All Things Reconsidered in the Inflation Debate

By Andrew Musgraves, Product Manager

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…