Do Investors Need Commodities in Their Portfolios Again? | Portfolio Manager Views Podcast

Hussein: Welcome to Portfolio Manager Views. I'm Hussein Allidina, head of commodities at TD Asset Management. I'm joined by two of my esteemed colleagues today, Humza Hussain and Adam Grinbergs. Today, we're going to be talking commodities. We're going to talk about what commodities are, what drives commodities, why commodities should be part of most asset allocations maybe before we get into the meat of it all.

I'll start with you guys. I think it's important and helpful to provide a bit of context on your respective stories. So maybe, Humza, we can start with you.

Humza: I've been at Dan for four years prior to that. For the ten years prior to that, I was at Red Path, which is the Canadian brand of the largest sugar refiner in the world. There I was on a I guess you would call it a value-added team, since we're the largest refiner, we kind of thought we had an informational edge on sugar, on freight, on natural gas, things that we used.

And so, our job is to take risks and add value to the team.

Hussein: And. Adam.

Adam: Yes, sure. So, my name is Adam Grinbergs. Thank you for correctly pronouncing it in the introduction.

Hussein: I practiced.

Adam: It was much appreciated. I've been a mining engineer for about seven years, working at different mining operations before coming to TD Asset Management. I worked for a couple of large Canadian gold mining companies and I did things like surveying short range scheduling, I did long range planning, I did backfill engineering, I did drill and blast and yeah, I came here after deciding that I didn't want to spend the rest of my life living under a rock.

Hussein: So, let's get into commodities a little bit and you guys can pick and choose how you want to answer these, but maybe just like first principles, you know what are commodities? Oftentimes we know when visiting with clients, there's a lot of focus on commodity equities. So maybe make that distinction, but sort of what are commodities and what are we talking about?

Adam: Commodities are like physical goods that are not substantially differentiated by the general public. Like if I work for a work for a gold mining company, you make one ounce of gold that's not different from the other brand of gold. That's one of the defining features of commodities. They're like produced usually from the Earth or some other natural resource, and they basically are the foundation of everything about our modern way of life.

Hussein: But we're not investing in the actual bushel of corn or barrels of oil or ounce of gold. So how are we taking exposure?

Adam: So, there's futures contracts that you can use to get access to without... maybe we don't have the logistics, the desire to purchase physical iron ore or gold or copper. We can enter into a financial contract to receive the change in price of the underlying.

Hussein: And they differ, Humza, from I know you did some work on this a couple of years ago. Commodities differ from commodity equities. How?

Humza: Yeah, we have to be really clear when we're talking about commodities, we're talking about the actual physical commodities and not the commodity equities. What we found over time is that the commodity equities actually have a higher correlation with the broader equity market than they do with the commodities themselves, especially in times of stress that the correlation between commodity equities actually becomes higher with the broader equity market versus the commodities.

Hussein: Just frame for me, Humza, kind of what's driving commodity prices today and kind of what do we see as the sort of drivers over the course of the next several years?

Humza: So, in the background you have the contradiction all commodity cycle, peak to peak to trough, 30 years, oversupply prices go down, there's not enough Capex, then the prices start to rise, then you get Capex. So that's kind of the economic cycle that's going on in the background. We ... there's a lot of things that give us confidence in saying that we're in the kind of very early innings of the commodity cycle.

Humza: We think it kind of started in the last few years. So that's the background. You always have that. I think on top of that, you have a lot of thematic tailwinds for commodities. I think a lot of the things that are going to drive the world for the next 20, 30 years are energy intensive, material intensive.

Humza: And so, you can think of like decarbonization, electrification, the air builds out, you can think about geopolitics, re-shoring, friend-shoring, ** near-shoring. So, there's a lot of big things that are driving commodities.

Hussein: Thematically.

Humza: Thematically.

Hussein: So, if just unpack that commodity cycle a little bit. So, I started in commodities in 2001 and from 2001 probably through 2011, commodities like everyone wanted to talk to us. Right? And Adam, you were wearing boy shorts. But, but generally everyone wanted to talk to kind of commodity folks because commodities frankly were ripping. 2012 through 2020 was a very challenging period.

