Q: Inflation is a topic that has garnered a lot of attention lately, how might this time be different?
A: The biggest difference now versus in the past, is the Federal Reserves’ recent policy change to an average 2% inflation target, from the previous single-point target of 2%. We believe the Fed will keep rates low as in the past, but will now allow inflation to exceed 2% to maintain the longer-term average at 2%. This policy switch is geared towards stoking inflation.
COVID-19 has also impacted all aspects of the global economy unlike past events that were more compartmentalized or regional. For example, the 2008 financial crisis was mainly isolated to housing and banks. That’s not to say its reach didn’t extend beyond those two sectors, but it was nowhere near the extent we saw with COVID-19 in terms of supply chain disruptions, etc. The actions taken by the Fed and the government addressing the 2008 crisis were also more targeted. Conversely, we now have a synchronized global recovery effort taking shape as vaccines become available and governments reignite their economies. Stimulus is widespread and direct to consumers this time as well. This restart is occurring at a time when consumers, especially U.S. consumers, have strong balance sheets and are being directly provided additional funds that will create spending and therefore demand.
Q: What are some leading indicators to follow as it relates to inflation and inflation expectations?
A: I pay particular attention to the producer price index (PPI). PPI includes goods and services purchased by other producers as well as goods and services purchased by consumers. A higher-cost incurred from a producer-to-producer transaction doesn’t necessarily get passed through to a consumer, but it is still representative of an imbalance in the supply and demand for said material or good. In other words, inflationary pressures can occur at different points on the supply chain curve. Historically, price movements at the producer level are more correlated with commodity prices, which intuitively makes sense given it is earlier in the supply chain process. Given my focus on commodities, this is the index I follow more closely.
Another macro-economic data point I monitor is monetary policy. In a globalized economy, the monetary policies of other nations provide insights into inflationary concerns across the globe. If other central banks begin to hike rates, it is likely a sign that inflationary pressures are real and, given globalization, the chances that some of those inflationary pressures get imported into the U.S. increases.
Lastly, rates cannot be ignored. If there is one data point that could derail the inflation theme, it is higher rates, especially in the belly of the curve. A sharp move higher in rates could lead to USD strength and keep a ceiling on inflation.
Q: From the point of view of commodities, what is occurring that might ultimately lead to inflationary pressures?
A: COVID-19 had a profound effect on commodities. It curtailed supply by shutting-in capacity, it redistributed demand and it shifted capital flows. Think about how consumer trends changed due to COVID-19; spending for leisure and entertainment were redirected towards home improvement, spending for out-of-home food consumption was redirected towards in-home food consumption, spending for business attire was redistributed to casual attire, etc. These events led to reduced inventories and offline capacity as demand channels shifted.
As we emerge from COVID, it will be about “following the money.” Will consumer habits change course again? Broadly speaking, there will undoubtably be a mismatch in select industries where demand outstrips supply, or a supply response is too slow to absorb rising demand, and this is where inflationary pressures will develop. Supply chains are still constrained, inventory levels are still inadequate and consumer trends are constantly changing.
Q: Where do you see the most opportunities in commodities as it relates to this inflationary theme?
A: When I look across the commodity complex, there are two types of situations developing. One in which supplies are already critically low and the other one in which supplies are adequate but the forward outlook indicates those inventories will be drawn down as a rebound in demand outpaces the supply response. The former situation is prevalent in the grains and oilseeds while the latter situation is indicative of energies.
In both cases, we see opportunities in the forward part of the curve. In other words, with respect to the grains and oilseeds, it’s going to require more than one crop year to replenish inventories, so a long exposure to new crop contracts is an attractive risk/reward in our opinion. Similarly, owning crude oil, for August 2021 delivery for example, is attractive because it should capture pent up consumer demand from the reopening of the economy and still be within the period that the supply response will not be able to react quickly enough.
Q: Some firms have mentioned the idea that commodities are entering into a new super-cycle, what is your opinion on this?
A: Commodity super-cycles are defined by extended periods during which prices are well above (or below) their long-term trend. Some analysts believe we are entering into an upswing super-cycle. Typically, this occurs when there is abnormally strong demand growth and supply cannot keep pace. In other words, inflationary pressures stem from the pull of demand, rather than supply-side events, which can produce sharp spikes but tend to be more transient in nature. The last major upswing super-cycle occurred because of BRIC nations (Brazil, Russia, India and China) experiencing rapid economic growth.
I am unsure as to whether we are entering into a super-cycle or if this is just a reflation trade, but the key will be to see how supply responds. There is offline capacity, but it remains unclear if it has been permanently shut-in due to COVID-19 and financing issues, or has just been idled. In any case, we do believe there is still upside potential in select commodities as the mismatch between demand and supply will be exacerbated as we emerge from COVID-19. If inflation ends up gripping the real economy, commodities, as indicated below, could be a way to play offense in a portfolio.