Pay attention to commodities in an inflationary environment

MARKETS are governed by cycles. In financial media, almost all the attention is given to shorter-term cycles. The longer cycles are usually not analysed in any detail, with the common assumption being that the most recent trend will continue.

Most people in the financial industry today have never experienced an inflationary boom nor an inflationary bust. The last time we sustained high inflation was in the late 1970s. Since then, it has been one big disinflationary cycle that led to a bull market in both equities (price-earnings multiples rose in the last four decades from single digits to the current 28 times) and bonds (interest rates dropped from 20 per cent to their lowest point of zero per cent).

Buying ultra-long dated US government treasuries in 1980 would have yielded a return similar to equities.

Over the last 20 years, interest rates have averaged 1.41 per cent a year. This trend leads many, including the Federal Reserve, to believe that inflation will remain contained at the 2 to 3 per cent level as it has for much of recent history, and that current interest rates of 5.5 per cent are at the upper end of their long-term range.

This assumption is a potentially dangerous one for investors. I still remember my father fixing his investment cash deposits at rates near 20 per cent in 1980, back when I had no idea what an interest rate was. I just remember his happiness at achieving such a high return with “no risk”. Back then, the fear was that higher commodity prices and inflation, coupled with a high fertility rate globally, meant we would all run out of food.

The exact opposite happened. World fertility rates dropped drastically, agricultural yield surged from technological breakthroughs, and central banks got inflation under control by aggressively hiking interest rates.

Fast forward to today, where investors were expecting up to six interest rate cuts from the US earlier this year. These expectations have been pared back significantly as recent economic reports showed much stickier inflation. Investors may be making the same mistake from 1980, but in reverse.

What would cause inflation to be much more sticky? Cycles like these have historically lasted at least a whole decade. The disinflationary boom that started in 1980 resulted in a four-decade bull market for bonds.

A possible reason for sustained higher inflation comes from Japan’s recent experience, after it endured three decades of deflation. The new governor of the Bank of Japan made a key speech in December where he outlined his thoughts on how Japan was going to face a reflationary future, citing demographics as a contributing factor.

The narrative since 2010 was that the world was following Japan’s experience in a sustained deflationary cycle. The combination of an ageing population, too much debt and low birth rates would cause continued deflation and low interest rates globally. A counter-intuitive argument that refuted this was put forward by independent research analyst Dario Perkins of TS Lombard last month, who titled it A Big Thing Everyone Got Wrong.

How could Japan’s future suddenly become more inflationary, despite continued weak demographics?

Perkins’ argument was that it is not just about demographics but about the relationship between savings and investment. He pointed out that if savings decline more than investment, the equilibrium interest rate moves higher. As baby boomers hit retirement age and drop out of the labour force, retirees will spend more and save less. As more and more boomers retire, this trend will accelerate, causing structurally higher inflation.

The deflationary pressures of the last three decades started just as baby boomers needed big increases in investment after World War II, and entered middle age after 1980. This raised savings just as population growth dropped and longevity increased, reducing investment demand while boosting savings. All this caused the equilibrium interest rate to fall dramatically. Perkins argued that this trend will not continue.

The Bank for International Settlements (BIS) already warned about this in 2019, before the pandemic, where they estimated that the demographic structure of inflation from developed markets shows a U-shaped pattern. The populations of young and old are inflationary, while the prime working-age cohorts are disinflationary.

We are in the process of seeing the working-age cohort shrink significantly across developed markets. The BIS predicts a sustained inflationary impulse over the next 20 years.

Disinflation over the last 20 years accelerated from global productivity gains and China’s entrance into the World Trade Organization, exporting deflation via cheaper goods. China is no longer a low-cost labour market, and geopolitical trends and the US-China trade war are all inflationary in nature.

We have just experienced significant bullish action of commodity prices, particularly in gold which reached an all-time high this year. But it is not just gold that has risen, the increase is a broad move across many commodities.

While everyone follows Nvidia’s stock price, the price of cocoa has actually outperformed Nvidia’s massive 77 per cent gain, surging by 142 per cent this year.

A deflationary counterargument against the implications of baby boomers’ retirement leading to a sustained inflationary impulse in the US is the continued inflow of immigrants. More than 3.3 million foreign-born workers entered the US in 2023. It was one of the largest demographic moves in one year in US history.

This influx of workers is helping to keep a lid on wages and supplying labour where they are needed. If this continues, the ongoing migration will continue to expand the labour force and potentially counter the inflationary impact of tightness in the jobs market. It also helps to explain the extraordinary jobs creation in the US in 2023 and so far this year.

Investors should keep an eye on whether future economic data releases continue to point to higher inflation in the future, which would warrant a consideration to further diversify their portfolios away from just equities and bonds.

We had a taste of an inflationary boom between 2000 and 2007, when gold, oil and emerging markets had significant gains, as US equity markets struggled.

An inflationary bust, where high inflation is coupled with weak growth, last happened in the 1970s. The possibility of such a stagflationary environment in the future has increased.

Investors may want to start thinking about additional diversification in their portfolios by adding commodity exposure, especially if bonds and equities continue to be highly correlated.

The writer is head of investments for Singapore at AlTi Tiedemann Global. The views are solely the author’s, and do not reflect the views or positions of AlTi Tiedemann Global or its subsidiaries. This content should not be considered as financial advice.