Pierre Kunkel, Vice President of Media for the McGill International Portfolio Challenge (MIPC), recently sat down with Ellie Clapton, a portfolio specialist within the multi-asset team at Ninety One to discuss natural resources and a decarbonization investment theme in this current market environment.

Ninety One is a global asset manager with emerging-market roots. Dual-listed in London and Cape Town, Ninety One manages C$203.1 B in assets and is committed to providing long-term returns for clients while also championing sustainability.

1. Why has an investment involving commodities piqued your interest? Are there any specific commodities that your team is particularly interested in?

The opportunity set is really broad, the transition towards a low-carbon economy is creating an investment cycle across a wide range of natural resources that will play a key role in global decarbonization. We are seeing powerful trends for many resources and in the equities of companies that extract them. This creates new opportunities for investors as we transition from a fossil fuel-based energy system to a metals-based energy system.

This trend is creating structural demand for materials and products enabling the transition and that is creating this major thematic long-term growth tailwind. In our view, the transition will result in an increased investment in climate solutions, like wind turbines, and other technologies essential to move towards a decarbonized economy. This is going to create demand for a broad range of materials and products. Although some products will have vastly different outcomes, we believe that most metals and minerals have a role to play as “enablers” of the energy transition.

Wind and solar power, as I have mentioned, is one reason that these commodities are needed in the energy transition. But it is far from the only reason. The electrification of transport, for example, is going to require significant amounts of materials. Take copper for instance. The copper content in electric cars is much greater than the amount that is used in combustion engine vehicles. And that is not even mentioning what is required for charging infrastructure and batteries. Although the composition of the batteries will vary between automobiles, we expect nickel, lithium, cobalt, phosphate, and other mined products to be essential inputs. Those companies that have exposure to areas of structural growth offer the potential to compound returns at above-average rates of return over long periods of time.

2. You evoked being interested in companies with exposure to key commodities. Would you be open to looking at futures contracts to gain exposure to the commodities themselves?

We do not invest in physical and there are a lot of reasons why.

Equities are the preferred vehicle to gain exposure. Firstly, the universe is much broader, you cannot invest in all materials via the physical futures market, but you can access them via equities. And secondly, when you look at an equity index such as BCOM you will notice that it has outperformed physical indexes over a long period of time due to the absence of storage costs, among other factors.

3. How do you choose the equities to capitalize on decarbonization?

We focus on producers. We are not looking at blue sky explorers, we want those companies that are already producing with good cash flows. We want quality companies and it’s important that they have a good return on capital because it’s a capital- intensive sector.

4. With copper for instance, would supply and demand dynamics be favorable due to the regulatory environment and the time it takes to make a new mine operational? Would it be a reasonable assumption to expect this to be a tailwind for copper?

Generally speaking, yes. The rise of ESG and sustainability considerations are influencing physical commodity markets, and it is difficult to bring new supply. There are barriers to entry and barriers to ownership.

It is not only the case for copper, but also the case for other metals such as steel. Although steel is one of the most carbon- heavy metals within the complex, it is a critical input for wind turbines. As the need for these materials is increasing, supply is not keeping up.

5. Many tout the benefits of commodities being upstream of the production process which enables inflation passthrough. Do you see the inflation-mitigating properties of commodities as a double benefit?

Yes, looking back there is an evident historical relationship between natural resources, natural resource equities, and inflation. This is a pattern we would expect to persist. This is all quite circular and selfserving as the decarbonization trend will put upward pressure on commodity prices which in turn creates further inflation, an environment in which we would expect natural resources equities to fare well as they have in the past.

6. Starting last year, we saw geopolitical events that influenced inflation and an uptick in geopolitical risk. Do you see commodities as a way to hedge against geopolitical risk?

The rise in geopolitical risk has been apparent, notably with the war in Ukraine starting last year and currently in the Middle East. These events have and may continue to result in oil supply constraints. One would expect oil prices to benefit and provide an inflation hedge. It is a very useful asset to have within a broader portfolio. However, you cannot talk about geopolitical risk and inflation hedging without gold. You have seen tensions in the Middle East driving the price of gold higher as it is seen as a ‘safe haven’ asset and an inflation hedge.

