Equity markets. Commodity producers: Positioning for a maturing cycle

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1 Commodity producers: Positioning for a maturing cycle Chief Investment Office Americas, Wealth Management 11 June :25 pm BST Bert Jansen, Strategist; Rudolf Leemann, Analyst Commodities and commodity producers tend to outperform in a maturing cycle. Constrained supply, as a result of commodity producers' restrained capital spending, and robust demand has led to solid free cash flow growth and improving profitability. Corporate debt is unusually low, which provides a useful cushion amid rising US interest rates. We recommend to invest in a broadly diversified stock selection of commodity producers with exposure ranging from metals and oil (hard commodities) to fertilizers and agricultural products (soft commodities). Even though global commodity producers have risen strongly over the last two years, they have significantly underperformed the MSCI World index since the onset of the Great Financial Crisis (GFC) ten years ago (see Fig. 1). We believe that the time has come for commodity producers to outperform the wider market. This is because commodities and, as a consequence, commodity producers, tend to outperform during the later stages of the business cycle, when inflation rises and economic growth slows. Due to the significant downturn in the wake of the GFC, commodity producers' discipline with regards to capital expenditure is reassuring and likely to last longer than usual, in our view. Free cash flows are solid, while unusually low financial leverage provides a cushion against rising US interest rates. The biggest risk for commodity producers to underperform is an economic downturn in the US or China, which would lead to falling commodity prices and commodity producers' profitability. But this is not part of our base scenario. The commodity producers' cash-flow cycle is entering a sweet spot, allowing for share buybacks and paying out an average dividend yield of 3.4%. This is one percentage point higher than that for MSCI World and relatively safe, in our view. We recommend to invest in a broadly diversified stock selection of commodity producers with exposure ranging from metals and oil (hard commodities) to fertilizers and agricultural products (soft commodities). Source: istock Fig. 1: Global commodity producers - upside potential Thomson Reuters CRB Commodity Producers Index - relative performance versus MSCI World* ( 1 January 2008 = ) *Total returns. Source: Thomson Reuters, UBS, as of 8 June This report has been prepared by UBS Switzerland AG. Please see important disclaimers and disclosures at the end of the document.

2 Commodity producers positioning for a maturing cycle Economies and equity markets move in cycles. So do commodities and companies producing them. In this note we focus on the global commodity producers, including companies exposed to hard commodities, i.e. those which are mined or extracted such as energy, steel and metals, and to soft commodities, such as fertilizers, crop protection and agricultural & farm machinery (see Fig. 2). Although there are company-specific factors that can have an impact on individual share prices, commodity prices tend to be a significant driver of commodity producers share price performance. Indeed, share prices of commodity producers and commodity prices have tended to move in tandem most of the time over the past 18 years (see Fig. 3). Even though commodity producers have risen strongly over the last two years, they have significantly underperformed the MSCI World index since the onset of the Great Financial Crisis ten years ago (see Fig. 4). The recent outperformance of energy stocks, for instance, barely shows up in the chart, despite the strong rise in oil prices this year. Agricultural-related stocks have been more resilient, but are also still well below their peak relative to MSCI World in Over the past 35 years, commodities outperformed equities, on average, by 14% during economic expansions and by 16% during slowdowns. They underperformed equity markets by 11% and 15% during recessions and economic recoveries, according to Goldman Sachs. We believe that the time has come for global commodity producers to outperform relative to the wider market. This is because commodities and, as a consequence, commodity producers, tend to outperform not only during economic expansions but also during the later stages of the business cycle, when inflation rises and economic growth slows. The latter may sound counterintuitive because economic slowdowns can easily be associated with weakening demand for commodities. But this is not borne out by historical evidence. Over the past 35 years commodities have outperformed equities significantly during each of the periods characterized by economic slowdowns and/or rising inflation (see Fig. 5). We use the S&P GSCI commodity and S&P 500 indices as proxies because of a lack of historical data for the CRB core commodity index and MSCI World, respectively). The chart also shows that commodity prices, a major driver of commodity producers absolute and relative performance, have Fig. 2: Commodity producers - diversified exposure to hard and soft commodities CRB commodity producers index sector weights, in % Note: CRB = Commodity Research Bureau. Source: Thomson Reuters, UBS, as of 11 June Fig. 3: Commodity-driven Performance of commodities and commodity producers Core commodity CRB index (lhs) CRB global commodity producers index (rhs) 5,000 4,000 3,000 2,000 1,000 lhs = left hand scale; rhs = right hand scale. Source: Thomson Reuters, UBS, as of 11 June Fig. 4: Commodity producers Relative performance of CRB commodity producers sub-indices versus MSCI World Index* *Total returns, rebased. Source: Thomson Reuters, UBS as of 11 June Chief Investment Office Americas, Wealth Management 11 June