Hussein: If you were a commodity producer, if you were trading commodities from the long only side that cycle or the last sort of 12 years, we exploited sort of that investment that we made through the Commodity super cycle 2002 through 2012. And I guess the argument is because we've been under-investing for the better part of the last 10, 12, 14 years, we're in the early innings of what's going to be another investment cycle or super cycle.

Hussein: Can you contrast a little bit? You know, 2002 was very much China and China accession to WTO and the industrialization of the emerging market. China is not growing the way it did in 2002. What gives you confidence outside of the challenge supply side is that demand is going to lift commodity prices higher and maybe unpack a little bit of those thematics.

Humza: The things we traditionally look at for the economy is exactly supply. So, we can say, yes, supply is very, very tight. We can look at the kind of the age of capital infrastructure is. It's very, very old. But outside of that, if you're thinking thematically, like one of the big things for me in terms of outside of the traditional economic cycle is if you look at what's going on in the world, we're kind of on the precipice of the largest fiscal expansion since World War Two, right?

Humza: So, we and fiscal expansion is a very fancy way of saying you're printing a lot of money and a lot of this policy is industrial policy driven all over the world. And I think we all understand what's going on in the world. Everybody's looking for a kind of economic independence, security independence, material independence. And so, I think that's going to be a big driver for commodities over a little while because it helps commodities on both ends.

Humza: Right? On one hand, you know, fiscal expansion is printing money. When you're printing money, you want to tilt your portfolio towards more real assets. And commodities are the most real assets. So, it should help commodities from that perspective. But because this is all industrial policy driven, right, this all reshoring, friend-shoring, near-shoring this, all rearming, right.

Humza: This is all about this is not like easing credit. This is materially driven. And so that's going to support commodities as well, because it's going to be very, you know, to build all these factories to rearm to you know, bring all this manufacturing back domestically to become economically more independent. These are all very, very big infrastructure projects. And so, they're...

Hussein: Very commodity intensive.

Humza: Very commodity intensive, very material intensive, very energy intensive. So, I think that is one of the bigger, if not the biggest theme that's going to be driving the world over the next, I don't know, 10, 20, 30 years.

Hussein: I want to spend a little bit more time on the micro. And Adam, maybe, you know, we can talk a little bit about the metals and give your sort of experience there. But copper comes up, I think quite frequently in conversations that we're having, whether it's, you know, related to the infrastructure that we're building or, you know, the MAG seven and the AI that Ben and Damian are always, you know, talking about more from a supply side and then maybe we can get to the demand side, but from a supply side.

Hussein: Adam When we look at our supply demand balances, is it fair to say that copper is the most challenged from a supply side perspective and on the demand side, you know, we see some pretty lofty numbers on the amount of copper that we're going to need to satiate this sort of hyperscale or datacentre power gen demand. Do we have the copper supply to meet that?

Hussein: And if not, how do we find equilibrium?

Adam: Sure. So on the supply side, I think Humza made a good point earlier when he was referring to the commodity cycle of exploitation and then investment, because copper is one of the commodities where that can be most clearly seen in the idea that you need, you know, pretty long lead time mines that are coming in to production mindset came into production.

Adam: I think there's a statistic that ones that came into production from 2005 took an average of about 13 years to build and in the last five years, maybe six years, those mines that have come online have taken something like 18 years to build. So, the problem on the supply side is that it's very slow moving. And then to answer your question about like, what does the project pipeline look like? There are not a whole lot of green lights as far as the mining companies go.

Adam: There are a few that can come to mind, but the overall trajectory is pretty slow.

Hussein: I'm sorry, I've just got to jump in. So, the time it takes me after I make the decision to deploy capital is growing from 10-ish years to 18 and in some instances, is that is that regulatory? Is that environmental? You know, we've got a new prime minister in in Ottawa who is looking to develop resource in Canada.

Hussein: Does that lead time get shorter or is it geology or is it the quality of or what? What gives?

Adam: I think some of it is regulatory for sure. I think that there have been administrations which have been very unfriendly to like in the Canadian space. You have the maybe oil and gas or metals and mining types of projects I think maybe going forward. We could be hoping to see some alleviation of that in Canada. I think that globally there's also issues where there's it's sort of a populist issue a lot of the time where there are people who are very anti-mining, despite the fact that it's such a meaningful contributor to their local economies.

