Look out for abundant money supply, increasing velocity of money, higher breakeven inflation rates in bond markets, a weaker dollar, higher commodity prices and backwardated commodity futures curves.

The threat of inflation has not been top of mind for many investors for some time, and understandably so. Over the past four decades, inflation has been subdued for a variety of reasons—globalization and competition, the information technology revolution, cheap labor supply from developing economies, adverse demographic trends and global savings gluts, to name just a few.

Lately, however, we are seeing some shifts in macroeconomic trends that make us think a more inflationary environment may be around the corner. We want to remind investors what to expect when you’re expecting inflation, and why we believe it represents such a favorable environment for investing in commodities.

The Inflation Equation

Inflation requires two things: money supply and money velocity.

We know we have the first part of the inflation equation, money supply. In response to the global coronavirus pandemic, the past 12 months have seen central banks around the world pump massive amounts of liquidity into the market. Even relative to the quantitative easing programs of the post-financial crisis era, this creation of money by central banks was unprecedented. On top of that, many governments around the world have provided direct fiscal payments to their citizens in a way not seen in our lifetime. Add all of this up, and you get the remarkable growth of the money supply shown in figure 1.

Figure 1. Recent Exponential Growth in Money Supply

Source: Bloomberg. Data as of December 31, 2020. For illustrative purposes only.

So far, however, much of that money has been sitting idle in bank accounts. It appears we are still missing a pickup in the velocity of that money—that is, the frequency with which each unit of money gets exchanged for goods or services in the economy.

When the threat of the pandemic subsides, economies re-open and we become mobile again, we believe that pent-up demand will be released, boosting spending. The big upside surprise in January’s U.S. retail sales suggests that some of that consumer confidence is already returning. As the rate of spending builds, all of that extra velocity will likely create inflationary pressures.

But don’t just take our word for it, bond markets have also started to anticipate potential inflation. Over the last few months, we’ve seen both the five-year breakeven inflation rate and the five-year, five-year forward breakeven inflation rate grind up steadily.

Figure 2. Recently Markets Priced for Higher Inflation

Source: FRED. Data as of February 3, 2021. For illustrative purposes only.

Poised for a Comeback

A more inflationary environment could also set the scene for a comeback by commodities.

Because they are tangible, real assets, often with inelastic and ultimately finite supply, the price of commodities tends to rise with inflation. As figure 3 shows, the Bloomberg Commodity Index has historically moved in line with U.S. Consumer Price Index (CPI). This is why commodities are often used by investors as a hedge against inflation. Commodities have generally been a reliable hedge for surprises in inflation, the component of inflation that doesn’t get priced in traditional assets. In our view, this is because many important commodities are directly represented in inflation baskets, whereas real estate rents and index-linked bond principal values take time to re-set, companies may see profits squeezed if they are unable or unwilling to pass rising costs immediately onto their customers and, during times of uncertainty, investors may price higher-risk premiums into traditional assets.

As we can see, commodity prices have already risen along with the recovery of consumer prices since the height of coronavirus crisis.

Figure 3. Commodity Prices Have Correlated With Inflation

Year-over-year change in the Bloomberg Commodity Index and the Consumer Price Index for All Urban Consumers: All Items in U.S. City Average

Source: Bloomberg. Data as of January 31, 2021. For illustrative purposes only. Nothing herein constitutes a prediction or projection of future events or future market behavior. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.

The second reason an inflationary environment has often been positive for commodities is that their prices tend to rise when the U.S. dollar weakens—and global inflationary dynamics have tended to coincide with a weaker dollar. Over different time periods, we’ve observed that, independent of sector, commodities have been negatively correlated with the dollar (figure 4).

Figure 4. Commodity Price Correlation With the U.S. Dollar, December 1990 – January 2021

Source: Bloomberg. Data as of January 31, 2021.For illustrative purposes only. Correlations are measured with the DXY Currency Index relative to Bloomberg Commodity Sector Indices.

We believe this is partly due to the simple fact that most commodities are traded and priced in U.S. dollars, and partly due to the complex interplay between the dollar and global inflation dynamics. Real interest rates are already negative across the U.S. yield curve, and rising inflation in an environment of accommodative monetary policy is likely to sustain those negative real rates. That in turn suppresses international demand for U.S. dollar-denominated assets, especially fixed income assets.

A weakening dollar and rising commodity prices can also create a feedback loop. Abundant, cheap dollar financing helps to spur global trade, which tends to favor exporting and often commodity-based emerging economies. The rising dollar-denominated trade surpluses in those countries are quickly lent out to create local credit expansion, which further increases demand for raw materials. The widening growth gap between these economies and the U.S. incentivizes further dollar flows out of the U.S. and into global trade.

At the same time as demand is rising, supply can become more constrained, because commodity producers and miners receiving U.S. dollar revenues while paying wages and other costs in local currencies tend to reduce capital expenditure or raise local commodity prices to maintain their cash flows. Over the past decade, a stronger dollar made the local costs of production cheap, enabling the strongest producers to maintain supply and suppress prices in order to eliminate weaker competitors. By contrast, a weakening dollar takes away the luxury of being able to maintain low prices to gain market share.

Risk and Roll

The two further reasons why we anticipate a comeback for commodities are indirectly related to the inflationary dynamic.

The first is to do with the recovery in investor risk sentiment. Today’s market consensus appears to be for a weaker dollar, higher bond yields and breakeven rates, a benign credit environment and in favor of more cyclical sectors and regions over defensive positions. With that backdrop, any extra cent that finds its way into financial markets will likely make its way to risky assets—including commodities.

We think that investor demand will grow in anticipation not only of commodity prices increases, but also in anticipation of higher roll yield from futures contracts, regardless of market direction. This is because the shape of the futures curve—downward-sloping (backwardated) or upward-sloping (contangoed)—is a reflection of inventory dynamics and scarcity in commodities.

When investing in commodities, we want to focus on commodities with positive roll yields (backwardated futures curves) and avoid commodities with negative roll yields (contangoed futures curves). While we don’t know which commodities are going to be backwardated and contangoed in the future, we do see that inventory conditions for most commodities tend not to change much over time; we tend to see trends—“sticky” backwardation or contango regimes.

Recently we’ve seen more commodities move into backwardation, to the extent that the Bloomberg Commodity Index as a whole has started to deliver a positive roll yield (figure 5)—and we believe this new regime could stick around for a while. In terms of inventories and scarcity, widespread backwardation suggests that, on average, we are chewing into existing inventories rather than producing more: these are the commodity supply-and-demand dynamics that lead to inflation.

Figure 5. Commodity Futures Curves Have Recently Swung Into Backwardation

Source: Bloomberg. The “slope” of a futures curve is here represented by the percentage difference between the prices of the nearby contract and the one-year contract, in order to look-through seasonal fluctuations in the curve. We then use the weighted average of all of the commodities represented in the Bloomberg Commodity Index at each point in time to calculate a “slope” for the Index as a whole.

In sum, we believe that global fiscal and monetary stimulus, the potential for U.S. dollar weakness and supply-and-demand balances all point to an opportune time to invest in commodities.

Compared with other assets that are considered to be inflation hedges, such as equities, Treasury Inflation Protected Securities (TIPS) or real estate, commodities are attractively valued after years of sluggish economic growth and being out of favor with investors, and they do not exhibit interest-rate sensitivity. We think now is the time to favor commodities that are geared to global economic recovery and can generate potential positive roll-yield income. Longer-term, we also believe that a commodities allocation, particularly one that is actively managed, can be useful for gaining exposure to the industrial and precious metals that are critical for the infrastructure of the future green economy.