All Things Reconsidered in the Inflation DebateAndrew Musgraves, Product ManagerMarch 09, 2021
Unprecedented monetary and fiscal policy over the last decade has helped support several of the fastest economic recoveries on record in the U.S. Once again, these forces have rekindled the great inflation concern among investors, despite the fact that any meaningful inflation has not been an issue since the 1970s. Whether or not inflation develops beyond a popular discussion topic and becomes reality is certainly a worthwhile conversation, but examining prior results is an effort in preparation. Although out of favor more recently, it’s time to reconsider an allocation to natural resources and commodities for the possibility that inflation materializes after the pandemic-driven downturn.
Inflation Expectations Normalizing and Then Some
Think back to this time a year ago. The idea that inflation would be mentioned, let alone considered as a real concern, would have been met with a certain level of scrutiny. However, securities held by global central banks are increasing by approximately $250 billion per month and have increased nearly $6 trillion in total over the last year. The level of liquidity that has been pumped into the system already along with the prospects of additional programs on the way, have driven long-term inflation expectations beyond the 2% threshold, which has been the accepted barometer for some time.
Stimulus and the Fed’s Willingness Fuels Inflation Expectations (5 Years Ahead)
Source: Bloomberg. Data as of February 2021. Past performance is not a guarantee of future results. Inflation expectations are measured here using a 5-year, zero coupon USD inflation swap. The swap is a derivative used to transfer inflation risk from one party to another through an exchange of cash flows. In a zero coupon inflation swap, only one payment is done at maturity where one party pays a fixed rate on a notional principal amount, while the other party pays a floating rate linked to an inflation index.
Inflation Trade Anew
Generalizing different scenarios that one might find themselves faced with as an investor presents a relatively straightforward picture, in our view. We believe investors anticipating the possibility of an increase in inflation or global growth should seek to maintain or add exposure to natural resource equities and commodities.
After all, the historical link between global growth, natural resources equities, commodities and inflation is quite logical and well-established. Historically, economic expansion has increased the demand and need for raw materials, led to supply constraints among producers and, in many cases, ultimately contributed to higher prices for these assets.
Growth and Surprise Inflation Scenarios Show Link to Natural Resource Equities and Commodities (1970 – 2020)
Source: VanEck, CRSP, FactSet, Bloomberg. Data as of December 2020. See definitions and disclosures below. “Positive Inflation Surprise” determined by quarters where a year-over-year percent change in inflation (as measured by U.S. Consumer Price Index for All Urban Consumers - CPI-U) was higher than 1-year-ahead forecasts from Philadelphia Federal Reserve Bank’s Survey of Professional Forecasters (from January 1970 to December 1977) and University of Michigan’s inflation expectations survey (from January 1978 to December 2020). Global growth measured by periods where World Bank’s real global GDP growth (year-over-year % change) was greater than the prior year.
Modest Inflation Supportive of Natural Resource Equities
Perhaps somewhat understated, though, is the impact that even modest inflation can have on the relative attractiveness of these assets on an average-return basis. While it seems unlikely that we see 6% inflation at any point in the near future, the U.S. Federal Reserve Bank has indicated their willingness to allow near-term inflation to run past its historical 2% average before intervening by targeting higher interest rates.
In this environment, natural resource equities have responded with those within energy, diversified miners and gold exhibiting strong outperformance relative to U.S. stocks broadly. Besides the underlying favorable fundamentals that result from improving demand in terms of recovery, these companies, generally speaking, currently have healthy balance sheets, attractive valuations, and the ability to generate significant free cash.
Average Return of Various Assets Classes in Varying Inflation Regimes (1970 – 2020)
Source: VanEck, CRSP, FactSet, Bloomberg. Data as of December 2020. See definitions and disclosures below.
Response Already Visible
Predicting what might occur in the future given the depths of the past year and the truly unparalleled response is the final part of the discussion. However, we can see that commodity prices have shown signs of strength at this early stage in the recovery. In fact, the broader picture becomes perhaps even clearer by isolating commodities used for industrial purposes, whose usage reflects ongoing and forthcoming productivity output and is less about investment demand.
Commodity Prices Already Coming Back
(Commodity Research Bureau (CRB) – Raw Industrials Spot Price Index*)
Source: Bloomberg. Data as of March 2021. Past performance is not a guarantee of future results. *CRB Raw Industrials Spot Price Index is a price index constructed from a basket of various industrial commodities including copper scrap, lead scrap, steel scrap, tin, zinc, burlap, cotton, print cloth, wool tops, hides, rosin, rubber, and tallow.
