The low yields on government debt suggest concerns of deflation amongst bond market practitioners, who are happy to hold these assets for the next 10 years or so for precious little return, but just as a store of value, unlikely to be eroded by inflation. Such a scenario has provided the right environment for long-duration assets such as technology, biotechnology and other ‘growth’ stocks to thrive, whilst shorter-duration assets such as cyclical or ‘value’ equities and commodities struggle.
Nevertheless, five-year forward inflation expectations are hovering around 1.8% and if this should transpire then government bonds (other than index linked) will offer little protection of purchasing power. Whilst inflation expectations are not currently rising it is interesting to note the recent steep rises in commodity prices, with the Bloomberg Commodity index nearing the highs last seen six years ago, and wonder whether these will feed through to trigger a pick-up in those expectations.
To provide a few examples, copper now trades above $7700 a tonne, having risen around 60% since the first lockdown and has reached its highest price for seven years. Iron Ore is close to $130 a tonnes, a five year high. Such prices are certainly influenced by the acceleration of Chinese output following their gaining of control of the virus in the spring and indeed copper has typically tracked closely with Chinese GDP as one of the most important materials in building property and manufacturing cars given the quantum of wiring required.
These increases in raw material costs for companies should feed through to the inflation data in time if they are successful in passing on the increased costs rather than having to absorb them. In the short term we feel such rises will be subdued given the current focus, in light of the pandemic, of policymakers, businesses and workers is to try and continue as normally as possible. Workers are generally not in a position to demand wage hikes and so businesses may have to bear the brunt initially. But as vaccines are provided and life returns to near normality, the economic upturn, as the West follows the East out of lockdowns, should lead to even greater demand for raw materials and will begin to justify passed through price rises, thus triggering higher levels of inflation.
Intriguingly though, foods are also witnessing similar increases in price with soybeans at a four and a half year high, corn prices at an eighteen month high and cocoa at a nine month high. Rising food prices for consumers should do the same and, with the higher cost of living, could give rise to increasing wage demands. However, it is not quite so clear where this price inflation is coming from. Has production been reduced due to workers unable to gather crops or is it the La Nina weather patterns in evidence this year which give rise to droughts on some continents and floods on others. Either way, such price fluctuations are usually temporary and may last no more than a year.
Overall, calling the price direction of various commodities remains tricky and prices have traditionally been volatile, making direct investment a risky exercise. Some of the upside can be captured via our equity holdings and the potential for inflation to rise above expectations captured by our index-linked sovereign debt holdings.