The views expressed are those of the authors at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.
Nick Petrucelli, Portfolio Manager
Jake Coyne, CFA, CAIA, Investment Director
We believe:
Inflation continued to rise above market and Fed expectations in the first half of 2022, persisting at elevated levels last seen in the 1980s. This was contrary to the “transitory inflation” narrative that dominated 2021. Looking ahead, we expect supply/demand dynamics to start normalizing in certain industries, as supply chains heal and less supportive fiscal and monetary policies filter through the economy. In our view, this will reduce year-on-year CPI changes in the coming months.
However, we see three forces in place that heighten the risk that high inflation will be an enduring feature of the economy in the years ahead, making it critical for investors to consider the resulting investment implications.
This inflation backdrop represents an important structural change from the regime investors have been operating in for decades and has significant impacts on asset markets. In a period of persistent inflation, we believe there are three crucial attributes to look for in investments:
In our view, commodities and natural resource equities offer the strongest combination of these attributes and benefit from a positioning tailwind. Investors who fled the asset classes during the 2010s bear market are now starting to reaccumulate exposure as they find their portfolios poorly positioned for the new economic environment.
On a multiyear time horizon, fundamentals for these assets also appear strong. Most natural resources have five-plus year supply cycles leading to prolonged upward or downward cycles. With capital expenditures having dried up following the bear market, we are now starting to see the impact as production stagnates. Meanwhile, fossil fuel demand will likely take many years to replace and building out renewables will be highly energy- and material-intensive. So far, producers are not materially raising production guidance in response to higher prices, policy is not changing in a manner to incentivize production, inventories are low across the commodity complex, and spare capacity is being eliminated. For instance, OPEC will be at full production later this year and the US’s Strategic Petroleum Reserves will have drawn down, leaving little buffer for oil markets.
The Russia/Ukraine war has further added pressure as significant crude oil and products have come off the market, grain supplies have been put in question, and high energy prices in Europe have closed many energy-intensive industries, such as fertilizer plants and metals smelters. In our view, it appears we will need a prolonged period of high prices or a severe recession to balance commodity markets.
In addition to these favorable supply/demand fundamentals, we also see potentially attractive near-term investment opportunities in these asset markets. These are even absent further commodity price appreciation in the future, as we believe the markets are pricing in significant downside already. For example:
Furthermore, we see investment opportunities in other asset markets if inflation persists in coming years. Notably, we think it’s worth considering the potential headwinds these assets may face if interest rates continue to rise.
Today’s investors are potentially witnessing a regime change to an inflation environment we have not seen in decades. In our view, it is critical to prepare portfolios for the risk of persistently heightened inflation by considering which assets are best poised to navigate this market. For now, we believe the commodity-related complex is the inflation hedge to emphasize, though a diversified implementation of various inflation hedges may provide more consistent performance as the cycle evolves.
Juhi Dhawan, PhD, Macro Strategist
Inflation is the top concern of policymakers around the world as consumers and companies struggle with the effects of soaring input costs and severe supply disruptions. Supply-chain bottlenecks have become a mainstream topic and hopes for “normalization” have repeatedly been put on pause since the COVID outbreak. In this note, I consider the cyclical outlook (the next 6 – 12 months) as well as the enduring economic shifts that could result from these disruptions.
In the second half of this year, I expect to see inflation, which is extremely elevated, begin to decelerate — and a key component of that change will be reduced supply-chain pressures. From a goods-economy standpoint, slowing consumption and growing production imply that inventories are being built again, and in response, steep price increases should adjust to more modest levels. In the service economy, on the other hand, spending is likely to rise this year and, given the tight labor market, inflation may be stickier. As I discuss here, all of this has implications for consumers, a range of industries, and the Federal Reserve (Fed). It also raises the question of how companies and governments are addressing the issue of building resiliency in supply chains for the medium term. These efforts may ultimately prove to be an antidote for anemic global growth.
The unusual environment in 2021 was a byproduct of significant fiscal and monetary stimulus, but also a misalignment in the goods and services economy because of COVID. People had money in their pockets, thanks to policy support, but they couldn’t spend it on travel, recreation, and other services. Instead, they spent it on goods. That created a surge in goods demand just as factories in Asia and elsewhere were struggling to respond with more supply, as a result of stringent COVID policies, rising infection rates, and other factors. The end result was supply-chain bottlenecks, which have contributed to the fear among many today that there is no end in sight for high inflation.