Adam: I think that there's an environmental aspect that has historically been very important and there are so many horrible issues that have taken place with mines, especially tailings issues.

Hussein: So, supply side challenge, I've got all this robust demand Humza, talked about a few things that are supportive of commodity demand broadly. But you know, copper in particular, can I use something else like how does this AI stuff work if I don't have the copper? And my understanding is that sort of spend on copper relative to kind of the overall economics of the next hyperscalers is relatively de minimis.

Hussein: Is there something else that we can use?

Adam: Yeah, there's like the potential for substitution. The downside to that is that the thing that you would be substituting with most likely aluminium or aluminum, depending on what

Hussein: side of the Atlantic we're on exactly.

Adam: Is actually kind of under siege itself in the short term at least. You have large amounts of aluminum supply that are basically disrupted right now. So, the ability for like a hyperscaler to substitute in the near term doesn't really seem conceivable. In addition, I think that a lot of the typical like substitutions that have been done have been things like air conditioning where it has sort of been engineered in that they have figured out a way to substitute it.

Adam: But I think that they are different materials with different conductivity levels. And yeah, I think that you do need them. I think it is you do need copper still for the datacentres regardless.

Humza: I think with like all commodities you have got to solve it by higher prices. Right. So, you got, you got to ration demand somewhere. It's not going to get rationed at the AI or for our grid. But you know, you need copper prices to get to a level where you start rationing other types of demands. Right. Maybe like cladding on houses.

Right. Or you start recycling more. So, copper can easily double in price. And maybe that's what it's required to incentivize that behavior in other places.

Hussein: So, an example of that, we weren't using a tremendous amount of aluminum, aluminium in air conditioning until copper prices rallied in 2004 or five six. And then sort of that pulled aluminum up with it. As that substitution happened, we've seen the same thing happen in platinum and palladium in the catalytic converter. Maybe I can zoom out a little bit and we're going to get back to the micro because we obviously geek out on this stuff.

But the macro why do I if I don't have a commodity allocation today and most obviously don't because of the performance of commodities from, 2012 to 20, why Humza, do I want a commodity allocation today. What does it do in my portfolio that the equities that the fixed income that the real estate and infra I'm long of already doesn't do.

Humza: Yeah. So, I look at this from two perspectives. The first one is kind of portfolio construction. I mean the career portfolio is always going to be equities and you're trying to diversify around that. Historically, 60/40 has been kind of the gold standard because bonds were negatively correlated with equities. And so that portfolio was the best. It worked great for, you know, the two decades prior to COVID.

Humza: But if you actually zoom out, that correlation has been positive for roughly 70 of the last hundred years. So now it kind of feels like we're going back into a regime which is more normal. And we've seen that over the last six years where bonds and equities have been positively correlated. So, you're not getting that diversification.

Hussein: And that correlation is a function of where inflation in the broader economy is. So, 70 of the last hundred years, to your point, inflation wasn't sub 2%. Yeah, courtesy of maybe financial repression. Following the financial crisis. Since 2020, inflation has been north of ... so the commodity helps me in so much as it's providing that diversification that I need today know because fixed income is potentially not.

Hussein: But commodities are also helping me because of their inflation beta. Yep. Right now, there is this idea that we use less commodity per unit of GDP right during the Strait of Hormuz crisis, A lot of folks have said, well, we use less energy today. So, the impact of higher energy prices is going to be muted. Do commodities still provide that inflation protection?

Humza: So, they have over the last you know, we saw what happened in 2020/2021. There was the best inflation hedge, right? In 2021, equities were down 20%, inflation was at 8% and commodities were up 25%. So that it gave you that inflation beta. Same thing happening in 2022. And the other point I would make is, like, yes, we are becoming more efficient with our commodity use.

Humza: But I think what's changed over the last few years is that commodities now have a higher kind of geopolitical component to it. So, commodities move on their internals. But I think we're also moving we're in a world where there's a lot of external factors that are driving commodities as well, and that's, you know, material security, independence. You're stocking stuff.

Hussein: I think what's interesting is at least in my career, um, you know, the 2002 through 2011, 12 period was very much about, you know, we didn't call it FOMO then, but, you know, folks wanted to own commodities because commodities were rallying. Most institutional investors justify the commodity allocation that they made in, you know, 2007 or 2008. Um, on the heels of the diversification and the inflation protection that the asset class provides today, you know, we have a number of institutional investors looking at the asset class, not because of the micro that you and Adam have talked about, but because of the macro.

