Aging demographics trend, technological innovation, historically low interest rates, high global debt, and the exporting of deflationary pressures from emerging countries are some of the reasons why inflation has been low over the past thirty-plus years. Although the above are structural forces that remain intact, the benign inflationary trend can also suffer bouts of aberrations leading to sudden and sharp rises in the inflation rate. Are the Fed's unprecedented easy monetary policies and the massive government fiscal stimulus and deficit spending programs slowly tilting the balance in favor of a less benign inflationary trend in the future?
What is causing inflation in 2021?
The current rise in inflation can be best explained by the mismatch between demand and supply. The equilibrium price and equilibrium quantity occur where the supply and demand curve intersect. Equilibrium occurs when the quantity demanded is equal to the quantity supplied. If the price is above the equilibrium level, then the quantity supplied will exceed the quantity demanded, and vice versa.
The pent-up demand after the Covid-19 pandemic lockdown brought back consumers eager and willing to spend. At the same time, the bottleneck in the global supply chain and shortages have led to elevated inflation. Fed Chair Powell also signaled new concerns about inflation the other day, suggesting inflation can last longer than previously expected.
Can commodities be an inflation hedge?
When investors talk about inflation, they often refer to a rise in commodities. The common thinking is that commodities are hard assets that can outperform when inflation rises. Is this true, and can commodities help protect investors during periods of rising inflation? What type of commodities offers the best inflation hedge?
Different commodities tend to react differently to inflation
Although commodities can act as a hedge against rising inflation, it has had a mixed record, longer-term. The best performers during periods of rising inflation have been precious metals and energy. Surprisingly, commodities such as industrial metals and agricultural products have mixed results. Even during inflationary periods, it is common to see some of these commodities decline. Industrial metals and agricultural commodities tend to depend on other factors, such as the physical demand of the underlining asset and financial constraints.
Commodities react differently depending on the stages of inflation
Commodities tend to react differently based on various stages of inflation. At the peak of inflation commodity prices tend to surge sharply higher in an irrational and erratic short-term burst. However, when inflation subsides, commodities tend to decline sharply lower over a brief period. When the threat of inflation ends, commodity prices gradually fall in value with little fanfare, declining over many years and many decades.
In the past three decades, inflation has been subdued, averaging around 3% per year. During most of the 1980s, 1990s, and early 2000s, commodities reacted to low inflation with a slow and gradual rise. Gold, another good proxy for inflation, was flat to down over most of the 30-year window.
Current dilemma for commodities
Is the rise in inflation over the past year transitory? The fact that many commodities continue to trend higher after breaking out of their respective intermediate-term resistances is troublesome. It is unusual for commodity prices to continue to surge higher without first consolidating. It is also equally puzzling commodity prices would recover this quickly after the US and the global economy slipped into a recession a little over a year ago. Also, the National Bureau of Economic Research (NBER) has only recently called an official end to the February 2020 recession. The fact that commodities continue to rise uninterrupted hints that investors are concerned about the higher-than-normal inflation rate.
CRB Index, Crude Oil, and Gold
CRB Index has rallied sharply from its 4/21/20 bottom at 101.48. In one-plus years, CRB has cleared crucial resistances, including the 2018 downtrend (176-177), 2008 downtrend (197), the May 2018 reaction high (206.95), and the extension of the 2008 uptrend breakdown (215), and the 2011 downtrend (216). The latest breakout above 216 renders a pivotal test of the 38.2% retracement (243.67) from Jul 2008 to Apr 2021 decline and the extension of the 2004 breakout (245). A surge above 245 signals a sustainable CRB rally toward 287.73 (50% retracement) and 331.62 (61.8% retracement). Another overbought condition is likely to develop into this rally. Initial support rises to 221-226 (Sep 2021 breakout, Oct 2020 uptrend, and the 50-day ma), and below this to intermediate-term support at 205-207.5 (May 2018 reaction high, 10-mo ma, and 200-day ma). The 30-mo ma at 175 remains longer-term support.
