Back in November of 2020, we published a Matco Insights piece titled “The Inflation Debate and What it Means for Your Portfolio”. Within that publication, we primarily focused on the relationship between inflation and the labor market, as well as inflation and government spending. The conclusion was ultimately that inflation is more likely to be a persistent concern when the following two conditions are met: government debt is at lower levels and unemployment rates are much lower.
With that in mind, one development that stands out thus far in 2021 is the significant rise in commodity prices. These raw material inputs, also known as the commodity complex, are not directly part of inflation calculations. However rising commodity prices that serve as raw inputs for construction and other consumer goods may trickle down into higher price tags for consumers in the end. So, has our thesis on inflation changed? We will work through a few primary points to address this question.
A Closer Look at the Commodity Complex: Low Base Effect
In terms of the commodity complex, there is not a single pre-defined basket of commodities. In any event, we have put together what we feel is a relatively diverse basket of raw inputs. This will demonstrate the range of price increases we have observed. Over a 1-year time frame, gold currently sits at the bottom of the list having appreciated approximately 11% while lumber currently sits at the top of the list, having appreciated approximately 266%. The average price rise within the basket we have identified, over the last year, is 72%. The question that comes to mind is: will commodity prices continue to rise and lead to inflation?Admittedly, no one has a crystal ball and knows the answer for sure. That said, let us approach the question with math and logic. Will commodity prices continue to rise? We believe this is very likely, for a couple of reasons. First and foremost, we are in the early stages of the next long-term economic expansion. At this point in the economic cycle, it is very common to see commodity prices rise. Secondly, the economy has been wavering back and forth between “super-lockdown” and “lockdown” for over a year. There is a high probability that several sectors of the economy have pent-up demand that will begin to be satiated over the coming 12 to 24 months. However, the percentage increase in commodity prices we have seen this year is in large part due to what we call “low base effect”. This is a fancy way of saying that prices last year – due to the recession – were extremely low. Let us look at oil as an example. About a year ago, the U.S. oil price (WTI) was trading at approximately US$34. Today it is at approximately US$67 – a 97% increase. For oil to increase by 97% over the next 12 months, it would have to reach US$132. Although this is possible, we believe it is unlikely. Oil may very well continue to rise due to pent-up demand beginning to unwind, but to double again would be a low probability case. This is just one example, but we could apply similar math and logic across the broader commodity complex.
The Central Bankers Perspective: Transitory-Mania
Global central bankers are generally tasked with maintaining a healthy economy. More specifically, North American central banks have a dual mandate of “price stability” and “full employment”. With price stability being part of that dual mandate, they have recently been grilled by journalists, economists, and market participants as to whether they have concern over the recent rise in inflation or pricing pressures. The thought by market participants is that if central bankers fall behind the curve, they will be forced to increase interest rates more rapidly than they anticipate, playing catch up to curb inflation, subsequently threatening the economic recovery. Although this concern has been widespread and well documented within news headlines, central bankers have consistently responded that their analysis suggests current pricing pressures will be “transitory”. Transitory is simply a fancy way of saying “not permanent”. Central bankers are of the mindset that the low base effect recently discussed and pent-up demand from consumers will both have impacts on inflation and prices, but that the impact will be short-lived.
What Does This Mean for Your Portfolio?
Admittedly, we have had some excellent debates within our Matco investment meetings about the outlook for inflation. However, central banks would like to see a higher level of inflation so that they can effectively “inflate away their debt”. Our investment team believes we may see higher inflation than what we have seen over the last decade, however it is less likely to reach levels that would materially threaten a consumer’s level of income or purchasing power. Although possible, it remains a tail risk. What we do agree on unequivocally is that there are ways we can protect against the possibility of rising inflation through proper portfolio construction, at a low opportunity cost to the investor.So how have our portfolios been positioned to accomplish this? Here is how:1. Asset mixA greater allocation to equities over fixed income, as equities represent a better hedge to rising inflation.2. Equity exposure:A greater allocation to the cyclical sectors of the economy within our equity portfolios. These sectors tend to pass along pricing pressures to the consumer, allowing them to maintain stable margins and earnings growth throughout the cyclical stage of pricing pressures.3. Fixed income exposure:Inflation can lead to higher interest rates, which hurts bond prices. However, replacing fixed rate bond exposure with floating rate bond exposure protects our bond portfolios from rising short-term interest rates. Additionally, replacing medium-term corporate bonds with preferred share exposure provides protection from rising medium-term interest rates as preferred shares benefit from rising 5-year interest rates.Our investment team frequently revisits our portfolios to ensure we are properly positioned for what lies ahead. We have been implementing these particular adjustments within our portfolios over the last 12 months, and we continue to observe their positive benefits through the performance of our investment strategies year-to-date.Persistently higher inflation remains a tail risk; however, ensuring your portfolio is properly positioned to weather such risks can mean a great deal to your portfolio’s success. Is your portfolio positioned to protect against the tail risk of inflation? Contact a Matco Portfolio manager to book a portfolio review, and we can help assess your portfolio’s current inflation risk exposure.Trevor Galon, CFAChief Investment OfficerEmail: tgalon@matcofinancial.caLocal: +1-403-718-2130
MATCO FINANCIAL INC.
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