Jonathan Marriott, Chief Investment Officer
From oil to lumber to copper to corn, commodity prices have been soaring, and yet central banks see an inflationary spike this year as transitory. This view was repeated in the output of the Bank of England (BoE) Monetary Policy Committee on Thursday this week. As a result, while tweaking the rate of bond purchases, they kept interest rates low and continue to support the economy. The current commodity price headlines would make you think that rampant inflation is in store. However, this is only part of the picture.
This time last year, overproduction, a lack of storage capacity and slumping demand drove West Texas oil price to collapse, briefly even going negative. The pandemic was getting worse and the global economy was shutting down. Production was eventually reduced and expenditure on exploration cut. Now, however, the distribution of vaccines is allowing economies to reopen, demand is picking up again and the oil price is returning to pre-pandemic levels. The futures market reflects expectations and last year this reflected an expectation that prices would recover, this has now reversed and the futures curve shows lower oil prices the further out you look.
The sell-off last year in other commodities was less dramatic, but cuts in production, some due to the pandemic restrictions, have reduced supply and demand is now picking up rapidly. During the pandemic, inventories were reduced and they now need to be rebuilt. In some materials, this is accelerated by the expected spending on infrastructure, particularly in the US, following President Biden's American Jobs Plan. The pandemic may continue with tragic consequences for some parts of the world, however, the vaccine roll-out has given hope of a return to normal. In the US and the UK, we are seeing this already.
One area that held up during the pandemic was electronic goods as people switched to working from home. A fire in Japan led to reduced supply of semiconductor chips at a time when demand was extremely high, and thus a shortage has developed. Car manufacturers have been particularly affected as they cut orders for these components as a result of pandemic sales, only to find they are last in line when they are seeking to boost inventories on the back of stronger sales, resulting in manufacturing plants having to cut production or temporarily shut down. If people are unable to get materials this will slow production which in turn may slow the pace of economic recovery.
Most commodity futures curves are now negative. Lumber, a key material for US house builders, has seen prices move dramatically higher, but the futures curve shows an expected 30% drop in the next year. It is fairly typical that commodities are cyclical. Increased demand raises prices, this eventually leads to increased production which then lowers the price again. Production swings lag prices and can lead to distortions. Last year we saw this in the oil market to the downside; we are now seeing the reverse to the upside. The size and speed of the economic shutdown and reopening has been as unprecedented as the reaction in commodity markets.
So as the global economy recovers from the pandemic, we are seeing a pick-up in demand which is being met by a lack of supply. The question is whether this will be passed on to consumers. The cost of building materials such as copper, steel and lumber may be higher but this does not necessarily raise house prices. In the short term, rising costs may just squeeze the margin for some manufacturers. When looking at individual companies, we need to assess their ability to pass on rises in material costs.
Central banks such as the BoE and the US Federal Reserve (Fed) generally have a 2% target for inflation. The base effect of price rises from a low point last year were always going to lead to higher inflation this year. The shortage of commodity supplies will no doubt provide a further boost to inflation this year. Thus it is widely expected that year-on-year inflation will exceed the 2% target in the US this year. The pound is higher than it was a year ago and oil prices have less effect on consumer price index (CPI) due to taxes, which may blunt the inflation threat in the UK. Spot commodity prices may have further to go in the short run but in the long run some supplies will pick up or get substituted. Price rises themselves may also reduce demand.
Pandemic restrictions moved consumption from services into goods and, as things ease, we may see the trend reverse. We are seeing some evidence of this as restaurant bookings have become difficult to obtain and domestic coastal accommodation is hard to find. What is clear is that consumer substitution from services to goods and now vice versa have swung the traditional supply demand dynamics, but yet offer little clarity on whether the equilibrium between the two looks any different from the pre-pandemic picture beyond 2023.
As the dramatic cyclical swing brought about by the pandemic moderates, we expect the longer-term pre-pandemic deflationary influences to return. Ageing populations, automation, artificial intelligence and globalisation through the use of the internet all contributed to keeping price rises under control even when unemployment was at record lows. In a post-pandemic world, unemployment will be higher which may add to the deflationary mix. The supply chain disruption we have seen in the last year, not only from the pandemic but also from the blockage of the Suez Canal, may raise questions about globalisation and just-in-time production, reducing that effect. However, on-shoring production will probably see greater automation and, as a result, may not increase costs.
The Fed has said it is looking for an average inflation rate of 2%, so a rise above that target should not lead to an automatic tightening of interest rates. Similarly, we would not expect other developed markets’ central banks to tighten in response to a rise in inflation this year. For that to happen, we would need a full recovery and clear signs of a more sustained rise in inflation. Even when that does happen, the rising debt pile will make economies more sensitive to rate rises. As a result, the ultimate normalisation of rates is likely to be slow and the peak in interest rates is likely to be at a much lower level than in previous cycles.
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