Q32020, Part 4
Commodities as a Hedge Against Inflation
Managed money is pushing the price of commodities higher as a hedge against a declining dollar, especially in the metal markets. Every market has two sides. Market bears will point out that in 2009, the money supply expanded dramatically and not only did inflation not appear, but U.S. interest rates also had to be cut to prevent deflation. Higby Barrett has zeroed in on four factors that prevented runaway inflation in the U.S. in 2009.
First, many countries in the world depend on a trade surplus with the U.S. to drive their economies. So, when faced with an increase in the U.S. dollar money supply, many countries chose to lower interest rates to generate economic activity and increase tax revenue. Some believe China will try to take a more active world role, but that would require a legal system that is truly open to the world. China clearly feels its ability to keep secrets is a competitive advantage. While two-year lows for the U.S. dollar index is generating market talk, it is still significantly above 2009 levels.
Figure 1: U.S. Dollar Index, 2008 to Present (source: ICE)
The second factor is the U.S. velocity of money. The expansion of the money supply is unprecedented but the economic bounce from the additional money is being offset by the money experiencing a lower multiplier effect. Increasing the money supply is like pushing on a string. The money is spent at a big box store and then the big box store either expands, buys another store, buys its own stock, or disperse dividends of which 90% go to the asset class (affluent investors who reinvest in the market).
Figure 2: U.S. Velocity of M2 Money Stock (source: Federal Reserve St. Louis)
The problem with assets is an asset requires maintenance, so the affluent buy the stock market. Buying a lake house might sound like fun, but after two weekends of staining the deck in 100-degree heat, a for sale sign appears (boat included). Not exactly the “fun in the sun” the buyer envisioned.
The incredible increase in the U.S. saving rate is in small part the result of average households saving more, but the primary driver is the asset class dumping money into the stock market. Other investments that require little maintenance are bonds and metals. With interest rates at a historically low level, stocks and metals are currently perceived by many as the preferred low maintenance investment opportunity. CNBC and other news outlets cite controversy over corporations buying back stock, which increases the price of the stock. With government pensions and 401Ks dependent on the performance of the stock market, the potential expansion of the stock price without increasing profits is viewed as a positive that reduces the long-term problem of underfunded pension programs.
Figure 3: U.S. Personal Savings Rate (source: Federal Reserve St. Louis)
The third factor is the ability to outsource labor. The largest risk is wage inflation that will create an upward spiral is prices. The logic is a person with more money will spend more, which will require more labor. To buy the labor will require higher wages, which will increase spending. A major factor muting the impact of wage inflation is outsourcing. By tapping into the vast world reserve of labor, the U.S. exports inflation, and imports deflation. Even China, which just topped $10,000 per capita income, is already outsourcing labor to Bangladesh and Myanmar. Wage inflation is occurring in poorer Asian countries. If Myanmar wages continues to expand at its current pace, by 2020 the per capita income will be approximately $9,026 or an additional $7,618. For perspective, assuming a worker cuts and sows 30 shirts per hour for 8 hours per day for 260 days or 62,400 shirts annually, the extra labor cost equals 12 cents per shirt. The cost push inflation is minimum for U.S. consumers. The more impactful inflationary concern is price pull from workers buying a greater quantity of basic goods, such as milk, meat, fruits, and vegetables.
Table 1: Per Capita Income (annual)
The fourth factor is the expansion of production capacity. The expansion of production is the result of technology advances and an increasingly efficient world transportation system. The world currently has an excess of steel production, textile capacity, ocean vessels, transportation equipment, coal production, crude oil production, natural gas production, agricultural production, and chemical production. For example, when crude oil price exceeded $40 per barrel, the number of hydraulic fracturing wells being drilled started increasing. At $80 per barrel, the world oil spigots would be fully open. It is difficult to make a strong case for inflation with unused capacity and low prices. Higby Barrett believes China and Asia in general will dramatically increase purchases of commodities, but in the near term not only can the world markets handle the volume, but many sectors, especially agriculture, severely need the business.
It should be noted that what matters to future prices is not dependent on what eventually happens but what motivates someone to buy in the present. To that end, the following is the bullish mindset behind the massive inflation belief. The basic “Economics 101” classes in college taught that increasing the money supply and its velocity to stimulate demand in an economy is highly likely to produce rising prices for goods and services. History shows this to be generally true. It must be pointed out, however, that the last time major central banks of the world moved to infuse significant liquidity into their financial systems just over 10 years ago, it did not produce price inflation anyone would deem problematic. Still, the amount of monetary stimulus created during the 2008 financial crisis pales in comparison to what has been and will be created during the Covid-19 pandemic. It seems hard to fathom that central banks could be able to print so much money in such a short period of time, and still be able to escape “paying the piper” down the road. History shows that significantly rising price inflation stimulates demand for hard assets, including speculative buying interest seeping into the agricultural futures markets.
Developing countries of Asia account for 52% of the world population. For agricultural commodities, the increase in purchasing power has resulted in a higher floor price. The long-term price impact is a higher floor price but not an inflation spiral.
