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Are commodities an inflation hedge or the opposite?

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Seems we’re at the stage of the sell-off where analysts turn Homeric. Here’s the latest from Goldman Sachs’ commodities desk:

Macro markets today are facing a navigational challenge worthy of Odysseus. In the Greek myth, Odysseus chose to risk his ship by sailing close to the rocks of Scylla rather than risk being pulled under by the whirlpool Charybdis. In our view, policymakers are trying to navigate between the Scylla of high physical inflation today, and the Charybdis of supply constraints that could slow future growth. While it appears that much higher rates are needed today to lower demand and inflation, they may also drive a fall in capex and investment that will prolong the structural undercapacity in physical commodities and hence this environment of high headline inflation and lower growth throughout the 2020s.

We believe that promoting higher investment in capacity – and bearing Scylla’s cost of higher physical inflation today – can policymakers avoid the Charybdis of stagflation.

As in the myth, staying close to Scylla’s cave is mild as Odysseus would suffer minimal damage (ie keeping rates lower, leaving prices higher to drive investment); however, if his ship is sucked down by Charybdis (a decade of stagflation after high rates kill off the capex cycle), he would lose his entire ship. It is important to emphasise that policymakers can solve the core inflation problem without entirely fixing the headline inflation problem given the importance of persistent wage inflation in driving core inflation.

Goldman’s commodities team concludes that Goldman clients should buy commodities. A decade of under-investment in carbon extraction means the complex “can still generate returns even should core inflation return to more normal levels”, it says:

Investors should remember that Fed-induced slowdowns are simply a short-term abatement of the symptom – inflation – and not a cure for the problem – under-investment. More broadly, when macro imbalances are physical and supply-driven, financial-based macro policies surrounding demand cannot resolve them, only co-ordinated investment policy can. With central bankers now focused on the costs of high inflation, there is a risk that the long-run cost of too deep of a recession is the end of the capex cycle and a failure to grow sufficient capacity to debottleneck the system. When Volcker took the Fed Funds Rate to 20 per cent in 1980, it was after a decade of rising capex, allowing the subsequent fall in demand in the space to debottleneck global supply chains.

In the current environment, the ‘capital-heavy’ capex cycle has barely begun and is at risk f rom a recession or resumed only through a return of physical inflation after growth resumes. Crucially, because the Fed looks to lower inflation at the lowest cost to the economy, most Fed-induced recessions are mild, and allow the capex cycle to continue, as was the case pre-Volcker in the 1970s.

The counter argument comes from Albert Edwards at SocGen, whose notes can often make Greek tragedy look like light relief. Predictions of a Fed-guided shallow recession are a “normal spurious landmark we pass at this stage in the cycle before all hell breaks loose and both the economy and markets collapse”, he says.

As evidence Edwards cites the New York Fed’s own forecast briefing of June 17 that put the chances of a hard landing at “about 80 per cent”:

Perhaps the more interesting question is not how deep the recession will be, but how large the fall in yields will be? The recent inflation surge broke the close link between the real economy data and bond yields. Will a recession dispel inflation fears (temporarily) and drive bond yields substantially lower?

A hard landing for the US economy would force the Fed to capitulate, though sky-high inflation would make a full policy reversal unlikely. But what if inflation dissipates quickly? Edwards points to copper’s 15 month low and highlights that cyclical carbon commodities were laggards during the GFC:

If (when) the oil and agricultural complex joins this bear market, headline CPI inflation could quickly collapse to below zero just as it did in 2008/9 when headline CPI fell from +5% to -2% in just 12 months. A similar fall into negative inflation would likely take bond yields substantially lower, even if core CPI stays sticky above 2%. Although a sub-1% 10y yield seems to me entirely plausible, I suspect we won’t now see a fall below the March 2020 0.3% low as the secular Ice Age trend of lower lows and lower highs in each cycle is broken. The new secular trend may now be for higher inflation and higher yields, but a cyclical recessionary shock awaits.

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