But there are a number of signs that conditions are improving, including a sharp decline in the Supply-Chain Bottleneck Indicator, a metric I developed to gauge price pressures as companies were struggling with backlogs and input costs (Figure 1). In addition, consumption of goods is likely to decelerate from its torrid pace as consumer priorities shift toward consumption of services that were previously not available. Rising interest rates, which tend to hurt durable goods spending disproportionately, will further the demand adjustment and supply will rebalance as a result. I expect this will begin to show up in inventory-to-sales ratios. Already there has been some improvement in areas like general department stores, with inventories rising to “above normal.”
Meanwhile, freight costs have seemingly topped out and the relentless backup of ships in US harbors seems to have peaked, though it remains elevated. The pace of US import growth has also slowed, suggesting that a catchup will occur, especially if goods demand continues to dip. If more product is unloaded in areas where demand has cooled, it is likely that discounting will occur and price gains will not only slow but will, in some cases, decline in order to clear inventory.
Among the areas most affected by supply-chain bottlenecks was the automotive industry, which single-handedly added 200 basis points (bps) to the CPI in 2021. Encouragingly, auto production has been rising since the fourth quarter of last year, although progress has been spotty given shortages in the chip industry as well as the impact of the Russia/Ukraine conflict on the availability of certain parts. Inventories are still below average in the US, but I think we’re seeing things begin to turn. This is feeding into used car prices and leases, where price gains are slowing sharply. Ultimately, auto industry experts believe normalcy will return in 2023, but we will be left with a stark illustration of the complexity of supply chains and the potential for disruptions to hamstring production.
As noted, I expect that inflation will be more persistent in the service economy in the near term. Take the housing market, for example. Shelter is the single biggest component of the Consumer Price Index (CPI) and has a fairly large weighting in the Fed’s preferred Personal Consumption Expenditures (PCE) core measure of inflation. Past increases in rent and prices mean this component will rise through much of 2022.
The good news is that there are more new homes and apartments under construction than at any time in the last 45 years (Figure 2) and we are approaching a point where that should mean rising home completion rates. In addition, the Fed’s rate hikes are having the intended direct impact on housing demand, with sales declining meaningfully as rising rates deter buyers. With demand cooling and supply improving, I expect house price gains to slow this year and rent gains to stabilize and eventually slow, though likely not until 2023.
As for the inflationary impact of the tight US labor market, there are some reasons for hope. Last year, I estimated that five million “missing workers” could reenter the labor market as the economy reopened. As of June 2022, we were only about a half million jobs below the pre-pandemic peak. There have been recent signs that some older workers are returning as the pandemic recedes, and there is room for some improvement among immigrants, mothers with young children, and workers who hold multiple jobs.
Continued employment gains in childcare and nursing care, which remain well below pre-COVID employment levels, could help bring more workers back. It’s also notable that demand for temporary work visas is two to three times normal. A decision by Congress to allocate these visas in a timely fashion could make a meaningful difference, as could new STEM student visas proposed by the Biden administration.
I think this backdrop leads to several key takeaways:
I think the challenges we’ve seen during the pandemic, which were exacerbated by the Russia/Ukraine conflict, will drive the US, as well as other countries, to build more resilience into supply chains. To date, there has been a “just in time” approach, with goods ordered only as needed, to achieve cost efficiency. But over the past two years, we saw this approach falter.
Consequently, I think we’re witnessing a shift to a “just in case” approach, including a willingness to carry more inventory and to diversify supply chains with regional hubs. We could also see countries take a more strategic approach to supply-chain management — as in the case of the semiconductor issue, where we see US policymakers thinking about ways to boost US manufacturing capacity. “Critical supplies” onshoring is possible in strategic areas such as health care and smart technologies, for national security purposes. Rising geopolitical tensions, including Middle East tensions, have also raised the stakes for companies in terms of their geographical footprint and ability to ensure the security of critical inputs. “Friend-shoring” of new facilities is another area for companies to consider. It is imperative that government policy focus on issues such as port congestion and the availability of “last mile” transportation to complement the work being done by corporations.
On the labor market front, overreliance on cheap labor in China or Asia more broadly is likely being reconsidered. Companies are also seeking new ways to scale production, looking for alternative sources of labor, and focusing more on the human element of the decisions they make.
