While the media and policymakers are fretting over recession of the U.S. economy, commodity prices are sending a very different signal. Steady rising commodity prices historically stem from robust economic growth and increasing inflation pressure. “Not this time,” some argue. They think that the current soaring prices are consequences of speculative money flow and point to the dismal U.S. GDP growth and benign expected inflation as evidence. What they have missed are: 1) Commodity prices are determined by the aggregate world economy. As a percentage of the total world GDP, the U.S. economy has been declining for years. A U.S. slowdown would have a lesser impact to the world demand in commodities than previous recessions. 2) The U.S. economy is growing at 6% in nominal terms, not a bad figure if the inflation had been kept under the Fed target of 2%. Unfortunately, the Federal Reserve is misguided in making inflation judgment using the core PCE deflator, which excludes food and energy and currently stands a little above 2%, instead of the headline CPI, currently at 4.3%. 3) The traditional measure of expected inflation, which is the spread between 10-year Treasury and 10-year TIPS, is severely distorted under the current market condition. The credit crunch has led to a massive flight-to-quality – investors seek safe heavens in Treasury securities, pushing yields down. According a study by the Cleveland Fed, after adjusting for the liquidity distortion, the expected inflation has in fact shot up 45%.
Consumers have a real reason to worry about inflation. At the end of the day, they pay the headline inflation, no matter how central bankers are unwilling to recognize that.
Figure 1: Inflation expectations and commodity prices
Inflation Tax
You can make money in a bull market by riding the rising tide. You can also make money in a bear market by betting against it. But you can hardly make money in a market of high inflation.
Inflation is an implicit form of tax, imposed on not only investment profit but the principal. When taking income taxes into consideration, investors need to earn a higher rate of return than the rate of inflation to break even (See Table 1). As the current U.S. headline inflation reaches 4.3% in 2008, investors in the 28% tax bracket, for instance, would have to earn 6% just to preserve their real purchasing power.
Table 1: Breakeven return adjusted for inflation and income tax.
Investment Strategies
Steepen U.S. Treasury Yield Curve: When the yield on 10-year U.S. Treasuries dropped below 3.4% and the corresponding liquidity-adjusted expected inflation rose above 3.2%, something is seriously wrong here. Along the yield curve, we have a real interest rate of -2.1% at the frontend and 0.2% at the backend. Not only will the overall real interest rise back to its long-run rate, but the spread between the short-dated and long-dated treasuries will widen to reflect the soaring inflation expectations.
Long Commodity Currencies: The robust and lasting commodity boom also brings widely fluctuations in commodity prices, making it difficult for investors to hold outright commodities in their portfolio. Exchange rates of small open commodity exporting economies, such as Australia, Canada, South Africa, Chile, and Brazil, are the present values of expected commodity prices and tend to move more gradually than commodity prices. Empirical studies have shown that commodity prices Granger-cause exchange rates. An investment example is to long the Brazilian real by investing in the risk-free Brazilian treasury securities. With the Brazilian CPI at 4.66% and the policy fund rate at 11.75%, this strategy can generate a real income of 7% plus capital appreciation in the currency.
Sideline U.S. Equities: A recent study indicates a negative growth in consumer expenditures when excluding spending on food and energy. As 70% of the U.S. domestic economy relies on consumer spending, this is not good news for Corporate America. When consumer spending slows, earnings slow. We have yet to see the reported earnings drop, but it is important to remember that historically corporate earnings are significantly overstated in periods of rising prices as they are reported in nominal terms.
It’s the inflation, stupid!
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