3 significantly lagged the recent pick-up in inflation. This suggests that there is plenty of potential for commodity producers to catch up relative to the wider market. What happens during the later stages of the business cycle is that equity markets anticipate economic slowdowns amid rising inflation and interest rates which tend to be a drag on valuations. In contrast, commodities are driven by current supply and demand. Even when commodity demand slows, it is still strong relative to the available supply. It is only when the economy goes into recession that commodities underperform equities. We do not expect such a scenario to materialize in the foreseeable future. Valuation relatively attractive Typically, valuations are not a driver of commodity prices. What, after all, is the intrinsic value of a bushel of wheat or a barrel of oil? But in an equity context commodity producers can be valued, both in absolute terms and relative to the wider market. Currently, commodity producers look relatively expensive, based on P/Es (see Fig. 6). But this is largely due to the depressed level of earnings per share (EPS). Energy is a good example, where EPS are recovering from a low base, following the negative impact of sharply lower oil prices in 2015 and The absolute and relative P/E of the commodity producers should fall further, driven by above-average EPS growth. For example, consensus estimates expect 31% CAGR for EPS of the global energy sector, compared to 13% for MSCI World. On a dividend level, which is more stable than EPS, commodity producers look more attractive. Commodity producers currently offer a dividend yield of 3.4%, which is 40% above the average level for MSCI World (see Fig. 7). Commodity producers economics 101 Fundamental to commodity producers' fortunes is, ultimately, an attractive balance between supply and demand. With most commodities, the challenge for producers is to commit to a supply level, via capacity build, years ahead of the actual demand materializing. And once this capacity is available it does not normally go away quickly. This leads to imbalances which can last for extended times, both during expansions and contractions. Different commodities have different lengths of a "pork cycle" (see Fig. 8). Whenever there is too much supply, reflected in prices below production costs, producers leave their market or cut capacity. Once supply undershoots demand prices rise, which again is followed by capacity expansion with a lag. Within our commodity producers' basket the length of this general cycle can be as short as six months with agriculture, while typically much longer with mining or oil & gas. The exact length varies across Fig. 5: Commodities, recessions and inflation S&P GSCI commodity index relative to S&P500, US inflation and US recessions Source: Thomson Reuters, UBS, as of 11 June Note: S&P GSCI index = Commodity index, total returns. US CPI = US headline inflation; Shaded areas show US recessions as defined by The National Bureau of Economic Research (NBER): Jan 1980-Jul '80, Jul '81-Nov '82, Jul '90-Mar '91, Mar Nov '01, Dec 2007-Jun '09. Fig. 6: High P/Es due to depressed EPS CRB Commodity Producers index P/E, 12-month forward* *A relative P/E of 90% indicates a 10% discount to the wider market. lhs = left hand scale; rhs = right hand scale. Source: Thomson Reuters, UBS, as of 11 June Fig. 7: An above-average dividend yield CRB Commodity Producers index dividend yield, 12-month trailing* Relative to MSCI World (in %, lhs) Absolute (x, rhs) Relative to MSCI World (%, lhs) Absolute (%, rhs) *A relative dividend yield of 140 indicates a 40% higher dividend yield relative to the wider market. lhs = left hand scale; rhs = right hand scale. Source: Thomson Reuters, UBS, as of 11 June Chief Investment Office Americas, Wealth Management 11 June

4 single commodities but as well is dependent on the state of local and global economies. The "toughest" stage of that generally recurring cycle is when the producers come out of a phase of growth exceeding demand (growth). At that point commodity prices start to decline, while the increased financial leverage has risen due to the preceding investment activity. Hence, cash-flows from operating activity shrink and the burden to service debt is high. Often on top of that, there are still capital expenditure commitments from ongoing expansion projects. Fig. 8: The pork cycle, stylized Supply build-up and reduction lag actual demand, exaggerating price swings and the financial impact on producers The "sweetest" stage of the cycle is when the previous cycle's capacity has been reduced, market participants have left, balance sheets have been repaired and demand is rising reflected in rising prices. Operational leverage now works for investors Currently, the producers' cycle is entering the latter "sweetest" stage. For hard commodity producers some key conditions have already been met, with metals and mining more advanced than oil and gas producers, while soft commodity producers are following behind. Source: UBS Fig. 9: Reducing debt Net debt to equity of CRB commodity producers index versus MSCI World (in %) Due to the severe cyclical downturn the producers have experienced in recent years, we believe that the capital discipline phase of the cycle might well last longer than usual (2-3 years). During this phase we would expect cash flows to grow, without pressure from markets, or management, to re-invest in capacity expansion. Current capital expenditure (capex) guidance remains strongly weighted toward capital discipline, even if sales prices are above break-even in most commodities. Hence, we believe companies return their cash to investors for longer. Why? Well memories remain fresh of the last cycle, when management found themselves investing in expansion projects that hardly covered their cost of capital over the cycle. Rather, the focus continues to be on shareholder returns, i.e. dividends and share-buybacks. Source: UBS, as of 30 April Financial leverage as a cushion There are two main reasons the commodity producers' financial leverage (net debt/equity) rises: 1) they outspend the operating cash flows because volumes and prices have been falling and, 2) they outspend the operating cash flow because they invest more. As per the "toughest" stage of the cycle described earlier in this note, both can happen concurrently, but equally, both can happen independently of one another. As lenders and creditors are well aware of the existence of the pork cycle, they demand a higher risk premium (higher interest rates) and lower financial Chief Investment Office Americas, Wealth Management 11 June

