Consumer Price Index
The Bureau of Labor Statistics released a key measure of inflation, the monthly Consumer Price Index (CPI) rose to a 40-year high. The CPI for the 12 months ending January rose 7.5%, not adjusted for seasonal swings. The year-over-year price increase is the highest jump since February 1982. The consensus projections from economists were for 7.3% or worse than forecasted.
CPI less food and energy increased by 0.6% in January and 6.0% between January 2021 and January 2022, marking the largest increase since August 1982. Food prices rose 0.9% in January, and 7% over 1-year, with all grocery prices increasing. Energy prices jumped 0.9% last month and 27% year over year, dominated by fuel oil and gasoline prices.
The rapid inflation raises the odds of a double rate hike (50 basis points) in the next FOMC meeting in March. The Federal funds rate futures are pricing in a 50% chance that the Fed will raise interest rates by 50 basis points in March, from a 30% chance before the release of the new CPI data.
The financial markets reacted negatively to the hot inflation numbers. The yield on the benchmark 10-year Treasury yield traded to 2.03% or the highest levels in 2-1/2 years. The SPX Index fell 83.10 points or -1.81%, the Dow Jones Industrial Average declined 526.47 points or -1.47%, and Nasdaq Composite Index plummeted 304.73 points or -2.10%.
When investors talk about inflation, they often turn to commodities. Rising inflation tends to favor commodity prices, as this asset class outperforms other assets. Will commodities be a hedge for 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 commodities n general can act as a hedge against inflation, specific commodities have mixed records. Historically, the best performers during rising inflation have been precious metals and energy. Surprisingly, industrial metals and agricultural products offer mixed results during inflationary periods. These commodities depend on other factors such as physical demand (supply and demand) of the underlining asset and financial constraints.
Commodities Also React Differently Based on the Stages of Inflation
Commodities react to inflation differently. At the peak of inflation, commodity prices tend to explode higher in an abrupt and irrational short-term spike-up fashion. However, when inflation subsides, commodities can decline sharply over a short period. When the threat of inflation ends, commodity prices gradually fall in value with little fanfare. The decline can occur over many years and possibly decades.
In the past three decades inflation has been subdued, averaging around 3% per year. During the 1980s, 1990s, and early 2000s commodities reacted to low inflation with slow and progressively rising prices. Gold, a historically dependable proxy for inflation, was flat to down during this entire time frame.
Commodities have quickly risen sharply after many years of relatively low inflation. It is unusual for commodities to surge in this fashion when the U.S. and the global economy just emerged from the pandemic-induced recession just two years ago. The National Bureau of Economic Research (NBER) has called an economic trough in April 2020. However, many economists and investors continue to believe inflation is not sustainable, at least from the longer-term perspective, regardless of rising commodity prices.
Technical Views on CRB Index, Crude Oil, and Gold
The explosive rally in CRB from a low of 101.48 (4/21/20) to a recent high of 262.13 (2/10/22) resembles the previous inflationary spikes, including Nov 2001-Jul 2008 and Mar 2009-Apr 2011. A recent surge above the top of a long-term secular trendline at 220 warns of a CRB rally to 267.87 (61.8% retracement from the 2011-2020 decline). Above 267.87 reaffirms that this is more than an inflationary spike. Will this be a turning point to a repeat of the inflationary periods of the 1970s and early-1980s? Initial support rises to 239-241 (Jan 2022 breakout and 50-day ma) and below this to 219-220 (extension of the long-term downtrend channel breakout and the 200-day ma).
CRB Index has maintained its longer-term downtrend over the last decade. Rising inflation is sustainable rests on the outcome of the test of resistance at 267.87 or the 61.8% retracement from the 2011-2020 decline. A convincing breakout reverses the long-term downtrend, signaling a sustainable CRB uptrend and higher inflation. The CRB trend change will likely influence the direction of U.S. interest rates and stock prices.
Like the CRB Index, WTI Crude Oil is barreling higher. WTI Crude Oil's 2020 collapse to 6.50 (Apr 2020) has been unprecedented, losing 90% of its value in 4-months. The recovery from the April 2020 bottom (6.50) to Feb 2022 high (93.17) has also been unparalleled, as Crude Oil gained 1,333% over the past 1-plus year. The breakout above critical resistance at 74-77 (2008 downtrend, late 2014 breakdown, and the Jul/Oct 2018 reaction highs) reverses the decade-old downtrend and warns of real and sustainable higher oil prices. The next resistance is 93.5 (61.8% retracement from 2008-2020 decline). A breakout reaffirms the trend reversal and suggests the next Crude rally to 112-115 (2011/2013 highs).
