Inflation and the coming commodity super-cycle

In December 2020 I published the article, “The Coming Inflation Tsunami and How to Protect Your Portfolio,” warning that inflation could burst forth suddenly and with force, that it would have devastating effects on investor wealth and that exposure to commodity futures represents the best possible hedge against inflation. At the time, the feedback from most investors by far was overwhelmingly dismissive, citing a variety of reasons, most often these:

• Hey, we’ve had QE for over 10 years and there’s no inflation anywhere in sight;
• We’re in a recession, how could inflation possibly emerge?
• Unemployment is high, how could labor costs increase?
• Central bankers are still struggling to ignite inflation, they might try exceeding the 2% target and then hit it ‘from above.’

Later the “transitory” inflation did emerge. By today the Fed and other central banks really did give themselves ample maneuvering space to hit that inflation target from above. From how high exactly, or how soon they’ll ultimately hit it, nobody can predict.

My own concern is that things could get a lot worse before they get better; the M2 money supply has been growing at an average clip of nearly 19% per annum for two years now while in the inflationary 1970s it never exceeded 13.8%!

As a reminder, through the decade of the 1970s inflation averaged 9%, but investors lost 65% of their wealth in real terms (based on the performance of a typical 60/40 stocks/bonds allocation).

Today we can’t rule out the possibility that our present, transitory inflation will be worse than in the 1970s. So what to do? For sure, investors should take bold action to protect their portfolios, and there aren’t very many good alternatives. Contrary to popular opinions, stocks on the whole are not a good inflation hedge. Gold and Silver will eventually shine through and should certainly be considered. Farmland is another viable option. Prior to 2021 I would have suggested Bitcoin as well, but at current prices I’m no longer as convinced. But one asset class trumps all other when it comes to inflation hedging…

The best hedge: commodity futures

As a currency’s purchasing power declines, the prices of real stuff that people use in their daily lives will rise, particularly energy, metals and agricultural commodities. This common sense idea is also supported by much empirical evidence.

For example, in the paper titled, “Assessing Managed Futures as an Inflation Hedge Within a Multi-Asset Framework,” published in the Journal of Wealth Management (April 2011), the authors concluded that, “Managed futures outperform the other asset classes… No other asset class presents itself as a viable inflation hedge.”

Their finding corroborated an earlier Alliance Bernstein’s research which found that “managed futures” (i.e. exposure to commodity futures prices) had the highest inflation beta of all asset classes:

Well, commodity prices have been rising lately (though not yet Gold and Silver), providing yet another corroboration of their merit as an inflation hedge. Recent research from Deutsche Bank’s Jim Reid also suggests that this time could be somewhat different: the current commodities cycle has so far been the strongest on record, eclipsing all of the previous 20 cycles since 1914 , as the following chart shows:

Commodity futures double up as a portfolio diversifier

Commodity futures provide investors with another benefit: as a portfolio diversifier. If the current stocks and bonds bubbles burst they’ll take most of the asset classes with them and there will be few escape routes for investors. However, commodities have not seen the inflationary effect of QE over the last decade and they’ll probably not collapse when bubbles elsewhere do.

A mere reversion toward “normal” valuation levels may present an attractive investment opportunity in its own right as well as a real means of diversification just when this is most urgently needed. Adding exposure to commodities like energy, metals and key agricultural commodities should be among the most compelling investment alternatives for the decade of 2020s.

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