5 gearing than they do for defensive industries to compensate for the cyclicality of the market. Fig. 9 shows: a) that the industry was in a phase of outspending cash flow until about mid-2016 and that this has since started to reverse, and, b) that the financial leverage (net debt/equity) always stayed well below the overall markets' leverage (MSCI World rebased at %). Currently, the net debt/equity ratio of CRB commodity producers is 33% (MSCI Word: 57%). Fig 9 also shows that the commodity producers are reducing their financial leverage which suggests that the "sweetest" stage of the pork cycle has begun. We expect financial leverage to fall further, helped by rising cash flows. This may not be an optimization of capital returns in the short term, given the current, very lows cost of debt. But the low financial leverage is reassuring because it helps to cushion high and cyclical operational leverage. Direct commodity vs. producers investing So, investing in commodity producers, rather than commodities directly, offers operating leverage, i.e. disproportionally rising earnings for producers, which is cushioned somewhat by the low financial leverage. In addition, producers use part of their cash flows to pay a dividend yield of roughly 3.4%, which is one percentage point higher than that for MSCI World (2.4%). We consider the dividend as relatively safe because of the producers low financial leverage and growing free cash flows. Share buybacks, which are increasingly common, may provide additional shareholder returns. There are typically no such recurring returns with direct commodities exposure. In a normal contango price situation (futures prices are higher than spot prices to compensate for storage costs) the investor has even to accept a roll-loss (equivalent to the price difference between the futures and spot price) which is usually not compensated for by the return on the cash collateral (i.e. the yield on the cash backing the commodity futures). In the mature phase of the business cycle oil often experiences a backwardation price situation (i.e. the spot price is higher than the futures price) which lead to roll-gains for the investor. For commodities such as agriculture or precious metals, however, backwardation is rare. Fig. 10: Only marginally higher drawdown Commodities, commodity producers and world sectors - Maximum drawdown , %* Consumer Staples Healthcare Utilities Energy MSCI World Consumer Discretionary Industrials Commodity Producers** Commodities** Materials Financials Telecoms Information Technology (90) (80) (70) (60) (50) (40) (30) (20) (10) 0 *MSCI level 1 sector classification; total returns. **Commodities = S&P GSCI Commodity Index; Commodity Producers = Thomson Reuters CRB Commodities Producers Index. Source: Thomson Reuters, UBS, as of 11 June 2018 Fig. 11: China important at different levels Share of global (estimate in %, volume weighted) Source: UBS, OECD, United Nations, as of 11 June 2018, underlying estimates refer to base years between 2013 and 2017 In any event, we would highlight that our positive view on commodity producers relative to the wider market is not driven by a bullish view on commodity prices in and of itself, but based on the overall "sweetest" stage of the cycle as described above, i.e. a phase of earnings and cash-flow growth. Chief Investment Office Americas, Wealth Management 11 June