Several other factors indicate that corporate supply chains will continue to evolve. The focus on sustainable investments is forcing a rethink of physical risk related to water shortages, hurricanes, and other factors, suggesting a drive for more geographic diversification. In addition, the accelerated move toward automation is changing the types of inputs companies will have to source from their suppliers for future production. Both of these factors add to the need for companies to reevaluate suppliers, understand all the links in a vertically integrated process (instead of relying on outsourcing of operations to suppliers), and consider regional hubs of production as well as diversification of inputs.
Critically, the Russia/Ukraine conflict put the spotlight on the need to plan for energy and food security. This is especially true in Europe, which has been hardest hit by the crisis, but is evident in other countries as well. The coming decade could well see the unleashing of a capital expenditure cycle led by government spending in these areas of strategic importance. This could be an enduring shift that lifts nominal growth in many parts of the global economy where it has been weak for a long time. This, in turn, would imply somewhat higher interest rates over time.
I believe the macro impact of supply-chain reorganization will last for many years, creating uncertainty and a variety of winners and losers at the country and company level. For example, I think the potential winners could include:
On the other hand, the potential losers are likely to include:
In aggregate, profitability could be negatively impacted with companies needing to find alternative sources of efficiency gains rather than relying on previously cheap input costs. While cyclical pressures should bring goods prices and aggregate inflation lower in coming months, it is worth considering whether a shifting geopolitical landscape means the end of the deflationary forces that prevailed for a prolonged period before the pandemic.
Finally, the repeating nature of these disruptions will bring forth government intervention. Active government policies on climate change, energy and food security, health management, national security, transport, and labor force development are likely to be themes that resonate over the coming decade.
David Chang, CFA, Commodities Portfolio Manager
Joy Perry, Investment Director
Our commodities outlook for the balance of 2022 is strong. We expect tight cyclical conditions to be inflationary and therefore supportive of the asset class in the near to medium term. Low existing inventories and additional supply disruptions caused by the war in Ukraine and China’s zero-COVID policy during the first half of the year, coupled with sustained commodity demand, are supportive of futures curves and continue to put upward pressure on prices in the near term.
Given the strong rebound in commodity prices over the past year, many investors wonder if it’s too late to invest in commodities. We think not. The structural environment is supported by strong tailwinds, including the low-carbon energy transition, potentially long-term sanctions on Russia, and regionalization of supply chains. While the opportunity in commodities is structural, the risks are mostly cyclical. The primary risks today revolve around the potential for continued lockdowns in China, a severe recession in Europe, and aggressive central bank tightening, especially in the US. An imminent supply response, notably from OPEC or shale producers, is possible, but so far shows few signs of materializing.
Commodity inventories, in aggregate, are the lowest since the early 2000s and have been falling as the fastest pace in nearly 20 years (Figure 1). At the same time, production responses continue to be slow and commodity demand has rebounded amid the waning pandemic.
Low inventories are supporting futures curves, with one-year implied roll yields positive for a wide range of energy, materials, and agricultural commodities (7%, annualized, for the aggregate Bloomberg Commodity Index as of 31 March 2022). Importantly, strong roll yields mean investors can be patient. Unlike the past decade, commodity investors are not currently paying a cost for holding an inflation hedge.
The effects of Russia’s invasion of Ukraine will continue to be felt broadly across the commodities complex. The war has contributed to the spike in energy prices, with Brent oil moving from US$79 per barrel in January to US$130 per barrel in March, before settling at about US$110 at the end of June. Notably, this increase has not yet been sufficient to trigger demand destruction; today, we do not expect oil demand to drop off until approximately US$200 per barrel. Unfortunately for consumers, gasoline and diesel prices are the highest they’ve been in many years, leading governments to scramble for solutions, including releasing supplies from strategic petroleum reserves to put a damper on further price increases. The war is pressing other commodities higher as well. Russia is the world’s second-largest commodity exporter, behind the US. And with Russia and Ukraine both major global suppliers of corn and wheat, a food crisis later this year is not out of the question, given the slowdown in agricultural exports from the region.
Exacerbating the cyclical tightness are structural conditions that could sustain the trend of commodity cost inflation. Low prices over the past decade disincentivized production investment, limiting supply growth and resulting in low spare capacity. While capital spending has risen year to date, it is mostly being offset by cost inflation. Labor costs are increasing, and the price spike in energy — which is an input to the production of all other commodities — is creating generalized inflation across the asset class (Figure 2).