As global markets continue to recover from one of the largest deflationary shocks since the Great Depression, investors should be reconsidering and revisiting how these growth- and inflation-sensitive assets may provide them the diversification and return benefits they are looking for.
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Exposure to commodities markets, such as precious metals, industrial metals, gas and other energy products and natural resources, may subject a portfolio to greater volatility than investments in traditional securities. The commodities markets may fluctuate widely based on a variety of factors including changes in overall market movements, political and economic events and policies, war, acts of terrorism and changes in interest rates or inflation rate. Because the value of a commodity-lined derivative instrument and structured note typically are based upon the price movements of physical commodities, the value of these securities will rise or fall in response to changes in the underlying commodities or related index of investments. Investments hard asset sectors may be subject to greater risks and market fluctuations than a portfolio that has exposure to broader range of sectors. The portfolio may be susceptible to financial, economic, political or market events, as well as government regulation, impacting the hard assets sectors (such as energy, metals and real estate sectors). Precious metals and natural resources securities are at times volatile and there may be sharp fluctuations in prices, even during periods of rising prices. Securities of small and medium sized companies often have greater price volatility, lower trading volume and less liquid than larger more established companies. The stocks of small and medium sized companies may have returns that vary, sometimes significantly, from the overall stock market. Investments in foreign securities involve risks related to adverse political and economic developments unique to a country or a region, currency fluctuations or controls, and the possibility of arbitrary action by foreign governments, including the takeover of property without adequate compensation or imposition of prohibitive taxation.
Broad based securities indices are unmanaged and are not subject to fees and expenses typically associated with managed accounts or investment funds. Investments cannot be made directly in an index. All indices listed are unmanaged indices and include the reinvestment of all dividends, but do not reflect the payment of transaction costs, advisory fees or expenses that are associated with an investment in a fund. An index’s performance is not illustrative of a fund’s performance. Past performance is no guarantee of future results.
“Base & Industrial Metals” represented by S&P GSCI Industrial Metals Index from January 1977 to December 2020 and CRB Commodity Metals Index from January 1970 to December 1976. “Commodities” represented by Bloomberg Commodity Index. “Diversified Miners” represented by MSCI ACWI Select Metals & Mining ex. Gold & Silver Index from September 2001 to December 2020, EMIX Global Mining ex. Gold & Energy Index from January 1986 to August 2001, and CRSP’s Industry Portfolio (Mines) from January 1970 to December 1985. “Energy Equities” represented by S&P Global BMI Energy (Sector) Index from August 1989 to December 2020, EMIX Global Energy Index from January 1986 to July 1989 and CRSP’s Industry Portfolio (Energy) from January 1970 to December 1985. “Gold (Bullion)” represented by NYMEX spot gold price in $US/oz. “Gold Miners” represented by NYSE Arca Gold Miners Index from October 1993 to December 2020, Dow Jones Global Indexes All World Gold Mining (Sub-Industry) Index from February 1992 to September 1993, S&P 500 Gold (Sub-Industry) index from October 1989 to January 1992 and CRSP’s Industry Portfolio (Gold) from January 1970 to September 1989. “Natural Resource Equities” represented by S&P Global Natural Resources Index from December 2012 to December 2020, an equal-weighted blend of returns for S&P Global BMI Energy and Materials (Sector) indices from August 1989 to November 2012, an equal-weighted blend of returns for EMIX Global Energy and Global Mining indices from January 1986 to July 1989 and a blend of returns for CRSP’s Industry Portfolios (50% Energy, 10% Mines, 10% Chemicals, 10% Wood, 10% Boxes and 10% Agriculture) from January 1970 to December 1985. “Oil, Gas & Consumable Fuels” represented by World Bank Energy Price Index. “REITs” represented by FTSE NAREIT All Equity REITs Index from January 1972 to December 2020. “U.S. Bonds” represented by Bloomberg Barclays U.S. Aggregate Bond Index from March 1976 to December 2020, Bloomberg Barclays U.S. Aggregate Government/Credit Index from March 1973 to February 1976 and a blend of returns of Ibbotson SBBI bond indices (70% U.S. Intermediate-Term Government Bond Index and 30% U.S. Long-Term Corporate Bond Index) from January 1970 to February 1973. “U.S. Stocks” represented by S&P 500 Index.