Key initial support rises to 85.5 -87.5 (Jan 2022 breakout), 81-82 (1/24/22 low and 10-wk ma), 76-79 (50-day, 30-wk ma, and 10-mo ma), 74 (200-day ma), 61.56-62.43 (May/Aug/Dec 2021 lows), 56 (30-mo ma), 50.5 (early-2021 breakout), 40-42 (Jul 2004 breakout), and 33.55-35 (2009 low and 1998 uptrend).
Gold has experienced long-term bull and bear trends, including the 1970s to early-1980s (structural bull), 1980 to 2000 (structural bear), 2001 to 2011 (structural bull), and the late-2011 to present (structural trading range). The Jun 2019 breakout above 1,377.50 has led to a sharp rally that briefly recorded new all-time highs (2,089.20 - 8/7/20), eclipsing the prior Sep 2011 all-time high (1,923.70). Since the technical base is 799.40 points, gold can rally to 2,723 overtime. An overbought condition coupled with a failure to follow through above its prior 2011/2021 highs (1,923.79/2,089.20) has led to the recent high-level consolidation.
Key initial support remains at 1,673-1,752.5 (Mar/Apr/Aug 2021 lows and the 30-mo ma), and below this to 1,613-1,628 (50% retracement from 2018-2020 rally and 2018 uptrend), 1,519-1,566 (61.8% retracement and Jan 2020 breakout), 1,446-1,451 (Nov 2019 and Mar 2020 lows), and 1,377.5 (Jun 2019 breakout). Key initial resistance is 1,854-1,879.5 (Nov 2021/Jan 2022 highs and 2021 downtrend). A breakout here confirms a triangle breakout and the next gold rally to 1,919.20 (May 2021 high), and above this to 1,962.5-1,966 (Nov 2020 and Jan 2021 highs), and then 2,089.20 (Aug 2020 all-time high). A record-high confirms breakout and signals the next structural gold bull trend.
With CRB, WTI Crude Oil, and Gold climbing higher, investors are concerned about rising inflation, especially if supply chain bottlenecks continue to exacerbate supply-demand imbalances. The current rallies in CRB Index, WTI Crude Oil, and other commodities are nearing critical resistances, and convincing breakouts would reaffirm real inflation.
Is The Current Environment the same as the 1970s/1980s?
The two bellwether commodities, Gold and Crude Oil performed well during the inflationary period of the 1970s/1980s 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/1980s. 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 differ from the past. For one, OPEC is no longer as influential as it once was. However, we have other geopolitical factors such as Russia/Ukraine debacle to influence WTI and Brent Crude Oil prices. Second, many commodities have already appreciated sharply over the past 1-plus year and are now challenging critical intermediate-to-long term resistances. Will they break out? Third, alternative energy can influence the supply and demand of Crude Oil and other fossil fuel, at least longer-term.
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 inflation in the economy. But commodities do not always react accordingly. It is more common for a slow and gradual rise in inflation than a period when inflation suddenly skyrockets overnight. So, are there better inflation hedges under this scenario?
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 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. However, if inflation replicates the period from 1966 to 1982, then will the average SPX returns fall to the previous period of 2.82%?
Like commodities, real estate is another hard asset. It tends to hold up well 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. A sharply rising inflationary period, which leads to soaring interest rates, can hurt financing and the housing market.
Treasury Inflation-Protected Securities (TIPS) is one of the more popular fixed-income instruments for hedging against inflations. TIPS are government securities that pay interests and are indexed to the Consumer Price Index (CPI). TIPS can be an excellent fixed income hedge for conservative investors during periods of extremely high inflation. Interestingly, the iShares TIPS Bond ETF (TIP) has broken its 50-day ma (126.48), 200-day ma (125.78), and neckline support at 125.45. Support is 122.42-122.5, coinciding with the May 2021 breakout, 2020 uptrend, and the 61.8% retracement from Feb 2021 to Nov 2021 rally. It appears TIP has been a poor inflation hedge, at least so far.
Poor Inflation Hedge
Bonds that pay a fixed rate of return are unlikely to keep up with rising inflation since long-term fixed-income instruments cannot adjust for inflation. Rising inflation leads to higher interest rates, and higher yields translate to 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 losing value with the declining Bond price. Rising inflation would hurt fixed-income investments ex-TIPS the most.
It is difficult to refute the past 1-plus year rally in CRB, energy, and precious metals as rising prices point to inflation. However, as the CRB Index, WTI Crude Oil, and gold rally toward critical resistances, the outcomes may help decide if this is real inflation, at least from a longer-term perspective. Under rising inflation, commodities-based sectors such as Materials and Energy will excel. As interest rates rise, Financials can also outperform. TIPS will recover and outperforms fixed-income peers. Real estate and REITs can also protect an investment portfolio against sustainable inflation. And within commodities, WTI Crude Oil and gold remain good hedges in a diversified investment portfolio.