7. You mentioned geopolitical risk as well as circularity and feedback loops with commodities. One key risk that I see is resource nationalism. This risk is acute in Chile for instance, with the possibility of the nationalization of mining operations. Some might be worried that this would hamper the structural growth opportunity. The worry would be that due to restricted supply, prices would be driven to such heights that some would start looking for substitutes. Do you see this as a risk?

The countries where these mines operate have always come with heavy political risks. There could be a swing to the left and often there are governments sworn in that are concerned with sustainability and particularly the preservation of the area that the mine is located in. There can also be concerns with indigenous populations living in the area. These risks ebb and flow and it is something which we always have done – and continue to do so – pay close attention to.

8. Does your exposure to a broad basket of commodities offer ample protection from this risk?

To your point, I think our broad exposure is worth pointing out. What is also worth mentioning is that this structural opportunity is not limited to metals and mining but can also extend to energy and agriculture. 

We have a strong skillset in agriculture. There are massive opportunities in ammonia for instance. The nitrogen fertilizer industry is one of the main producers of ammonia. They sell to farmers and to industrial users. Pure hydrogen is important in a low-carbon world. It mainly travels by pipeline and only becomes liquid at -250 degrees Celsius. With ammonia, you can bind hydrogen with nitrogen so that it can be kept at more normal temperatures. This is an opportunity among many in agriculture, which plays a useful role in a broader portfolio context.

9. You mentioned that you would expect periods of high volatility when moving toward decarbonization. What would those situations look like and what would cause that volatility? 

I think you are seeing it right now with higher interest rates causing the equities of companies offering climate solutions to sell off due to the way that growth is discounted. What’s more, this volatility may be persistent. The process of decarbonization will take decades, not years. It very much depends on energy security. If you look at Extinction Rebellion, they would like to turn off everything today. The reality is that we do not have enough renewable energy at the moment. The UK, for example, a couple of years ago, had the most windless summer since 1979, which means wind turbines are not going to give you enough energy. You still need non-renewable energy, and you still need fossil fuels, but we have to work closely with those companies to ensure their transition plans are credible. 

In addition, there continues to be geopolitical risk. Russia could turn off its tap and the Saudis also want to maintain higher oil prices to raise revenues to afford to transition themselves. 

Ultimately, there are a lot of moving parts: the time it will take, the investment required, as well as the supply. The transition will most definitely be non-linear.

10. You mentioned the defensive properties of oil relative to inflation. Can you walk me through your cost-benefit analysis when it comes to investing in high emitters?

How does one weigh portfolio concerns with ESG concerns? It is obviously a difficult topic and I think it is one that policymakers and investors alike are grappling with. We are focused on generating returns, and the correlation between oil and inflation makes oil an important component of our portfolio. However, we are seeking to design net-zero targets for our investment teams aimed at driving real-world carbon reduction.

We seek to encourage change. That being said, it is not an open invitation to own anything. We need to analyze the transition plans of companies, some will be uninvestable due to their strategy, their balance sheet, or stranded asset risk. So, it is it is an interesting dichotomy given that we think natural resources equities are going to play a critical role in this multi-decade transition to a low-carbon economy.

It is important to be involved with these high emitters as by definition they can reduce their emissions the most because of the high base that they are starting from. In doing so, we are looking for very clear and coherent transition strategies and we are drawing on several different frameworks. As I have said, we cannot switch off oil overnight. So, it is best to stay with them and make sure that they are running sustainably.

11. Can you illustrate how engaging with these companies would have a positive impact?

I think BP and Anglo-American are good examples, in the past, they would have fire-sold off problematic assets to take them off their balance sheet to reduce their emissions. The problem is that the assets were sold to emerging market companies with little accountability, the result is that we were no closer to net zero. That is why it is better to stay invested to make sure that the likes of BP, Glencore, and AngloAmerican run down these assets credibly and reinvest the proceeds into more renewable areas.

