The fiscal and monetary policy decisions that were necessary to mitigate the impact of the COVID-19 have led to inflation at levels unseen for 40 years. In response, central banks have adopted a notably more hawkish tone. We think this marks an inflection point, from the moderate growth and low inflation of the past 20 years to a period of “sticky” higher inflation, and potentially a less favorable growth-inflation mix.
These economic conditions are meeting fragile financial markets. Both stock and bond valuations are stretched and vulnerable to rising rates, which suggests that investors need to question whether portfolios are genuinely diversified. The volatility and tight stock-bond correlation that has characterized the opening weeks of 2022 is likely to persist, in our view.
Commodities: The New Diversifier
To prepare, we advise investors to pair defensive portfolio tactics with offensive strategies tailored to the new conditions. When inflation upside has become the key risk, one refuge could be store-of-value assets such as commodities.
Commodities are an offensive diversifier in the sense that, historically, when inflation became a threat, they reliably outperformed all other major assets. But they are also defensive: in months when both stocks and bonds have sold off, on average they have added significant value—a potentially useful characteristic in our new regime of tighter stock-bond correlation. They have tended to perform exceptionally well during “inflationary-bust” or “stagflation” scenarios, when growth disappointed: our new regime may combine a growth slowdown with sticky inflation as monetary and financial conditions tighten.
Commodity Supply and Demand
We also think supply-and-demand dynamics support commodities.
Few commodity producers are investing. After a decade long losing streak, many investors are selecting CEOs who are focused on returning capital, while punishing the stock prices of those who do not comply. The growing momentum behind net-zero emissions policies and environmental constraints in general further disincentivize capex. There are no more subsidies and no more lucrative drilling and mining permits.
At the same time, demand is likely to be boosted by fiscal policies aimed at mitigating inequality. Poorer citizens’ consumption is more focused on commodity-intensive goods and services. In addition, while the path to net zero may weigh on fossil-fuel capex, creating the electric vehicle fleets of the future, building the infrastructure to support the electrification of mobility and the wider economy, manufacturing wind, solar and other renewable energy infrastructure, manufacturing batteries—this is all extremely commodity-intensive. Perhaps copper will be the new oil, the new strategic commodity for the next few decades.