Commodities and the Risk of Inflation
Memories of the great inflation of the 1970s have faded in the public’s consciousness. Half of today’s population wasn’t even born when inflation stalked the land and, in the decades since, the failure of inflation to reappear has naturally eroded interest in the subject.
But it is still worth looking back at the 1970s’ experience both because it can give us a sense of how far Washington can push the envelope on fiscal and monetary policy without igniting significant inflation and also in considering how to protect portfolios if inflation does reemerge.
Commodity prices are at the center of both of these questions, representing both a cause of higher inflation and a refuge for investors when inflation occurs.
In the 1970s, higher oil prices played a pivotal role in triggering bouts of inflation, boosting the year-over-year increase in the consumer price index to over 12% in 1974 and to almost 15% in 1980. It’s important to recognize that these surges in inflation were just as much about inflation psychology as inflation itself. In both cases, the spike in oil prices was due to conflict in the Middle East which dominated the headlines. Moreover, the price of gasoline is by far the best known price in the economy and spiking gas prices fed the general perception of out-of-control inflation.
Soaring energy prices also increased costs in agriculture, manufacturing and transportation and the general rise in prices led to demands for higher wages from a trade union movement that was much more powerful than today. Those higher wages, in turn, further boosted consumer prices across the economy and it took two painful recessions, culminating in double-digit unemployment in 1982, to break the back of inflation.
Of course, commodities were not the only cause of the 1970s’ inflation. Keynesian economists pointed to big budget deficits, used to finance the Vietnam War and fund social programs, contributing to economic overheating. Monetarists claimed it was all the result of the Federal Reserve allow the money supply to grow too rapidly. Demographics and the income distribution also likely had an impact as Baby-Boomers entering the labor market and setting up homes contributed to strong aggregate demand as did a more equal income distribution than prevails today.
In addition, throughout the decade, commodities provided a spectacular investment returns. Crude oil prices rose from $22 a barrel in 1970 to almost $130 a barrel by April of 1980. Corn and copper prices tripled over the decade while the price of gold rose from under $37 an ounce in 1970 to almost $680 ten years later.
A New Commodity Super-Cycle?
Data last week confirmed that the economy is now accelerating fast, with retail sales climbing by an astonishing 9.8% in March, housing starts hitting a nearly 15-year high and weekly initial unemployment claims falling to their lowest level in over a year. This acceleration is causing many to ask questions about the potential for higher inflation and some have even speculated on a new commodity “super-cycle”.
Some of the conditions for higher inflation have clearly returned. Massive fiscal and monetary stimulus have been deployed during the pandemic recession and neither the Federal Government nor the Federal Reserve are showing any signs of turning off the spigot even as the economy quickly recovers. Unions are, of course, a smaller part of the story today. However, more generous unemployment benefits, along with very slow growth in the working age population suggests that wages could accelerate as the recovery proceeds. But what about commodities?
Here the story is not nearly as compelling as in the 1970s.
First, the most important part of the commodity space is fossil fuel energy, accounting for 54% of the Goldman Sachs Commodity Index and 30% of the Bloomberg Index. Both crude oil and natural gas prices have rallied in recent months as vaccines have brought the promise of an end to the pandemic. However, with oil prices now back over $60 a barrel, shale oil output in the United States is likely to ramp up quickly as it has done in recent years whenever prices became more attractive. OPEC also has plenty of spare production capacity which could act as a barrier to much higher prices. In addition, growing efforts around the globe to combat climate change should limit the growth in demand for fossil fuels in the decade ahead.
The demand for food commodities should improve as economic growth accelerates in the wake of the pandemic. However, slower demographics should limit the growth in food demand. According to United Nations, global population grew by 1.9% per year in the 1970s but is only expected to rise by 0.9% per year in the current decade. These numbers may be further dented in the short run by higher fatalities and fewer births due to the pandemic. It is possible that strenuous global efforts to redistribute income could boost global food demand. However, despite recent changes in U.S. fiscal policy, there are few signs that this is a global trend right now.
Surging construction could also boost commodity demand around the world. This is particularly in focus today with lumber prices soaring to all-time highs in recent months and copper prices returning to their peaks of a decade ago. However, questions can also be asked about the durability of a construction surge. Chinese policy-makers are well aware of the dangers of over-investing in the construction sector and appear determined to achieve more balanced growth going forward. Passage of a large infrastructure program in the U.S. could, of course, add to demand. However, even if passed, government-funded construction spending in the U.S. tends to have a slow rollout, potentially allowing global suppliers to catch up.
Finally, in the precious metals space, cryptocurrencies appears to be diverting some demand which would normally accrue to gold in a market awash with liquidity. Moreover, while near-zero short-term interest rates are making it easy to finance positions in precious metals, eventual Fed tightening could prove a further headwind in this space as well as for commodities in general.
In summary, there are sufficient headwinds in the global economy and markets to cast doubt on the thesis of a new commodity super cycle.
Commodities in a Portfolio
That being said, there are plenty of other reasons to believe in some strengthening in inflation over the next few years including massive fiscal stimulus, pent-up demand, limited labor supply and the potential for a falling dollar. Such an environment poses a threat to the bond market and, by boosting long-term interest rates, to the stock market. In addition, the real value of investor cash holdings would, of course, be eroded faster by higher inflation. Given all of this, even if commodity prices don’t soar, they could easily match or exceed inflation, and given this potential, commodities are still well worth considering as part of long-term, diversified portfolio.