Like the CRB Index, WTI Crude Oil has broken out above critical intermediate-term resistance in the mid-70s, corresponding to the 2009 downtrend and the Jan 2019 reaction high. It is now hovering at 85 for the first time in 7-years. Although an overbought condition is developing into this recent rally, the ability to reverse a decade-old downtrend warns of sustainable higher oil prices.
WTI Crude Oil's 2020 collapse to 6.50 (Apr 2020) was unprecedented, losing 90% of its value in 4-months. The rebound from the April 2020 bottom to Jun 2021 high (76.98) was also unparalleled, as Crude Oil rallied 1,197% over the past year. The recent breakout above critical resistance at 74-77 (2008 downtrend, late 2014 breakdown, and the Jul/Oct 2018 reaction highs) reverses the primary downtrend channel and hints at the next rally to 93.5 (61.8% retracement from 2008-2020 decline) and above this to 112-115 (2011/2013 highs). Initial support rises to 75-77 (Oct 2021 breakout), and below this to 73-73.5 (10-wk and 50-day ma), 66.5-68/70 (10-mo and 200-day ma/30-wk ma), 61.5-62 (May/Aug 2021 lows), 53-57.5 (30-mo ma, Feb 2021 breakout, and Mar/Apr 2021 lows), and 50-53 (30-mo ma and the early-2021 breakout).
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 would imply a Gold technical target closer to 2,723, intermediate-term. However, 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 another consolidation. Key initial support remains at 1,673-1,700.5 (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 1,837-1,842 (Sep 2021 highs and Aug 2020 downtrend). A breakout here signals the start of the next gold rally to 1,919 (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).
With CRB at 241.18, Oil trading at 84.65, and gold hovering near 1,793.40, 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 US economy. On the other hand, if the current rallies in CRB Index, WTI Crude Oil, Gold, and other commodities peak, would this trigger a sharp reversal in commodity prices?
Today' environment differs 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 and early-1980s. Back then, many commodities were trading at historical lows allowing these commodities plenty of room to appreciate. Gold started the decade at $35 an ounce, while Oil began at less than $3 a barrel. Except for Oil, 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 (i.e., solar) and EV technology that can materially change the supply and demand equilibrium of Crude Oil and other fossil fuel. Nonetheless, we recommend investors and traders respect the dominant and prevailing trends of the various commodities.
Better Inflation Hedges?
Investors, traders, the press, and the media tend to react to inflation only when it has reached uncomfortably elevated levels. However, there is always some form of inflation in the system, 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 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 a temporary 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. A sharply rising inflationary period, which leads to soaring interest rates, can hurt financing and the housing market. The REIT sector (XLRE) can also excel when inflation rises.
Treasury Inflation-Protected Securities (TIPS) is one of the more popular fixed-income inflations hedging vehicles. These are government securities that pay interest 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. The iShares TIPS Bond ETF (TIP) has now broken out to new all-time highs.
Poor Inflation Hedge
Unlike TIPS, long-term Bonds that pay a fixed rate are unlikely to keep up with rising inflation. Long-term fixed-income investments cannot adjust for inflation. Rising inflation leads to higher interest rates, and higher interest rates result in lower bond prices. In rising inflation, an investor that holds a long-term Bond position will be locked at a lower interest rate, while at the same time, it loses value with the declining Bond price. If the inflation rate rises sharply, fixed-income investments ex-TIPS would be the most vulnerable asset class to own.
It is difficult to refute the outperformance of energy and precious metals during periods of high inflation. The sudden sharp rise in the CRB Index and WTI Crude Oil is unusual from a historical perspective. Depending on the distinct types of inflation that may arise in the future, there may be various inflation hedges to deploy to protect your investment portfolios. By tilting toward inflation-related sectors and stocks, TIPS, real estate, and select commodities, an investor can hedge against real inflation.