When investors talk about inflation they often turn to commodities. The common thinking is that in a rising inflationary environment, commodities tend to outperform other asset classes. So, is this true? And can commodities help protect investors during periods of rising inflation? If so, then what type of commodities offer the best inflation hedge?
Different Commodities Tend to React Differently to Inflation
Although most believe commodities can act as a hedge against inflation, it has had a mixed record. Historically, the best performers during inflation have been precious metals and energy. Surprisingly, commodities such as industrial metals and agricultural products can also decline in price during inflationary periods. These commodities depend on other factors such as the physical demand of the underlining asset and financial constraints.
Commodities can be Volatile Depending on the Stages of Inflation
Commodities react to inflation in a volatile way, but the move is often short-lived. At the peak of inflation, commodity prices tend to explode higher in an irrational short-term spike up. However, when inflation subsides, commodities tend to decline sharply lower over a short period. When the threat of inflation ends, commodity prices gradually fall in value with little fanfare, and this decline often occurs over many years and possibly many decades.
For example, in the past three decades or so, inflation has been subdued, averaging around 3% per year. Most of the 1980s, 1990s, and early 2000s commodities reacted to low inflation with slow and gradual rising prices. Gold, a good proxy for inflation, was flat to down during this time frame.
Current Dilemma for Commodities
Commodities today are showing unusual trading conditions as many commodities have risen substantially at a time of relatively low inflation. It is quite unusual for commodities to surge in this way when the US and the global economy slipped into a recession less than a year ago. The National Bureau of Economic Research (NBER) has yet to call an official end to the February 2020 recession. Although there is a lack of economic evidence to suggest inflation is sustainable, at least for the longer term, we find it interesting commodities continue to rise further.
The Technical on CRB Index, Crude Oil, and Gold
The CRB Index is approaching a key test of its intermediate-term resistance at 176, coinciding with the 2018 downtrend. A convincing breakout above this resistance zone would increase the risk for even higher commodity prices, medium-term. However, on a longer-term basis, commodity prices continue with their longer-term downtrend over the last decade. The real test as to whether rising inflation is a serious threat to the US economy remains at around 200-207 or near the pivotal 2009 downtrend and 2017, 2018, 2019, and 2020 highs. A lot is riding on this technical test. A convincing breakout may be signal higher inflation which may begin to influence the direction of interest rates and stock prices.
Like the CRB Index, WTI Crude Oil is barreling toward intermediate-term resistance. The 2018 downtrend is now declining near 58, suggesting formidable supply. Also, the 2019 highs are hovering near 63.5-66.5 providing strong secondary overhead resistance. A convincing breakout here signals the next WTI Crude Oil rally to long-term resistance at 75-77 or the 2009 downtrend and the Jan 2019 reaction high. Above this level would reverse the decade-old downtrend and warns of real and sustainable higher oil prices.
Gold has already completed a major technical breakout above its previous all-time high of 1,923.70 last summer. The breakout has led to a sharp rally toward 2,089 (Aug 2020) before transitioning toward consolidation. Since the technical base is 799.40 points, this still would imply a Gold technical target closer to 2,723, intermediate-term.
With Oil currently trading at 52.91 and Gold rising near 1,855, you must wonder if investors are anticipating rising inflation, especially if the monetary and fiscal stimulus policies and higher interest rates make their way through the economy. On the other hand, if the current rallies in CRB Index, WTI Crude Oil, and other commodities fail to surpass their respective intermediate and long-term resistances, would this trigger a sharp reversal in commodity prices?
Today' environment is different from the 1970s
One interesting point to note about the two bellwether commodities – Gold and Crude Oil. Both were two of the best-performing assets during the inflationary period of the 1970s and were excellent proxies for inflation. The OPEC oil embargo led to a sudden and sharp rise in the price of Crude Oil igniting a period of sharply rising inflation into the 1970s. Also, many commodities were trading at historical lows. So, they had plenty of room to appreciate. Gold started the decade at $35 an ounce, while Oil began at less than $3 a barrel. Today's dynamics do not appear to be the same as before. For one, OPEC is no longer as influential as it once was. Second, many commodities have already appreciated sharply over the past year or so. Third, there are new alternative sources of energy that can now change the supply and demand equilibrium of Crude Oil and other fossil fuel.
Better Inflation Hedges?
Investors, traders, the press, and the media tend to recognize inflation only during periods when it has reached uncomfortably high levels. However, there is always some form of inflation, but commodities do not always react accordingly. It is more common for a slow, and gradual rise in inflation rather than a period when inflation suddenly skyrockets overnight. So, are there better inflation hedges under this scenario?
Yes, several asset classes perform well under a slow and gradual rise in inflation. Stocks have an excellent track record of long-term outperformance. Over the past 100 years, stocks have returned on average of at least 8% per year. Stocks tend to also excel during periods of low inflation. Most importantly, with an 8% average return over the long haul, stocks can weather the storm even with short-term bursts of inflation.
Like commodities, real estate is another classic hard asset. It has a history of reacting favorably during periods of inflation. And much like stocks, it also performs well during periods of low inflation. The Housing Index (HGX) is a leading indicator of the real estate market. This asset class may make the best of all inflation-related hedges, at least from a very long-term perspective. The caveat is real estate investing uses leverage and depends on mortgage financing and the general direction of interest rates. In a sharply rising inflationary period, which leads to soaring interest rates, it can hurt financing and the housing market.
Treasury Inflation-Protected Securities (TIPS) is one of the more popular fixed-income inflations hedging vehicles. These are government securities that pay interest but are also indexed to the Consumer Price Index (CPI). TIPS can be an excellent fixed income hedge for conservative investors during periods of extremely high inflation.
Poor Inflation Hedge
Unlike TIPS, long-term Bonds that pay a fixed rate of interest are unlikely to keep up when the inflation rate is rising. Why? Long-term fixed-income investments cannot adjust for inflation. Because rising inflation leads to higher interest rates, and higher interest rates this results in lower bond prices. In a rising rate of inflation, an investor that has a long-term Bond position will be locked at a lower interest rate while at the same time loses value with the declining Bond price. If the inflation rate were to rise sharply fixed income investments ex TIPS would be the most vulnerable asset class.
It is difficult to refute the outperformance of energy and precious metals during periods of high inflation. However, as the CRB Index and WTI Crude Oil technical charts suggest it is not conclusive that there is real inflation, let alone sustainable long-term inflation. Depending on the different types of inflation there may be different inflation hedges to deploy. By adjusting the allocations of stocks, TIPS, real estate, and select commodities in your portfolio you can respond quickly to rising inflation if it finally appears.