation. The long beloved 60/40 portfolio (the industry standard in which an investor allocates 60 percent to equities and 40 percent to fixed income) experienced its worst six-month period in 40 years, wiping out trillions of dollars of value in only a few months.
It is no wonder investors are skittish about natural resource stocks. Both energy and materials are considered extremely economically sensitive. Oil has pulled back almost 30 percent from its June high of $120 per barrel. A global recession likely looming, natural resource investors went from asking, “Have I missed it?” to “How can we possibly allocate money to resources if we are heading into a recession?” in a matter of weeks.
These worries are not unfounded. During the global financial crisis (GFC), natural resource stocks collapsed. Materials and energy were two of the worst four sectors in the S&P 500, falling 60 percent from May 2008 to March 2009. As recession fears took hold a few months ago, traders fell back on the same tactic. As the market sold off from June 8 to July 12, materials and energy were once again among the hardest-hit sectors, falling 15 percent to 25 percent in only one month.
We strongly discourage investors from using recessionary fears as a reason to sell commodities. Commodity markets today bear no resemblance to 2008. Investors using the 2008 GFC playbook risk selling commodities right at the bottom, missing the huge potential returns embedded in these markets over the coming decade.
Investing in natural resource equities when commodities are cheap relative to financial assets is important, not only from a value perspective but also because it almost always corresponds with a bottom in the natural resource capital investment cycle — a cycle that produces years of supply shortages that is fixed only after years of increased spending.
The key insight here is that the commodity capital cycle may or may not correspond with the broader business cycle (i.e., expansion and recession). Heading into the GFC, the two cycles were in near-perfect alignment. Commodity prices were extremely high relative to the stock market in early 2008. Energy and materials made up 20 percent of the S&P 500 — a 30-year high. Natural resource capital spending had accelerated. Driven by high prices, insatiable Chinese demand, and endless analyst calls for a commodity “super-cycle,” energy and mining capital spending in the S&P 500 surged four-fold between 2000 and 2008 from $80 billion to an all-time high of $330 billion per year.
When the recession arrived, the commodity sector was hit hard. Energy stocks fell by 50 percent while mining stocks fell 65 percent, gold stocks fell 25 percent, and agriculture-related equities fell 40 percent. Natural resource equities rebounded in 2009 and into 2010, but then entered a decade-long bear market. The capital spending surge during the bull market of the middle 2000s ultimately resulted in new production of almost everything: iron ore, coal, copper, shale gas, and oil. The GFC represented a rare alignment of a bearish commodity capital spending cycle and a bearish broader business cycle.
It is no wonder that investors are skeptical of natural resource investments given the experiences of the GFC. However, we think focusing solely on one episode risks missing the point. As it relates to natural resources, the GFC was an anomaly: for most of the past 120 years, the commodity cycle and the business cycle have not been in sync at all. In fact, throughout the 20th century, resource equities have actually been good investments during most recessions.
To illustrate our point, let’s look closely at the 1930s. The Great Depression was unrivaled in its severity. In the United States, one person out of every four in the labor force was without work. Industrial production fell 50 percent from peak to trough and took a full decade to regain its pre-crash high. Wholesale prices collapsed by 30 percent, and the stock market fell 86 percent from its 1929 high. Between 1930 and 1932, the United States saw 7,000 banks fail.
Given their economic sensitivity, it is reasonable to think that commodities and natural resource equities must have fared terribly during the Great Depression. Surprisingly, natural resource investments did not collapse during the Great Depression; they turned out to be one of the best-performing asset classes. A simple equity portfolio made of equal positions in gold miners, oil producers, base metals miners, and agriculture companies made just before the stock market collapse in September 1929 more than doubled a decade later. By comparison, at the end of the period in 1937 the total return of the S&P 500 was still down nearly 50 percent. By 1946, when an investment in the S&P 500 finally reached its pre-crash levels, the same natural resource equity portfolio had tripled.
How could a portfolio of economically sensitive stocks lead the market during the worst economic collapse in history? The answer is the natural resource capital cycle. Commodity prices fell throughout the 1920s and by 1929, had become radically undervalued relative to financial assets. Just as important, low commodity prices starved the industry of capital throughout the decade.
For those fearing a recession, what happened to commodity-related equities in the Great Depression is a great example of what might happen today if a severe recession gripped the global economy. The radical undervaluation of commodities and commodity-related equities is greater now than it was back in 1929, and the level of capital starvation is just as great. History tells us that commodities could again be an excellent place to seek high returns, even if the 2020s experience a period of economic turmoil as severe as the Great Depression — a scenario we consider unlikely.
Leigh Goehring and Adam Rozencwajg are managing partners of Goehring & Rozencwajg. This article was excerpted from their report titled Why Resources During a Recession. Download a copy of the full report here.