2019 was a volatile year for commodities driven by geopolitics and 2020 doesn’t look like it is going to disappoint on that front either. This can make positioning a portfolio difficult and not just in commodities. Every asset class is exposed to uncertainty, whether it be the S&P’s ability to sustain its record-breaking momentum, or the extent to which bond yields can continue to fall in a world that already has $12.3trn in negative-yielding debt. Despite these headwinds, we are cautiously optimistic for the natural resources sector in the coming year. 
We believe commodities, and those companies that produce them, represent an attractive investment in an out-of-favour sector. In many cases, shares are trading at discounted levels relative to other sectors and also to their historic valuation range. Base metals such as copper and zinc are now at the cost curve which provides price-sensitive production support, and below which production cuts have historically been considered.
The sector has been out-of-favour for an extended period, with smaller market cap companies garnering even less attention, especially given the flow of capital to larger market caps and liquidity into passive exchange-traded funds (ETFs). Some exploration companies have fallen by the wayside having struggled to get any investor traction whatsoever. In addition, the majors have generally pulled back on exploring themselves, as shareholders have pressured them to pay down debt and focus on dividends. As a result, the whole sector has seen little grassroots project developments that would replace depleting reserves. The painful retrenchment following overbuild in the last price cycle has left the sector with a greater focus on capital discipline to avoid making the same mistakes again. Add to this heightened environmental requirements, which can make it more difficult to obtain project permits. Combined with a more challenging political backdrop in those countries with the natural resources, new developments can be less appealing for management teams.
It is the concern on demand, despite this backdrop of supply discipline, that leaves many of the base metal miners out of favour and trading at depressed levels. Many mining equities trade at a discount to the construction cost of a new mine. This is primarily driven by the US-China trade war, where the implementation of tariffs has disrupted commodity flows, knocked corporate and consumer confidence and caused a deceleration in global growth. This has also been exacerbated by destocking through the global industrial chain.
Whilst this all sounds very negative, the world is still growing, supply chains are rerouting with some manufacturing relocating to avoid trade restrictions. We also note that industrial companies can only destock so far. Latterly, consumer confidence appears to have bottomed and the Chinese industrial sector, as measured by Manufacturing PMI data, turned positive last month after nearly 12 months of contraction. The ratio of new orders to inventory (for the US-China-eurozone-Japan) also moved up sharply providing evidence that global manufacturing may sustain its recent move into expansionary territory, reversing a downward trend seen over the last 18 months.
The prospect of a cyclical recovery makes base metal investments, which appear to price in a bearish outlook, appealing and provide leverage to a recovery in demand. Copper exposure remains important in this respect; it is a bellwether for global demand and also a beneficiary of the electrification thematic. We believe the outlook for other commodities such as steel-input zinc, which is trading at the marginal cost of production against a backdrop of historically low visible inventory, is positive. We are optimistic on its related equities which have been heavily de-rated over the last year.
President Trump keeps telling the world a ‘Phase 1’ trade deal is close, suggesting it is probable but not certain, which would improve business confidence further. We are optimistic that a deal will be reached, but it has been deferred before and the US president’s actions are far from predictable.
However, geopolitics remains unpredictable and it is this uncertainty that justifies holding some portfolio insurance in the form of attractively valued precious metal mining names in an investment portfolio. CQS Natural Resources currently has 24 per cent of the fund in gold and silver miners to protect against this uncertainty. Historically, gold stocks have traded up as high as 3x their net asset value (NAV) due to their insurance properties, but currently trade around half that. As described earlier there has been a divergence in mining equity valuations based on market capitalisations, which is especially prevalent in precious metals. This has been heavily impacted by the flow of funds into passive ETFs such as the GDXJ, which has left smaller names out of favour and trading at a further discount, thus we believe they provide the most attractively valued opportunity, with most trading well below NAV.
Rob Crayfourd and Keith Watson are portfolio managers at New City Investment Managers. The views expressed above are their own and should not be taken as investment advice.