At the end of the 70s, inflation in the US reached 14.75%. There was a general fear that inflation would keep rising towards a fatal hyperinflationary spiral. In order to tackle the rapidly increasing inflation and to calm down consumers' and producers' anxiety, the Federal Reserve increased interest rates to 20%. In a single meeting, the Fed even hiked rates by 5% points!
The day when interest rates reached 20% translated into the best time in history to buy equities, bonds, or a combination of both. Inflation and short-term rates started a secular downward trend which clearly favored these two asset classes; until now.
Financial markets are currently undergoing the exact but opposite scenario. Interest rates cannot go lower (or more negative in some countries), and central banks have been fighting against deflation for nearly a decade now.
However, the unreasonable delay of the normalization of monetary policies, after more than 10 years of perfectly synchronized ultra-loose policies across the globe, will drive inflation up sharply in coming months.
This scenario will be negative for stocks (SPY, FEU) and bonds alike (TLT, AGG, BND), as asset classes. The herd and financial media remain focused on subjects like FAANGs, new and frequent all-time highs in stock markets, subdued volatility (VXX), bitcoin (OTCQX:GBTC), politics, etc. But they are missing the underlying economic trends that will give shape to the market in coming years.
The scenario described above will undoubtedly benefit commodities as an asset class, since commodity prices benefit from global economic growth, higher inflation, and tightening monetary policies.
(This is the first of a series of articles including foundation, strategy, and quantitative tactical allocation to profit from this scenario.)
Crude oil prices and its correlation with inflation
As the chart below shows, the correlation between crude oil prices and CPI is significant, especially when incorporating a lag of one month.
This means that increases in oil prices (USO) begin to filter through with a delay of around one month. Nonetheless, anyone could argue that CPI has been stuck stubbornly below the Fed's 2% threshold despite crude oil prices rising more than 150% since 2016.
According to the Federal Reserve, the unresponsive inflation in 2017 was due to transitionary factors such as a sharp contraction of cell phone tariffs. However, these transitionary factors will be phased out by March 2018, as the related base effect exits the calculation of the CPI index. At the same time, 2018's fresh highs in crude oil prices will start to be added up into the calculation of the index. This double-edge effect will further exacerbate the upsurge in CPI.
As the chart below shows, and giving some credit to the Fed, cell phone tariffs did indeed collapse between 2016 and 2017. Such a massive contraction could have brought down the overall inflation index by a few pips, but by March 2018, this effect should have completely been phased out.
PPI already moving forward
Crude oil prices, however, have a much more significant impact on the Producer Price Index (PPI), as it translates firstly into the production chain, before the higher production costs are transmitted to consumer prices.
Actually, a quick correlation analysis to the monthly changes of the three instruments (CPI, PPI, and oil prices) shows higher correlation between CPI and crude than PPI and crude (see below).
Looking at current various countries' PPI figures, the main intake is that these indices have already started to rise around the globe in a coordinated way. This will eventually be transmitted to consumer prices (see below). In some cases, the PPI index increased +200% from 2016 to 2017.
Corporations tend to delay transferring cost increases into prices as much as possible in order to avoid giving up market share. The outcome is however inevitable if the price of resources continues to increase, especially if there also is an aggregate demand boost coming from increasing consumer confidence. Consumer confidence indices currently operate at multiyear highs (see below).
Tax bill, wage growth, and inflation
In line with consumer confidence and demand, it is important to note that the GOP's tax bill will also boost spending. A tax cut is undeniably analogous to an increase in wages - something the Fed has been chasing for a long time.
Despite a significant lack of acceleration in the Fed's preferred gauge of wage growth in the US, i.e. the Average Earnings Index (yellow line), the chart below shows that other measures of salaries have been trending upwards more consistently. Especially industrial and manufacturing wages as indicated by the ECI Wages & Salaries Workers in Manufacturing Index (blue line).
Currency depreciation and inflation
Currency depreciation also plays an important role in inflation (and in commodity prices in the case of the dollar). For instance, take a look at Brexit. As the chart below shows, the sharp depreciation in the British pound (FXB) following the referendum quickly translated in a significant upsurge in the UK's CPI, which reached a whopping 3.1% year on year last month.
In a similar tone, the dollar last year recorded its worse year since 2003 and continues to fall rapidly (see below). The US Dollar Index (UUP) is currently testing a critical support level between 90 and 91. A break below could prompt a much more aggressive drop. This also has a positive effect on inflation.
The current scenario is the exact reverse replica of the market conditions in the end of the 70s
The stubbornly low inflation seen over the last few years, despite the performance of various economic indicators (such as employment, sentiment indicators, industrial output, GDP, etc.), continues to be one of the key discussion areas in financial media, buoying an extremely bullish view on equity markets. The chart below shows market sentiment reaching the highest bullish reading since 2010. At the same time, the bearish readings fell to the lowest in three years. This obsessive emphasis on equity markets deviates attention from other economic trends, such as the ones explained above.
As stated on the abstract, today's market conditions resemble the end of the decade of the 70s but in the exact opposite way. Towards the end of the 70s, inflation surged to 14.75% (see below). Back in the day, the world was frightened that inflation would continue increasing without control. And no one even considered that inflation could reverse.
