In Brief:

• Higher inflation is currently a key risk that is top of mind for many investors. As such, the role of commodities has gained special interest given recent positive performance and the possible impacts of decarbonization policies.
• Within commodities, oil, industrial metals and precious metals are the strongest performers during periods of low and rising inflation.
• The transition to a carbon-neutral world will inevitably impact commodities and their role as an inflation hedge in portfolios. Still, we expect this to be gradual.

Higher inflation is currently a key risk that is top of mind for many investors. The combination of still very loose fiscal policies, recovering private demand and a mismatch between supply and demand in pockets of the global economy may lead to inflation being much less transitory than many central bankers believe. Our view is that inflation pressures will recede in the second half of 2021 as base effects pass and supply catches up with demand. However, the risk of higher and more persistent inflation remains.

Historically, gold and commodities, real assets and inflation-linked bonds have been used to protect portfolios from the effects of inflation (Exhibit 1). The strong 10-year correlation of 0.73 between the year-over-year (y/y) growth of the Bloomberg Commodities Index (BCOM) and the U.S. Consumer Price Index (CPI) highlights the effectiveness of commodities as an inflation hedge. The role of commodities has gained special interest given recent performance and the possible impacts of decarbonization policies. We explore whether energy commodities and industrial metals remain effective in reducing inflation risks in this context.

EXHIBIT 1: COMMODITIES HAVE HISTORICALLY BEEN AN INFLATION HEDGE
YEAR-OVER-YEAR GROWTH OF BCOM VS. U.S. CPI

Source: Bloomberg, BLS, Dow Jones, FactSet, J.P. Morgan Asset Management.
Data reflect most recently available as of 05/10/21.

The impact of decarbonization

Many countries and regions are now stepping up their climate ambitions and the Leaders Summit on Climate 2021, hosted on Earth Day in April, saw a renewed commitment to reduce greenhouse gas emissions globally and achieve net-zero emissions by the middle of this century (see our Achieving Net Zero series introductory paper here).

The transition to a low-carbon economy suggests rethinking whether commodities will remain an effective hedge against inflation given the high weight of energy within commodity indices.1 Looking beyond the index, oil is the strongest performing commodity during periods of low and rising inflation, followed by industrial and precious metals (Exhibit 2). The next sections focus on energy and industrial metals.  

EXHIBIT 2: ENERGY, INDUSTRIAL METALS AND PRECIOUS METALS OUTPERFORMED TRADITIONAL ASSET CLASSES DURING PERIODS OF LOW AND RISING U.S. INFLATION
ARITHMETIC AVERAGE OF NOMINAL ANNUAL RETURNS OF DIFFERENT ASSET CLASSES FOR YEARS IN WHICH INFLATION WAS BELOW MEDIAN AND RISING, 1992 TO 2020

Source: Barclays, Bloomberg, Dow Jones, FactSet, U.S. Federal Reserve, J.P. Morgan, MSCI, Strategas/Ibbotson, J.P. Morgan Asset Management. Median inflation was 2.34% in measured period. Rising or falling inflation distinction is relative to the previous year. Low and rising inflation occurred in 6 of the 30 measured years. *EM debt based on the period 1994-2020. Based on Shiller S&P 500 Composite total return index (U.S. equities), MSCI AC World Index (World equities), Bloomberg Barclays Global Aggregate (Global bonds), Bloomberg Barclays Aggregate U.S. Treasury Index (U.S. govt. bonds), Bloomberg Barclays Aggregate U.S. Corporate Investment Grade Index (U.S. inv. grade), Bloomberg Barclays U.S. Corporate High Yield Index (U.S. high yield), J.P. Morgan EMBI Global (EM debt) and S&P GSCI (Commodities). Past performance is not a reliable indicator of current and future results. Data reflect most recently available as of 05/10/21. 

Energy

Energy, more specifically oil, has historically moved very closely with inflation given the higher weight in the CPI inflation basket and the flow on effects as this commodity is used in all parts of the economy, from fueling transportation to heating homes to powering factories.

However, this relationship will likely be challenged in the future, as energy demand changes from fossil fuels to renewable sources. It’s the pace of this change that matters. While the clean energy trend has gained significant momentum in equity markets since 2020, it has not been matched with the same momentum in displacing the use of fossil fuels. The main factors slowing the shift are technology, economic incentives and the availability of adequate infrastructure.

The advancement of clean energy technology to a point where it competes with fossil fuels on a cost basis is a relatively recent phenomenon. Still, the economics of clean energy investment are not always favorable in every case. For example, for heavy industries, one of the largest contributors to carbon emissions, the existing processes based on fossil fuels are generally highly efficient, due to the commoditized nature of its products, limiting the appeal of substituting with clean energy sources. Thus, it is hard to justify overhauling entire processes to use clean energy unless there are mandated changes or policy incentives.

The infrastructure to support clean energy takes time to build. Despite the recent push by governments globally, it will still be some time before clean energy is able to fully replace fossil fuels. While the share of fossil fuels as total energy consumption declines, and if the global economy continues to grow, the absolute quantity of fossil fuels needed could still rise, albeit at a slower pace than nominal GDP growth. This slow transition, combined with the fact that industry consumes 29% of total final energy, implies  there will still be a strong demand base for energy commodities for some time to come.

