An environment featuring higher-for-longer global interest rates is particularly inhospitable to alternative assets. Their net present value is lower because of a higher discount factor, this being precisely the negative wealth effect that is one of the results of a tighter monetary policy, which aims at slowing the domestic absorption of goods and services to bring inflation down.
Unsurprisingly, the performance of the S&P index of Global Real Estate Investment Trusts (REITs) has been dismal, both year-to-date and over the past three years (Chart I). Another popular alternative asset class, private equity, is also facing challenging times. According to recent research, financial leverage and market multiple expansion drove nearly two-thirds of returns for buyout deals from 2010 to 2021.1 Becausethere was preciously little effective value creation for so many years, a more expensive cost of capital is now exacting a heavy toll on this industry too, leading to multiple contraction and deleveraging.
But then another type of alternative asset is showing positive rates of price returns, both in the short and in the middle term: commodities. How to make sense of that? To begin with, financial leverage, the ratio debt to EBITDA (that is, earnings before interest, taxes, depreciation and amortization), capitalization rates (i.e., net operating income of the asset divided by its current market value or sales price), and similar factors that now destroy value of other assets play a minor role in primary products compared to simple supply and demand considerations. During the heydays of globalization, shifts in demand (typically driven by fluctuations in economic growth) played the upper hand on commodity price changes because production took place in the most cost- effective regions and supply was a given.
Since the Global Financial Crisis (GFC) and the onset of fractured globalization, the dynamics have changed. Uglier geopolitics along with insufficient investment and less efficient worldwide value chains gave rise to supply bottlenecks that make it possible for commodity prices to rise even with slower GDP growth. To be sure, there are a few extreme examples. In 2010 precious metals broke away from the general pattern of primary products and became inordinately expensive (Chart II). In this case, economic policy mistakes in advanced economies that led to inflation persistence seem to be another important factor behind the exuberant trajectory. Apparently, they induced a large chunk of investors to migrate from traditional financial securities to gold, platinum and silver to help protect the real value of their portfolios.
Following the short-term bottom recorded in 2016, which was an effect of the taper tantrum in the U.S. (the surge in Treasury expected yields resulting from the Federal Reserve announcement of the impending tapering of its policy of quantitative easing), precious metals prices rose by 74%. The implied compound annual growth rate (CAGR) from then to now is 7.4%, No less impressive are the percent changes adjusted for inflation: 33% and 3.7%, respectively. Therefore, exposure to this type of commodity paid out handsomely.
A second group of commodities, energy, had its prices adjusted upwards in a more spectacular way. The respective nominal percentages since 2016 are 126% (accumulated change) and 11.1% (CAGR). Adjusted for inflation, the percentages are 73% and 7.3%, respectively, and it is worth recalling that in the meantime there was a deep, although short-lived, downturn owing to the pandemic shock in 2020-21. Contrary to intuition, it is a story of higher costs of fossil fuels, a consequence of suboptimal capital expenditures on the supply- side and deteriorating geopolitics. The global primary energy matrix, it turns out, is still heavily dependent on oil, natural gas and coal, which accounted for no less than 77% of total in 2022, the same share recorded in 2000 (Chart III). Wind, solar, hydro and other low-carbon power sources advanced over nuclear and traditional biomass (wood, agricultural and animal waste). Such a surprising outcome results from peculiar phenomena taking place in key economies. While Russia has barely modified its energy mix because of strategic reasons (fossil fuels accounted for 88% of the per capita usage of energy at the turn of the millennium and for 86% 22 years later), Japan has indeed become less “green” (the contribution from coal, oil and derivatives rose to 85% from 81%).
The script of non-energy commodities - food, beverages, raw materials (timber, cotton, rubber, etc.) and metals & minerals - is less than spirited. Admittedly, there has been a steady recovery of prices since 2016 and the adverse impact
of the COVID-19 was considerably smaller, but the changes are relatively modest. The respective nominal percentages are 44% (accumulated change) and 4.8% (CAGR). Adjusted for inflation, they are 10% and 1.2%, respectively. In this context, one key driver has been, again, insufficient investment in past years. However, climate change, insofar it signifies larger and more frequent adverse shocks, together with more restrictive environmental standards are also undermining output growth in several geographies.
Against this backdrop, it is instructive to develop more comprehensive analytical models to detect supply gaps in situations where global demand is not growing strongly, may be going sideways or even trending lower. In the case of agribusiness, for instance, such exercise reveals that the industry runs in pronounced short-term cycles (Chart IV). During the pandemic crisis and in the
recovery afterwards, a net supply gap – a situation in which output falls short of consumption – emerged, thus catapulting prices in a way unseen in this century. Following the severe disturbances of 2020-22, a market correction occurred in 2023. A deflation of 9.4% was a sequel of increased output but such benign adjustment is apparently running its course since prices are rising again: +6.9% year-to-date through April. And it is not a singularity, because other commodities are becoming more expensive too. The respective changes for minerals & industrial metals, energy and precious metals are 8%, 10%, and 15%, despite higher-for-longer global interest rates. Not good news for central bankers.
1 McKinsey & Company (2024). Private markets: A slower era. McKinsey Global Private Markets Review. (March) pp 26.
DISCLAIMER - Pátria Investimentos may have had, may currently hold, or may build up market positions in the securities or financial instruments mentioned in this research piece. Although information has been obtained from and is based upon sources Patria believes to be reliable, we do not guarantee its accuracy and it may be incomplete or condensed. All opinions and estimates constitute Patria 's judgment as of the date of the report and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Any decision to purchase securities or instruments mentioned in this research must consider existing public information on such asset or registered prospectus. The securities and financial instruments possibly mentioned in this report may not be suitable for all investors, who must make their own investment decisions using their own independent advisors as they believe necessary and based upon their specific financial situations and objectives.