In order to crush the inflation surge and cool down markets, the Fed decided to hike interest rates from below 6% in 1976 to 20% in 1979. In a single Fed meeting, interest rates could be increased up to 5 points! (see chart below).
The previous chart reveals a critical aspect for markets today: 1979 was the best time in history to go long bonds and equities, and the beginning of the golden years for the 60/40 portfolio strategy.
However, today's scenario is the exact opposite to the end of the 70s.
- Central banks maintain their extremely loose monetary policies afraid of a hypothetical deflation spiral, whilst fighting a global currency war.
- The Fed's interest rates remain at emergency levels at 1.5% despite an unemployment rate at 4.10% and annualized quarter-on-quarter GDP growth at a 3.2%.
- The ECB's maintains its ultra-loose monetary policy despite strong economic growth. Interest rates remain at 0.00%, and the ECB reinvests all the procedures from the Asset Purchase Programme (QE). However, it has already started to wind down its QE programme and appears to be increasingly hawkish.
- The Bank of Japan continues to increase the size of its balance sheet, although last week, the yen rallied on the back of a reduction on the BOJ's long-term government bonds.
- Norway's and Sweden's central banks have already seen inflation breaking above their respective targets but have decided to maintain the loose monetary policy in order to avoid an appreciation of their currencies against the euro.
Reading between the lines, it could be argued that there appears to be an imminent shift in monetary policies from ultra-loose levels. Exactly the opposite scenario from the end of the 70s.
My hypothesis therefore is that under today's conditions, all-time highs in equity markets, multi-decade highs in bond markets, multi-decade lows in interest rates (in most Developed Countries), inflation starting to build up globally and central banks eventually being forced to normalize monetary policies, the market is perfectly set up for a secular bull market in commodity prices.
How commodity prices benefit from these scenarios
Inflation and commodity prices
I look below at the 12-month correlation between the Goldman Sachs Commodity Index returns year on year vs. CPI year on year official figures. As the chart below shows, the correlation between commodities and inflation remains positive for most of the last 10 years but, more importantly, the correlation is becoming more positive and for longer periods of time than ever since the data for the commodity index started to be collected in the 70s.
Rising inflation is positive for commodity prices under current market conditions.
Fed funds and commodity prices
Commodity prices have historically taken advantage from tightening monetary policies. A paper by Conover et al. (Conover, C., et al. 2010. "Is Now The Time To Add Commodities to Your Portfolio?". Journal of Investing, 19 (3) p.10-19) shows that, during monetary policy tightening cycles, a tactical allocation to commodity indices such as the Goldman Sachs Commodity Index (ETF: GSG, GSP), the Dow Jones-UBS Commodity Index (DJCI), the Bloomberg Commodity Index (ETF: DJP) or the Reuters/Jefferies CRB index increases a portfolio's alpha (excess return vs. the broad market).
(I will write about this, and how to profit from a quantitative strategic allocation that exploits this scenario in my next article.)
Equity markets and commodity prices: relative multi-decade lows
The last indicator I want to speak about in this article, is a well-known chart by Dr. Torsten Dennin, from Incrementum AG, which shows the current relative valuation of the S&P Goldman Sachs Commodity Index (GSG, GSP) versus the S&P 500 (SPY). The chart shows various well-defined super-cycles between equity and commodity markets.
As Dr. Dennin shows, commodity prices currently find themselves at the very bottom of the cycle. I expect it to start mean reverting in coming months.
The current low valuation of commodities, however, should not surprise anyone, since equities have been hitting all-time highs frequently recently, whereas commodities have performed very poorly over the last 5 years. The S&P GSCI fell more than 60% after the financial crisis and, after several years of underperformance, starts to recover now.
Such a long underperformance has only been replicated by one asset class in the past. This asset class was US equities after the 1929 crash. The two charts below show a similar performance between stocks and commodities during their respective crashes.
It is very rare to see an asset class underperforming for such a long period of time. But, historically, those same asset classes tend to outperform in following years. The chart below shows the crash, recovery, and rally of US equities after the 1929 crash.
Commodities appear to be building up a similar setup.
In conclusion, there are several indicators supporting commodity prices over the following quarters and years to come. Commodity prices in general will be buoyed by:
- A synchronised global economic acceleration,
- Higher inflation globally,
- Tighter monetary policies across developed countries,
- An upcoming bond market correction (and even a bear market if rates increase much faster than currently expected),
- Expensive valuations across several equity markets and sectors,
- Low relative valuations of commodities versus all other asset classes.
I would advise investors to look at commodity index ETFs rather than to individual commodities, although this depends on everyone's preferences. The scenario described favors the entire commodity spectrum. Therefore, diversifying away individual commodity risks is an attractive idea.
The two charts below show very attractive entry points in two of the most popular commodity ETFs:
- DJP: iPath Bloomberg Commodity Total Return ETN.
- GSG: iShares S&P Goldman Sachs Commodity-Indexed Trust.
Commodity indices have been showing absolute and relative momentum and strength over the last few months.
Also, as shown below, the current market set up is near perfect after the two ETFs posted respective textbook technical breakouts, once they upheld and bounced back up from strong technical support levels.
The rally has already started.
Disclosure: I am/we are long GSG, DJP, DJCI, GSP, DBC.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.