On the consumer demand side, the accelerating trend of electric vehicles (EVs) has benefited industrial metals demand but has led to decreased use of, and will continue to displace, fossil fuel-intensive internal combustion vehicles. Manufacturing and technology improvements should see the price disparity between EVs and internal combustion vehicles narrow. However, there is still a huge variation in prices among regions. Outside of the largest developed economies, the continued growth in EV penetration will still be dependent on the extent of local policy support such as tax incentives and EV infrastructure construction.

On the supply side, though the global investment in oil and gas supply has been gradually decreasing since 2014, investment plummeted in 2020 (Exhibit 3) alongside demand during the COVID-19 pandemic. The long lead times in supply often do not match the shorter variations in demand, potentially creating supply-demand imbalances in the future. In the near term, this could lead to higher prices for both oil and gas if global economies recover to their pre-pandemic levels, and we have yet to see significant and concrete clean energy transition policies being put in place. While we believe that energy commodities’, and specifically oil’s, role as an inflation hedge will be eroded by decarbonization, this will likely be a long process.

EXHIBIT 3: GLOBAL NOMINAL INVESTMENTS IN OIL AND GAS UPSTREAM
USD BILLIONS, 2010 TO 2020

Source: International Energy Agency, J.P. Morgan Asset Management.
Data reflect most recently available as of 05/10/21. 

Industrial metals

The other side of the decarbonization coin is industrial metals. As climate change policies take priority, governments are increasing green infrastructure spending to support the broader use of renewable energy and EVs. This has boosted the demand outlook for industrial metals, such as copper, aluminum, lithium, etc., as EVs and renewable power plants are very metal-intensive. For example, renewable energy systems can consume five times more copper than conventional energy systems, and the average battery EV consumes around 60kg more copper than a similarly sized internal combustion vehicle.

In the U.S. for example, the USD 2.25trillion American Jobs Plan proposed by U.S. President Joe Biden includes metals-intensive “green” spending as well. The plan proposes a USD 174billion investment in the EV sector, to establish a fully integrated domestic supply chain spanning from raw materials to batteries, as well as sales rebates and tax incentives for consumers to buy American-made cars. If passed, this investment would entail the construction of 500,000 EV charging stations by 2030, the replacement of 50,000 diesel transit vehicles and the full electrification of the federal vehicles fleet and 20% of the U.S. school bus fleet. Moreover, the plan would also include a 10-year extension for tax credits for wind, solar and other renewable energy projects.

The expectations of the increased demand from these initiatives has boosted the price of industrial metals since 2020. The recent rise in industrial metal prices has tracked well with the rise in the equity prices of EV and renewable energy companies since 2020, showing that many investors expect the decarbonization initiatives to bring huge demand for industrial metals. However, the demand created by these policies may not displace the traditional fundamentals, such as global industrial production, U.S. dollar strength and inflation for many years.

The estimated share of green demand from the total demand for industrial metals has yet to reach a level that could drive a structural rise in prices. As seen in Exhibit 4, the green demand share of total in 2020 for copper, nickel and aluminum was estimated to be 6.3%, 5.7% and 3.8%, respectively. For comparison, when the industrialization of China began to drive significant increases in copper prices in 2004, China’s demand share of the total was estimated to be around 21%. Looking back at previous supercycles, the structural demand share of the total from the catalysts were generally at similar levels as well. Based on the current trajectory, the green demand share of metals could reach the critical level by the early 2030s, but there are still risks that would impact this assumption even if the overall decarbonization trajectory is maintained.

EXHIBIT 4: ESTIMATED "GREEN" DEMAND SHARE OF COPPER OVER NEXT 5 YEARS
% OF TOTAL 

Source: BNEF, Carbon-neutral Pathways for the United States, CRU, IHS, J.P. Morgan Commodities Research, NEA, Tsinghua University's Institute of Energy, Environment and Economy (3Es), Wood Mackenzie, J.P. Morgan Asset Management. Data reflect most recently available as of 05/10/21.

One such risk is the substitution between different metals or outright reduction in the use of metals (also called de-contenting) in these new clean technologies. For example, certain EV makers have shifted from a nickel-based battery to an iron-based one to reduce costs, even though EVs have more range with a nickel-based battery. In solar photovoltaic (PV) applications, higher silver prices led to the reduced use of the metal in PV applications. As a result, even though global solar capacity rose by 20% y/y in 2020, the amount of silver in PV applications grew by less than half this rate. Directly relating the pace of the progress of green initiatives to the pace of industrial metals demand growth is complicated by the substitution and de-contenting in these technologies.

As a result, despite strong momentum from the decarbonization initiatives in recent years, the performance of industrial metals could still be driven by the traditional fundamentals. 

Investment implication

Commodity prices should be supported by the improving economic cycle and will continue to add to portfolio diversification and inflation protection given the long timeframe applied to decarbonization. 

However, the strong rally in prices and potential of fading demand from China amid changes in policy support measures have created downside risk to industrial metals. These near-term pressures should be offset by rising demand in other locations as the global economic recovery becomes more synchronized. This could also lift energy prices if supply remains constrained by underinvestment.

Over the longer term, if the current trajectory of decarbonization continues, the approach of using commodities as a hedge will become more nuanced and will move away from commodity indices with high weights to fossil fuels and low weights to commodities crucial to the growth in renewable energy. However, the correlation between inflation and industrial metals is one that should continue to hold. 

¹ Energy commodities are 29.97% of the Bloomberg Commodity Index (BCOM) and approximately 61.71% of the S&P GSCI, respectively.

0903c02a82b2760b