6 Risks By their very nature commodities are not for the fainthearted. Commodity prices which can be subject to wild swings even when underlying demand and supply is steady due to unpredictable factors such as the weather, currency fluctuations, geopolitics, interest rates and OPEC (dis)agreements. Although commodities and commodity producers are generally perceived as risky asset classes, their volatility is not exceptional when compared to the MSCI world equity index, which represents a well-diversified equity portfolio. The maximum drawdown of the S&P GSCI Commodity index and the CRB Commodities Producers index over the past 18 years has been a considerable 64% (in ). But this is only a touch higher than the 57% drawdown for MSCI World (see Fig. 10). At a sector level, commodities and commodity producers compare favorably even to the maximum drawdowns of 77-82% for MSCI World Financials (during the Great Financial Crisis in 2008), and Information Technology and Telecoms (during the burst of the dotcom bubble in ). Interestingly, the maximum drawdown for the global energy sector (54%) is slightly lower than that for MSCI World. So much for history, but what are the risks of investing in commodity producing stocks today? The biggest risks, in our view, are that aggressive monetary tightening by the Federal Reserve, or a global tit for tat trade war, will lead to a US and/or Chinese economic downturn. This would lead to falling commodity prices, driven by weakening demand, which would hurt commodity producers profits disproportionately. The impact of an economic downturn is likely to vary at a sub-index level hard commodities are generally more sensitive to an economic downturn than soft commodities - but overall, commodities and commodity producers are likely to underperform global equities in anticipation of and/or during a recession. This is what happened in the past and we do not see why it would be different this time around. Note, however, that the importance of China s demand for commodities overall is disproportionately high for metals. For other commodities, China s demand is close to, or even below its global population share (Fig. 11). Still, a hard landing in China would have negative repercussions for commodities and their producers. Investment conclusion We recommend investing in a broadly diversified stock selection of commodity producers with exposure ranging from metals and oil (hard commodities) to fertilizers and agricultural products (soft commodities). This is because commodity producers tend to outperform during the later stages of the business cycle, when inflation rises and economic growth slows. Commodity producers also provide a means of diversification because they do not tend to move in lockstep with the wider market. Chief Investment Office Americas, Wealth Management 11 June

7 Appendix Terms and Abbreviations Term / Abbreviation Description / Definition Term / Abbreviation Description / Definition A actual i.e. 2010A COM Common shares E expected i.e. 2011E Shares o/s Shares outstanding UP Underperform: The stock is expected to underperform the sector benchmark CIO UBS WM Chief Investment Office Research publications from Chief Investment Office Global Wealth Management, formerly known as CIO Americas, Wealth Management, are published by UBS Global Wealth Management, a Business Division of UBS AG or an affiliate thereof (collectively, UBS). In certain countries UBS AG is referred to as UBS SA. This publication is for your information only and is not intended as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. The analysis contained herein does not constitute a personal recommendation or take into account the particular investment objectives, investment strategies, financial situation and needs of any specific recipient. It is based on numerous assumptions. Different assumptions could result in materially different results. We recommend that you obtain financial and/or tax advice as to the implications (including tax) of investing in the manner described or in any of the products mentioned herein. Certain services and products are subject to legal restrictions and cannot be offered worldwide on an unrestricted basis and/or may not be eligible for sale to all investors. All information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to its accuracy or completeness (other than disclosures relating to UBS). All information and opinions as well as any prices indicated are current only as of the date of this report, and are subject to change without notice. Opinions expressed herein may differ or be contrary to those expressed by other business areas or divisions of UBS as a result of using different assumptions and/or criteria. At any time, investment decisions (including whether to buy, sell or hold securities) made by UBS and its employees may differ from or be contrary to the opinions expressed in UBS research publications. Some investments may not be readily realizable since the market in the securities is illiquid and therefore valuing the investment and identifying the risk to which you are exposed may be difficult to quantify. UBS relies on information barriers to control the flow of information contained in one or more areas within UBS, into other areas, units, divisions or affiliates of UBS. Futures and options trading is considered risky. Past performance of an investment is no guarantee for its future performance. Some investments may be subject to sudden and large falls in value and on realization you may receive back less than you invested or may be required to pay more. Changes in FX rates may have an adverse effect on the price, value or income of an investment. This report is for distribution only under such circumstances as may be permitted by applicable law. Distributed to US persons by UBS Financial Services Inc. or UBS Securities LLC, subsidiaries of UBS AG. UBS Switzerland AG, UBS Deutschland AG, UBS Bank, S.A., UBS Brasil Administradora de Valores Mobiliarios Ltda, UBS Asesores Mexico, S.A. de C.V., UBS Securities Japan Co., Ltd, UBS Wealth Management Israel Ltd and UBS Menkul Degerler AS are affiliates of UBS AG. UBS Financial Services Incorporated of PuertoRico is a subsidiary of UBS Financial Services Inc. UBS Financial Services Inc. accepts responsibility for the content of a report prepared by a non-us affiliate when it distributes reports to US persons. All transactions by a US person in the securities mentioned in this report should be effected through a US-registered broker dealer affiliated with UBS, and not through a non-us affiliate. The contents of this report have not been and will not be approved by any securities or investment authority in the United States or elsewhere. UBS Financial Services Inc. is not acting as a municipal advisor to any municipal entity or obligated person within the meaning of Section 15B of the Securities Exchange Act (the "Municipal Advisor Rule") and the opinions or views contained herein are not intended to be, and do not constitute, advice within the meaning of the Municipal Advisor Rule. UBS specifically prohibits the redistribution or reproduction of this material in whole or in part without the prior written permission of UBS. UBS accepts no liability whatsoever for any redistribution of this document or its contents by third parties. Version as per April UBS The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved. Chief Investment Office Americas, Wealth Management 11 June