Structural dynamics that could support continued commodity inflation include sanctions on Russia, deglobalization, the energy transition, and climate change:
Tom Levering, Global Industry Analyst
Tim Casaletto, Global Industry Analyst
We expect that ongoing supply-chain disruptions, rising energy costs, and structural shifts will continue to be inflationary, presenting headwinds for economic growth. Listed infrastructure can potentially help investors hedge the effects of inflation, mitigate cyclical volatility, and position portfolios to take advantage of structural growth themes.
We believe investors should consider establishing targeted exposure to global listed infrastructure assets, as these businesses are typically well positioned to cushion the impact of inflation on investment returns. Many of these assets are monopolies or oligopolies that earn returns above their cost of capital with little or no competition. This is particularly true for a segment of the market we call enduring assets.
These are long-lived physical assets such as electrical utilities, data infrastructure providers, and transportation infrastructure assets that feature stable income flows and some regulatory or contractual protection. The companies that own these assets tend to benefit from strong competitive positions and low sensitivity to economic cycles and commodity price swings. Given the twin secular themes of energy-sector decarbonization and global infrastructure investment, we believe investments in these infrastructure assets can be constructive in the short and longer term.
As investors weigh tactical repositioning of their portfolios for inflation, there are a few details to keep in mind. Some listed infrastructure companies enjoy explicit protection from inflation. Many regulated European utilities, for example, are allowed to maintain returns at a given spread above their region’s inflation rate. In other instances, the link between inflation and tariffs charged by a company is implicit: As costs increase, companies can maintain a predetermined level of return by raising prices and passing inflation-related increases in operating expenses on to customers. (Longer term, if inflation were to stay persistently high, regulators could increase allowed returns in future rate reviews, which typically take place every two to five years.)
Many other forms of infrastructure also tend to have inflation-protecting characteristics. Most toll roads can increase tariffs by some percentage of inflation. Owners of storage and transport logistics for oil and gas (so-called energy midstream assets) tend to correlate well with inflation given their energy-related exposure. Cable and data infrastructure providers often have competitive advantages that allow them to pass higher prices on to their customers. So, while these enduring assets do not protect portfolios from inflation surprises as directly as a commodities portfolio might, they may offer a more stable return pattern and potentially a higher real return above inflation over the medium to long term, which, in our view, makes them an attractive addition to an inflation-aware portfolio.
With regard to rising interest rates, a sharp, unanticipated increase would likely be a short-term headwind. However, as with inflation, associated costs (that is, interest expenses) should ultimately be passed through to consumers, and over time as nominal rates increase, regulated utilities should earn a return spread over the interest rates. In this way, the interest rate hedge is built in.
As with commodities, amid strong relative performance versus broader equities for infrastructure assets over the past 12 months, many investors wonder if growth has already been priced in. In the near term, we believe these assets have room to run, especially if equity markets remain challenged. Looking further out, we believe two secular themes eshould drive this market segment over the long term.
The first secular theme is the global energy transition and governmental support — most notably in the US, European Union, and China — for decarbonization. As the world moves to electrify the economy, demand for electricity will rise. As Figure 1 shows, if governments honor their carbon emissions reductions in line with net-zero commitments, the world will consume 70% more electricity in 2040 than it did in 2020.
Countries around the world will need to invest in their electricity grids, expand renewable energy capabilities, and modernize and decarbonize transportation infrastructure. Investments that are integral to the energy transition, including power networks, clean-power generation, and low-carbon energy and transport solutions, should provide strong growth and multiyear investment opportunities.
Today, the war in Ukraine rages on, accelerating Europe’s efforts to reduce its structural dependence on Russian energy supplies by stepping up investments in renewable energy and energy-efficiency solutions. European utilities will need to triple wind and solar capacity and increase investment in their electric networks in order to produce enough energy and eliminate the need for Russian oil and gas imports. Grids must be modernized to handle more renewables and improve international interconnections; investments in natural gas infrastructure and green hydrogen will also be necessary. Given these near-term pressures, the secular decarbonization trend, and an expected decade of massive need for clean energy investment, we expect the low-carbon transition to accelerate and remain inflationary for some time.
The second secular theme is investment in data infrastructure. Ever-increasing demand for data, coupled with governmental support for modernization and capacity expansion, should propel the development of cell towers, broadband networks, and mobile telecommunications systems. As a category, these businesses are generally stable, have solid growth prospects, and valuations that we continue to find attractive. Here again, listed infrastructure companies could feature above-average earnings-growth rates for decades to come. We believe there is plenty upside left given future growth potential and the supporting long-term tailwinds from decarbonization and data infrastructure investment.
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