You can’t go to a coffee shop without hearing about inflation. In a simple sense, it is affecting everyone. While 2-3 years ago, even mentioning it brought blank stares of bewilderment, it is a reality and brings on many opinions ranging from frustration to sadness, to political rage. While commonly tied together and for good reason, commodities are back in the mainstream. Everyone is an expert yet few have experience nor much exposure as a hedge in their lives nor portfolios. At the very least, the “transitory” excuse has faded, and we are having to deal with reality as consumers and investors beyond the central bank façade – they were indeed living in the clouds of Ottawa and Washington.
We can’t change the past, but we can plan for the future. As such, lets explore three things: 1) The relationship between commodities, currencies and inflation, 2) Central bank solutions, 3) Are you too late?
Commodities, Currencies and Inflation
While commodities and inflation are talked about in one breath, consumer inflation and commodity prices are related but different. Consumers buy manufactured goods, not direct commodities. Consumers don’t buy cotton, they buy clothing with a cotton blend. They don’t buy crude oil, they buy gasoline, a manufactured and heavily taxed refined product. You don’t buy corn, you buy processed, even if organic, foods.
Now this isn’t to say that underlying commodity prices aren’t affecting prices at the pump or the grocery check-out, they are. However, commodity prices are more volatile than the common measure of inflation, the Consumer Price index (CPI). They aren’t a direct one for one relationship.
Yet, this round of inflation really snuck up on both the consumer and investor for many reasons. Principally, it was “unexpected inflation”: central banks weren’t talking about it, nor were investment advisors, or even many institutional investors. In fact, commodities were a forgotten asset class that nobody cared about - just ask the team at Auspice – one of Canada’s few commodity focused managers. Even as COVID hit and commodities began to rally in mid 2020, the majority of experts were calling it transitory. We laughed – everything is transitory if you look over long enough time frame.
Most experts believed that a strong US dollar created too much of a headwind given commodities are typically priced in US dollars. This conventional wisdom, while intuitive, is wrong. Many have fallen into this trap and recent experience highlights the error - a low US Dollar is not needed if there is a systemic problem – and there was a systemic issue where resource CAPEX had peaked and been falling since 2012.
Source: S&P Global Market Intelligence
Following 2000s commodities boom, capex on commodity infrastructure has been in significant decline.
Further proof: commodities currencies such as Canadian and Aussie Dollars have not strengthened much since the commodity rally started in 2020. The US dollar strength since COVID hit in 2020 may be a surprise alongside commodity gains, however history tells us that the same strength has occurred alongside central bank (US Fed) tightening to start the 1970’s – with similar weakness showing up in equities as we have seen to start 2022.
The US Dollar and commodities have appreciated since 2020 with a particularly strong US Dollar and commodity rally since 2021.
What commodities have been is a leading indicator, given prices respond quickly to economic shocks that increase demand and systemic shocks, whether temporary or long lasting. This makes commodities a great hedge. But what happens next?
Can the central banks solve this problem?
Central banks focus on economics.
Central banks are raising rates, as they did in the 1970s to cool consumer demand. “Demand-Pull” inflation exists when widespread consumer demand with “too many dollars” are chasing too few goods. There is a chance raising rates will slow consumer driven demand and this type of inflation.
However, central banks have less effective (read none) policies for “Cost-Push” inflation - the type of inflation when prices increase due to wages and/or underlying raw materials (i.e. commodities). It is very difficult to stop, especially if due to a structural lack of supply, as we have now. Thus, the central banks’ efforts to slow consumer inflation by raising rates will not likely change the structural problem of input commodity prices…in fact it may exacerbate it.
While typical measures of inflation may settle from their current lofty levels, that doesn’t mean commodities will necessarily soften. In fact, we don’t think they will and there will be no soft landing for the economy nor stock market focused investors – those without real commodity diversification.
Notably, from 1970 to 1980, US Fed Fund Rates went from 3% to over 20%. This didn’t stop CPI/consumer inflation - it wasn’t until the 1980s when the commodity cycle rolled over and the economy was in shambles. From 1980 to 1983, CPI dropped massively while commodities softened – but not likely due too the Fed raising rates as correlation does not equal causation.
It took over a decade of US Fed Fund rate hikes, culminating at over 20%, before US CPI and inflation finally reversed its two-decade increase.
Are you too late to participate in the commodity cycle?
We surely don’t think so – here is why:
Commodity cycles are typically long, 10 plus years. We believe commodity “supercycles” have two basic ingredients – 1) an extended period of underinvestment in supply and 2) a generational demand shock. Today we have both and this just may be the start.
In addition to these basic ingredients, we believe that there are a host of other factors, depicted below, that exacerbate this cycle’s potency and longevity. The “green transition” has caused a commodity demand shock due to post COVID “build back better” infrastructure spending in both developed and emerging markets. It is inherently inflationary. Global governmental policies are no longer conducive to resource infrastructure development. Along with an ESG focus that makes the process more expensive, the goal of decarbonization is inherently inflationary until technology catches up. On top of this, rising unionization and “stakeholder capitalism” surely doesn’t encourage investment.
The two basic ingredients required for a commodity supercycle are an extended period of underinvestment in supply, and a generational demand shock. Today we have both.
Beyond the costs of “greening” our infrastructure and economy, rising rates and supply-chain complications further complicate the sector while the pending re-opening of a top economic superpower (China) may indeed be bullish. On top of all these factors that all existed as we started 2022, the tragic war in Ukraine by a megalomaniac Russian leader is not a problem quickly fixed – the effects are likely long lasting and further enhance a pre-existing cycle.
Moreover, if by miracle, supply magically catches up, we believe the shear unknown of all these factors create a volatile (and opportune) market for commodity trading for some time. Commodity and other asset volatility is likely to be “normal” going forward, that is to say much higher than the malaise that accompanied the stock market rally from 2010 to 2019. That was an artificial environment, not normal, driven by central bank QE. It is unlikely we will go back to low to no rates, zero inflation, and the resulting low volatility driven stock market. Very unlikely.
This is a generational opportunity
While central banks focus on economics, investors have some other options. Though few have commodity experience or perhaps have even invested in a commodity directly (sorry resource equity is not the same), there are products and expertise available to retail and institutional investors alike. With a professional investment path starting in the mid 1990s, the last time commodities were “called-out and forgotten”, Auspice has a 25 year plus experience base to draw from and 16 years of track record as an independent money manager.
Please contact Auspice for guidance.
IMPORTANT DISCLAIMERS AND NOTES
1. The S&P Goldman Sachs Commodity Excess Return Index (GSCI TR), is a composite index of commodity sector returns representing an unleveraged, long-only investment in commodity futures that is broadly diversified across the spectrum of commodities. The GSCI Total Return (“TR”) Index includes the return on cash collateral.
Futures trading is speculative and is not suitable for all customers. Past results are not necessarily indicative of future results. This document is for information purposes only and should not be construed as an offer, recommendation or solicitation to conclude a transaction and should not be treated as giving investment advice. Auspice Capital Advisors Ltd. makes no representation or warranty relating to any information herein, which is derived from independent sources. No securities regulatory authority has expressed an opinion about the securities offered herein and it is an offence to claim otherwise.
For U.S. investors, any reference to the Auspice Diversified Strategy or Program, “ADP”, is only available to Qualified Eligible Persons “QEP’s” as defined by CFTC Regulation 4.7.
For Canadian investors, any reference to the Auspice Diversified Strategy or Program, “ADP”, or Auspice One Fund “AOF”, is only available to “Accredited Investors” as defined by CSA NI 45-106.