Hussein: Is it fair to say that Humza for you, is this the first time you're seeing kind of these things kind of coalesce and I need commodities for macro portfolio construction and concurrently, like the micro looks quite good one.

Humza: Hundred percent in my career. So, I started in 2012 as well. So, for the last, you know, ten years prior to COVID, I was I just participated in a in the most bearish cycle that commodities have probably ever, ever seen, very low rates, low growth, low inflation. The commodities just moved on their internals. And it was a terrible cycle for that.

Humza: And just kind of little bit of a sideline. I started in 2012, like at the end of the last bull cycle. And I remember just as a desk we used to interact with like so many other funds and banks. And so, we were talking to like 10 to 15 people who had commodity desks. By 2020, there were two people left, you know, like everybody had just like exited commodities, like nobody cared about commodities.

Humza: And so, we enter this commodity cycle at a very interesting point in terms of like there's not a lot of commodity expertise out there. So, it's interesting and the world has absolutely changed as well, just in terms of what's driving commodities right now. So, it's super exciting. It's the internals of commodities and it's externals of commodities.

Adam: So sorry to interrupt, but can you maybe hear your take because you've been involved as well at the same time at many different levels?

Hussein: Yeah. So, look, I think I think if I contrast out the market and maybe this is a decent segway into where I was headed, but it feels very much that over the course of the last five, seven, maybe even ten years, really following the passage of Dodd-Frank after the financial crisis, I think the commodity market has changed where participation - Humza

Hussein: you talked about commercial and noncommercial or commercial and speculative participation. On the speculative side, it seems as though a lot of the open interest or a lot of the volume, a lot of the activity today is driven by CTAs or momentum quant players, um, and, and less so kind of the discretionary fundamental, the folks that like us are sitting down building supply demand balances, trying to predict surpluses and deficits.

Humza: Which is great for us because that's less competition and less people competing. And where we try (inaudible).

Hussein: It is we have to be able to manage risk. Right. And I think that that is a sort of something that we're focused on pretty regularly. It's not to say that, Adam, the fundamental folks are gone, like the folks that we talked to at the hedge funds in London, Singapore and New York are very fundamental, but I think they have a constraint where they all have a very similar drawdown profile.

Hussein: And I feel like the market responds far more to sort of headlines to Truthsocial, X, whatever you want to call it. And it feels a little less at times fundamental right. Last year around Liberation Day, we were trading kind of sentiment far more than we were fundamentals. Adam what really draws me to the space and why I've stayed in commodities through bear and bull and back again.

Hussein: It's a fundamental market. At the end of the day, corn can trade at $10 a bushel in perpetuity because the market physically settles. If corn should be at four based on the underlying supply and demand and it's at ten, you're going to see a production response. That'll take time. You'll see the demand response far quicker. But I do think the market has changed in its participation, and I think to Humza’s point it does afford us the ability, if you're able to wear the risk and manage the risk, the ability to add some, some risk premium, let's shift a little bit into kind of the individual commodities, if we can.

Hussein: And I'm going to kind of just spitball will be quick here. Um, let's start with I don't know; “corn” - Humza...

Humza: So, I think there was a lot of concern earlier in the year. There was uh, with the strait being closed, I think there was a lot there, there was a lot of, uh, kind of speculative buying of not just corn, but eggs in general. Uh, one of the factors was the stripping clause in the fertilizer not being available.

Humza: So, there were a lot of fears of that. The other one was, uh, again, like going back to what we were talking about before, just in terms of like political risk and things that our market becomes more sensitive. It was Trump's nonstop kind of proclamations that China is going to buy a huge amount of eggs any day now. And so, in that kind of environment, even if you're fundamentally bearish on the market, you don't take a short position, right?

Humza: So, the market had kind of become uneven in the sense that you were either out or long. Very few people want to short the market. And then there was also the aspect, the idea that, uh, over the last few years, maybe coincidentally, the best inflation hedge has actually been agriculture because it rallied in 2021, 2022, maybe didn't rally because of inflation, it probably rallied because Russia invaded Ukraine.

