Investment takeaways from the latest inflation data

Jake Coyne, CFA, CAIA, Investment Director
Willa Sun, Investment Analyst
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All eyes on inflation lately. US headline inflation, as measured by the Consumer Price Index (CPI), hit an eye-popping 9.1% year over year for June 2022, its highest level since 1981. The following month, it fell to 8.5% year over year, aided by some near-term energy price relief and improved supply-chain conditions, and may well have peaked for 2022 — a welcome respite for consumers and businesses feeling the pinch of today’s elevated prices. The US Federal Reserve’s (Fed’s) commitment to raising interest rates has pushed inflation expectations down as well (Figure 1), leading to a pause in the recent outperformance of inflation-sensitive assets.

However, we are not out of the woods by any means. Core US inflation (ex-food and energy prices) remains uncomfortably high at around 6%, with a broad number of contributors across the underlying subcategories. Better-than-expected jobs growth and historically low unemployment have also driven labor costs up sharply. More to the point, we think the structural inflation story 2022 began with is far from over. With that in mind, we believe now may be an opportune time for investors to add real-asset and inflation-sensitive exposures to their portfolios.

Figure 1
investment takeaways from the latest inflation data fig1

What has this meant for real assets?

With inflation expectations down and a global recession now baked into many economic forecasts, natural-resource equities and commodities struggled in June and the first half of July, before rebounding over the last month. We believe the structural supply challenges for these sectors are still in place and will remain important return drivers going forward:

  • Energy: A lower demand outlook, Russia’s ability to continue exporting, and US strategic petroleum reserve releases have put downward pressure on oil prices since early June. But supply challenges may persist, as materials/labor inflation moves marginal costs higher and recession fears further deter volume growth. In the meantime, elevated prices have allowed energy companies to continue returning capital to shareholders.
  • Industrial metals: China’s slow rollback of its COVID lockdowns and ongoing issues in the country’s real estate sector have weakened demand for industrial metals. But increased spending on global infrastructure and renewable energy could help offset some of this going forward, while investment in new metals production remains scarce.
  • Precious metals: Higher real interest rates and a stronger US dollar have been headwinds for gold prices, in spite of today’s lower-growth/higher-inflation macro environment. However, if global growth remains low and central banks reverse course on their rate-hiking cycles, gold and other precious metals could once again serve as a hedge against stagflation.
  • Agriculture: Ukraine’s ability to export wheat and favorable growing weather so far this year have conspired to push grain prices largely back to where they started the year. Yet global grain inventories remain quite low, with volatile weather patterns making future crop yields more difficult to predict.
  • Equities vs commodities: While natural-resource equities were down materially in the second quarter, the commodities themselves held up considerably better. First, while the equities are pricing in lower demand, the commodities are priced based on shorter-term supply/demand dynamics, which remain tight. 1Second, commodities’ “carry” (roll yield) has stayed positive, meaning price appreciation is not needed to earn positive total returns in this asset class.

Why invest in inflation-sensitive assets now?

Our bullish case for inflation-hedging assets has been consistent since early 2021 and is essentially intact as of this writing:

  • Policymakers seem complacent about inflation. The major central banks have undertaken the monetary policy battle against inflation, but they remain well behind the curve with the global economy having become dependent on low interest rates. On the fiscal front, suspended taxes in response to lofty gas prices and much greater spending on renewable energy infrastructure may stoke inflation higher.
  • The supply side of the equation is challenged. Policymakers are focused on reducing demand, but today’s inflation has been fueled in large part by scant supply. Some supply-chain bottlenecks are loosening, but the broad trend from goods to services only shifts stress to the labor supply. Meanwhile, energy and metals producers are not investing in new large-scale projects.
  • Labor and demographics are inflationary. One reason inflation has been so tame for most of the past 20 – 30 years is because the world “globalized” to incorporate low-cost labor sources. But now, there’s no readily available incremental source of low-cost labor, at a time when aging populations globally will likely further shrink the size of labor forces.
  • We see favorable investment entry points. Valuations for many inflation-sensitive assets have come down recently to what we think are attractive levels, making now a potentially opportune time for investors looking to add (or ratchet up) such exposures. In particular, after a decade of underperformance, natural resources and commodities still appear cheap relative to most other risk assets.
  • Inflation expectations are unrealistically low. The gap between actual inflation and inflation expectations is significant by historical standards. This means, for example, that a pullback in headline CPI could still result in an upside inflation “surprise.” For all the talk about inflation these days, current market pricing suggests that inflation over the next 10 years will be lower than the last 10!

1Roll yield is the amount of return generated in a commodities futures market after an investor “rolls” a short-term contract into a longer-term one and profits from the convergence of the futures price toward a higher price.

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