The returns of actual accounts investing in natural resource equities, commodities, gold (bullion), oil, gas & consumable fuels, base & industrial metals, energy equities, diversified miners, gold miners, U.S. equities and U.S. bonds strategies are likely to differ from the performance of each corresponding index or return stream. In addition, the returns of accounts will vary from the performance of the indices for a variety of reasons, including timing and individual account objectives and restrictions. Accordingly, there can be no assurance that the benefits and risk/return profile of the indices shown would be similar to those of actual accounts managed.
Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and non-agency). Bloomberg Barclays U.S. Aggregate Government/Credit Index is a broad-based benchmark that measures the performance of U.S. Dollar denominated U.S. Treasuries, government-related and investment grade U.S. corporate securities that have a remaining maturity of greater than one year. Bloomberg Commodity Index is designed to be a highly liquid, diversified benchmark for commodities as an asset class. The Bloomberg Commodity Index is composed of futures contracts on 20 physical commodities. Commodity Research Bureau (CRB) Index acts as a representative indicator of today's global commodity markets. The CRB measures the aggregated price direction of various commodity sectors, and is designed to isolate and reveal the directional movement of prices in overall commodity trades. Consumer Price Index for All Urban Consumers (All Items) is a measure of the average change in the price for goods and services paid by urban consumers between any two time periods. It can also represent the buying habits of urban consumers. This particular index includes roughly 88 percent of the total population, accounting for wage earners, clerical workers, technical workers, self-employed, short-term workers, unemployed, retirees, and those not in the labor force. The CPIs are based on prices for food, clothing, shelter, and fuels; transportation fares; service fees (e.g., water and sewer service). EMIX Global Energy Index EMIX Global Mining ex. Gold & Energy Index measure the returns of companies in the metal and mineral extraction industries excluding gold and energy companies. FTSE NAREIT All Equity REITs Index is a free-float adjusted, market capitalization-weighted index of U.S. Equity REITs. Constituents of the Index include all tax-qualified REITs with more than 50 percent of total assets in qualifying real estate assets other than mortgages secured by real property. Ibbotson SBBI U.S. Intermediate Government Bond Index is an unweighted index that measures the performance of U.S. Treasury and U.S. Government Agency bonds with maturities between four and seven years. Ibbotson SBBI U.S. Long-Term Corporate Bond Index is an unweighted index that measures the performance of U.S. corporate bonds with maturities of seven years or longer. NYSE Arca Gold Miners Index is a modified market capitalization-weighted index composed of publicly traded companies involved primarily in the mining for gold. The Index is calculated and maintained by the New York Stock Exchange. MSCI ACWI Select Metals & Mining Producers Ex Gold and Silver Investable Market Index (IMI) aims to focus on companies in the industrial and rare earth metals (excluding gold and silver) that are highly sensitive to underlying prices of industrial and rare earth metals. The index includes companies that are primarily engaged in the production or extraction of metals and minerals, in the mining of precious metals excluding gold and silver (e.g. platinum), or in the production of aluminum or steel. S&P 500 Index is widely regarded as the best single gauge of large-cap U.S. equities. The index is a float-adjusted, market-cap-weighted index of 500 leading U.S. companies from across all market sectors including information technology, telecommunications services, utilities, energy, materials, industrials, real estate, financials, health care, consumer discretionary, and consumer staples. S&P Global Natural Resources Index includes 90 of the largest publicly traded companies in natural resources and commodities businesses that meet specific investability requirements, offering investors diversified and investable equity exposure across three primary commodity-related sectors: agribusiness, energy, and metals & mining which tracks the global natural resources and commodities businesses. S&P GSCI Index is a world production-weighted commodity index comprised of liquid, exchange-traded futures contracts and is often used as a benchmark for world commodity prices. S&P North American Natural Resources Index provides investors with a benchmark that represents U.S. traded securities that are classified under the GICS® energy and materials sector excluding the chemicals industry; and steel sub-industry. UBS Bloomberg Constant Maturity Commodity Index is a rules-based composite benchmark index diversified across 29 commodity components from within five sectors, specifically energy, precious metals, industrial metals, agricultural and livestock.
All investing is subject to risk, including the possible loss of the money you invest. As with any investment strategy, there is no guarantee that investment objectives will be met and investors may lose money. Diversification does not ensure a profit or protect against a loss in a declining market. Past performance is no guarantee of future results.
Authored byAndrew Musgraves