12. Pivoting now to the macroeconomy: Predicting the macro environment can sometimes seem like reading tea leaves but it does seem that the market is coming to grips with a higher for longer narrative for interest rates. What is the macro view at Ninety One? Does this conform with the market view?

Ninety One does not have a house view but our multi-asset team, in which the thematic equity team sits (including our global natural resources) has a view. It can be a bit like reading tea leaves, but the team has a process whereby it thinks about the macro environment in two ways: cyclically and structurally to help them position accordingly.

Our team believes that cyclically, policy dynamics will drive inflation and future growth. In simple terms, when policy settings are tight, then growth and inflation tend to decelerate in the future with a lag and a recession might follow. Then, when policy settings are loose, growth and inflation tend to accelerate, again with a lag. Looking forward from here, there is the expectation from the team that weaker growth and inflation are going to continue to emerge in the developed world, particularly in Europe. And that’s because policy has been tight for the last six to 12 months and given policy lags, we think we are entering a time where we should begin to see the impact more fully. We think the risk is to the downside. Our main concern is that given the speed and the magnitude that we have seen in the hiking cycles, a recession in the developed world is likely, which means we should experience weaker growth. This should eventually see interest rates start to fall. Essentially, we think it is more likely in 12 months’ time from today that interest rates will be lower than where they are today.

That is a cyclical view, but there is also a more structural, long-term trend. Although we have seen inflation come down from the dizzying heights of the last year or so, we do think it is going to find a resting level that is higher than what we saw in the last cycle. We do not think we are going to go back up to 10% inflation, but we do think higher levels of inflation are likely to persist in the future, certainly relative to the pre-Covid era. This is because of things such as deglobalization, increasing defense spending, and demographic changes as millennials reach household formation stages, could all put structural upward pressure on inflation. This will lead to interest rates also being higher than they were in the previous cycle, even though they will likely fall from where they are today.

13. Despite lower growth due to tight monetary policy, wouldn’t it be possible that policies of subsidization of green initiatives put a floor under the price of commodities, effectively limiting your downside? 

There is a ton of money flowing into these initiatives and there has been a pivot in fiscal policy which accompanied with what was in the past, loose monetary policy. For instance, the FED’s balance sheet has doubled over the past couple of years and Germany’s debt is at record levels. It is unlikely that governments will be able to successfully grow the debt away, so the only option is to inflate it away. To a certain degree, a moderate level of inflation or one that is higher than what we have seen in the past is good because it enables governments to inflate away their debt. 

14. You evoked high debt levels and governments inflating away debt as an environment where there would be a floor under commodities. Could one argue that the market would price in these higher inflation expectations resulting in higher yields and limiting a government’s ability to take on much more debt? Would this weaken the price floor theory on commodities? 

Although we think that interest rates will be higher than in the past, we still believe that they are going to come down from what we are seeing today. We do not think it will be to the point where you are going to completely inhibit growth. We believe that governments will not want to deter investment towards decarbonization, so we would hope for rates to be at a reasonable level.

This communication is for professional investors and financial advisors only.

The information may discuss general market activity or industry trends and is not intended to be relied upon as a forecast, research or investment advice. The economic and market views presented herein reflect Ninety One’s judgment as at the date shown and are subject to change without notice. There is no guarantee that views and opinions expressed will be correct and may not reflect those of Ninety One as a whole, different views may be expressed based on different investment objectives. Although we believe any information obtained from external sources to be reliable, we have not independently verified it, and we cannot guarantee its accuracy or completeness (ESG-related data is still at an early stage with considerable variation in estimates and disclosure across companies. Double counting is inherent in all aggregate carbon data). Ninety One’s internal data may not be audited. Ninety One does not provide legal or tax advice. Prospective investors should consult their tax advisors before making tax-related investment decisions.   

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