Inflation seems to be falling, but that doesn’t mean the commodity supercycle is over

Article content

By Tim Pickering

Article content

Canada and the United Kingdom’s inflation rates have fallen to the lowest levels in two years, which has led to discussions regarding the potential for central banks to pause or even lower overnight borrowing rates, resulting in potentially lower mortgage rates, a leading source of everyday costs.

Article content

But what does it mean for everyday life?

The consumer price index (CPI) in the U.K. slowed to 7.9 per cent from 8.7 per cent in May, but Canada fared even better as the CPI for June was only 2.8 per cent, down from 3.4 per cent in May. Before we get too excited, let’s recognize that this stat is year over year, meaning it’s still up 2.8 per cent.

In June 2022, Canadian CPI was 8.1 per cent, which equates to an 11.1 per cent cumulative price increase over the past two years: prices are 2.8 per cent higher than they were one year ago and 11.1 per cent higher than they were two years ago.

Article content

Do average citizens feel like daily expenses have gotten cheaper? Not a chance. Groceries cost much more than last year, up 9.1 per cent, which is higher than the increase in May. Core measures of inflation — which strip out volatility — have not eased. Mortgage interest costs were up more than 30 per cent from June 2022.

It’s been reported that the drop in inflation was led by lower gasoline prices, without which the CPI would have only dropped to a four per cent year-over-year gain, down from 4.4 per cent. Mortgage levels also factor in here. Statistics Canada said the annual inflation rate would have been two per cent if mortgage costs are excluded. So, if we ignore gasoline, mortgages and groceries, inflation is lower?

Article content

Article content

Finance Minister Chrystia Freeland, someone with no financial background, on July 19 said this a “milestone moment” and that it “should provide a lot of relief to Canadians,” but there is more to the story.

The June inflation data may provide some reassurance to central banks that things are moving in the right direction, but not fast enough for the Bank of Canada to let its guard down — that is, to lower rates. A couple of weeks ago, the central bank indicated it’s still concerned about the trajectory inflation is taking. Moreover, it raised interest rates again because it’s now projecting inflation to stay high for longer. Nothing has changed since then.

Here is what the central banks won’t tell you, there are two types of inflation: one which they have some control over and one which they do not. Raising rates may be effective for “demand-pull” inflation, constraining the price of services and manufactured goods. By raising rates, we all spend less. However, it is not effective for “cost-push” inflation, which is driven by commodities and wages. They don’t have this lever. Central banks can neither control the commodity cycle nor labour issues, which are widespread, including the recent dockworkers’ strike in British Columbia.

Article content

We are seeing the effect of global supply constraints and record shortages develop in several food staples. The proof is easy to see: while headlines tout broad measures of year-over-year inflation softening, so-called “agflation” has soared in several staple food markets. This spring, we saw: 10-year price highs in sugar; 12-year price highs in Robusta coffee; 47-year price highs in cocoa; record highs in cattle; and record highs in orange juice.

As such, while raising interest rates may reduce the demand for the manufactured goods we buy, generally from abroad, can someone explain how raising rates increase short-term commodity supply or incent long-term commodity infrastructure investments? How does it reduce labour shortages, reverse aging demographics, resolve supply chain issues or resolve pandemics and wars? It doesn’t.

Article content

In the 1970s, it took more than a decade of central bank rate hikes, culminating at over 20 per cent, before CPI and inflation finally reversed a two-decade increase. Initial declines in CPI, driven by rising rates, were overcome by cost-push inflationary pressures twice.

After reaching 6.4 per cent in February 1970, rising rates drove the CPI down to 2.95 per cent in August 1972, only to increase to 12.2 per cent in November 1974. Higher rates again drove CPI down to five per cent in December 1976, only to soar again, peaking at 14.6 per cent March 1980. In both cases cost-push inflation pressures overwhelmed central bankers’ efforts to tame inflation.

During these hyperinflationary years, commodities (as per the Goldman Sachs Commodity Index) increased a cumulative 587 per cent versus 17 per cent for the S&P 500.

Article content

The false level of comfort that governments and central banks are communicating could prove problematic for the large demographic of Canadian retirees and pensioners relying on their portfolios to generate growth and income.

Even gasoline, highlighted by the July 18 Statistics Canada report as being lower, has just made a potential breakout to the upside, and traders have been growing long exposures as the Saudi Arabia-driven production cuts by the Organization of the Petroleum Exporting Countries kicked in during July (disclosure: Auspice recently initiated long positions in gasoline based on the recent uptrend).

We have seen this cycle before and believe the inflation risk remains to the upside. The two basic ingredients required for a commodity supercycle are an extended period of underinvestment in supply and a generational demand shock. Today we have both.

Article content

Capital expenditures in commodities have been in decline since 2012/2013. And the post-COVID-19 global unification towards greening the economy — estimated to be facing a US$15-trillion infrastructure gap prior to this — is leading to an unprecedented demand shock.

The greening of the economy is inflationary, and it’s not going away. The green transition, decarbonization, environment, social and governance concerns and stakeholder capitalism all come at a time when the world is already short of commodities. And what is widely brushed under the table is that the world is extremely commodity intensive.

As Mercer LLC, the largest investment consultant in the world, noted: “Commodities will remain an essential component of the economy, and investors should note that there is no transition pathway to a climate-neutral world that does not involve commodities.”

Article content

We don’t expect the Canadian or any other government or central bank to adopt appropriate responses, but there are things you can do to protect your budget and your portfolio.

One of the best forms of inflation protection is commodities. Almost everything we just described as being priced higher is commodity related, so it is crucial to recognize that commodities can contribute to a significant portion of the CPI’s volatility, resulting in a positive and often outsized response to inflation.

Products with direct investment in commodities, not resource stocks, managed by tenured commodity managers, may be able to provide this exposure and protection alongside the investment potential. Inflation may just be stickier than the central banks and politicians want you to think.

Tim Pickering is the chief investment officer and founder of Auspice Capital, the largest active commodity and CTA fund manager in Canada.

Article content