Humza: But statistically it was the best inflation hedge. And so, you had all these forces kind of piling into agriculture, and agriculture did quite well in the first half of the first quarter of this year, despite the fact that fundamentally we were well-stocked and everything. And I think what's happened over the last I would say month is that you can only, again, going back to what we were saying, you can only disconnect a commodity from its fundamentals for so long.

Humza: And I think over the last month what we're seeing as we're seeing that kind of convergence with fundamentals. And so, agriculture has corn, soybeans, wheat has all kinds of come off back towards more its fair value, I would say.

Hussein: The fertilizer issue is less of it feels like it's less of a concern today. And I know these changes day to day. Um, there's increasing sort of chatter about El Nino and Super El Nino. How does that impact sort of corn specifically or grains broadly and the softs and then I'm coming to you out of.

Humza: Yeah. So, we look at the world in terms of corporate, uh, the concept of there's a potential Super El Nino coming. Uh, what we've seen historically is that it is kind of more of a phenomenon that affects Southeast Asia. And so, a lot of the crops that are grown across North and South America, a lot of the big row crops, corn, wheat, soybeans, are going to be less impacted by El Nino.

Humza: You're going to have more crops that are growing across Southeast Asia. So, wheat is kind of a little bit more spread out. So, wheat could potentially have an impact. If you think about what's more grown across South Asia would be cane sugar and coffee. So those are probably the ones that are more susceptible to potential El Nino.

Hussein: And that impact would be net bullish or bearish.

Humza: Net Bullish.

Hussein: Maybe sticking with the El Nino theme. Natural gas.

Adam: The vast majority of natural gas consumption in the United States for residential and commercial users takes place in that sort of area. So, if you think about the likelihood and the expected impact, I think that it should mean that natural gas prices in the winter, this coming winter 26/27 should be likely to fall as the markets start to price in what the meteorologists have already been pounding the table.

Adam: These are people who don't like to look, but more than 6 to 10 days out and are now giving a 100% chance of an El Nino and a 62% chance of, you know, a five out of five El Nino for the months of the three month period of, you know, October, November, December and November, December, January.

Hussein: So potentially bearish U.S. natural gas on warmer on a warmer winter. Yeah, not related to sort of commodities does that imply that we're going to have temperate conditions potentially here in Toronto as well?

Adam: I wish that it did. I wish that it did. I don't think that it does. I think that it's more of the West coast of Canada that should see slightly warmer temperatures.

Hussein: Let's transition. I'm going to stick with you, Adam, on copper or Ali, what do you like more on as a three-year view.

Adam: On a three-year view if you think about, I don't know. I think that the thing that I anchor with a little bit on copper is this idea of the supply demand deficit, where the supply is relatively inelastic on the Ali side, you can there are ways to sort of address it that are already measures already being taken like bauxite is pretty common.

Adam: Alumina and aluminum like there are supply additions that are being built actually now that have been greenlit in places like Indonesia. On the copper side, you do need large majors in order to pull the trigger. I think I would be more constructive on copper than aluminium, although probably constructive on both given the world we seem to be heading into and the sort of, you know, surrounding uncertainties with the opening of the Straits of Hormuz is sort of officially ... people don't talk about it very much, but there are two aluminum/aluminium refineries that were that are behind the Persian Gulf right now or in the Persian Gulf, I should say.

Hussein: In Bahrain and the UAE...

Adam: In the UAE, exactly. One of them was hit by a drone and stopped while it was full of molten aluminium. And there are a range of speculations somewhere between 12 and 18 months for that material didn't come back. So, nobody wants to be short. Anything but I would maybe take copper for that though.

Hussein: So, I'm going to do two more really quick in the interest of time. Humza - gold?

Humza: So, I think from the from the inception of the fund, I think I can proclaim for the team that we love gold and we love gold and we've, we've kind of held that steady overweight since for the last three years. I know there's been a little bit of consternation. The fact of in in terms of what gold has done over the last few months so that gold hasn't been in a hedge.

Humza: We had this big geopolitical event, but gold has done exactly what gold does, right? Like at the moment, it's not a hedge for anything, right? You're holding gold because it's lowly correlated to everything store of value. It's a store of value, right. And so, it's not a geopolitical hedge. You know, it's not a dollar hedge. It's not a rate hedge.

Humza: Like at the moment it doesn't hedge anything.

Hussein: Have central banks been selling like this? Is the fear that sort of market participants write central banks are selling the Persian Gulf or the GCC central banks the Turks are selling. Yeah. Is that happening? Are you seeing that in the data?

Humza: So, Turkey is selling, Russia sold. India blocked imports of gold because their currency was weakening. But I think both Russia and Turkey have done on a swap and then even if they are selling the lesson coming out of this, as you went into a period of stress and what was the most useful thing for you? Gold was the most useful thing for you.

Hussein: And today, emerging market central banks are still sitting on a fraction of their aggregate reserves and gold.

Humza: Yeah, absolutely. So that the thesis is strengthened, right? Like when things become more orderly. What are these banks what are these countries going to do? They're not going to continue to sell gold. They're going to go back to accumulating it because it was the most useful thing when there was a period of stress. Right.

Hussein: We haven't talked. We've spoken very little about energy and crude, specifically the Strait of Hormuz. We have had a more constructive view than has been realized over the course of the last couple of months. Just very quickly on oil, why is oil at $70 with 9 to 12 million barrels a day of production still offline and a fraction of the traffic flowing through the Straits of Hormuz vis a vis the Feb 28 then and, you know, the 30 years before that.

Humza: Hussein, you are the energy expert! Why don't you talk about crude?

Hussein: Well, look, Hussein you've got energy wrong. Look, no, I do think that, you know, there is a lot of optimism around what's going to come next. I think the fundamental data reveals that we've drawn probably North of a billion barrels of oil in the last three months. I think part of the reason that energy prices are not higher today is because we've been depleting our savings account, right?

Hussein: We've been drawing from the SPR. The U.S. SPR is sitting just north of 300 million barrels today at a peak before President Biden started to sell into the Russia Ukraine disruption. And I put that in air quotes. We were at 1.1 billion barrels. I don't think that story can continue. Yeah, and I think China has saved the world by, you know, reducing their imports in the tune of 4 million barrels a day.

Hussein: Um, I'm still constructive here. I am very, very surprised that oil is behaving as well as it is. I take some conviction when looking at refined product markets and seeing cracks trading at all-time highs given where crude is. Um, if we look at inventories relative to flat price structure, things seem to be trading far too optimistically.

Hussein: I'm hopeful that the straits opens. Um, and, and I think that kind of potentially avoids a scenario where oil goes to levels where it has to ration demand, but I'm not willing to take that risk today.

Humza: Um, I think that's a big problem. Nobody's willing to take that risk. Right? So, I think the best way to characterize what oil has done is that usually you have a market that's able to kind of discount the future a little bit price and a little bit of risk. But I think with oil, there have been you know, if you're trying to go long oil to price in a little bit of a risk, who's on the other side of that trade has been the US government over and over and over again.

Humza: So, it's been a really hard trade to put on. And so, you have effectively what you're doing with oil is there's no ability to price in any sentiment, any risk. And so, what you're doing is just pricing in the near-term fundamentals where the market is solving right now. And we have been able to solve the market in the short term by depleting a tremendous amount of stocks across China.

Humza: The oil, Iranian crude that was on water, Russia crude that was on the water, SPR (Strategic Petroleum Reserve). And so, the price is true in the sense that it is where the market is solving right now, but it's not pricing in any kind of prospects, any kind of risk for the future.

Hussein: This was a lot of fun. We're probably out of time. Um, so I want to thank, obviously, both of you for you had to do this, but I want to thank you for doing this. I'd love to come back if that opportunity presents itself. There's, um. I think we just scratched the surface. Um, if I'm going to recap, you know, we're constructive commodities because we've underinvested in the supply side for the better part of the last 10, 12 years, despite the fact that commodity prices have been moving higher since COVID lows, we're not seeing investment in kind of the supply side as yet, which, again, is very consistent with what we saw in the 2000 through 2006 window.

Hussein: And we believe that commodities should be part of most portfolios because of the inflation protection they provide, because of the diversification they provide. Thanks, guys, for joining. Thank you for joining us on portfolio manager views. We hope you enjoyed that and hope to see you soon.