Insights & Advice

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The Reflation Trade

Over the past six months, an increasing number of investors have come to believe that a rise in the inflation rate is inevitable. That appears to be a sound bet from where I sit, even though the present data doesn’t support that wager.

The argument for increased inflation centers around money. The world is awash in the stuff.  Central banks have been printing money for years to stimulate their economies. Last year’s pandemic only opened the monetary flood gates even further. And the trend is not over.

During the next few months, here in the U.S., the Biden Administration is proposing another $1.9 trillion in Federal spending, which will then be followed by yet another multi-trillion-dollar spending program for infrastructure. Wherever you look—China, Europe, Japan—it is the same story. And while governments spend, central banks print money.

Why then, you might ask, is the inflation rate so tame? If you look at our Consumer Price Index (CPI), over the last twelve months the increase was just 1.4%. That is, and has been, far below the Federal Reserve Bank’s target of 2%. It is so far below their inflation target that the Fed has said they would be willing and happy to see inflation rise above that rate for some time into the future.

And yet, wherever you look on the commodity front, we see accelerating prices in soft, as well as hard commodities. Corn, soybeans, wheat, sugar, copper, lumber, oil, precious metals, and most other material prices have climbed well above the 1.4% year-to-year increase in the CPI. How can that be?

Because the CPI and many other inflation measures like the Producer Price Index (PPI), are heavily weighted in such as things as services and rents. Inflation by mundane variables like commodities are usually not much of a concern. That is largely because commodity prices fluctuate, and (over the last decade or so) were in down trends.

However, that period appears to be coming to an end. Some economists argue that the declining dollar, after years of strength, may have something to do with it. Since most commodities are priced in dollars, for foreigners, commodities have become cheaper to purchase in their currencies, sparking additional demand.

At the same time, after years of lower prices, mining and exploration companies reduced their spending budgets. Why produce more of something that was worth less and less? As a result, a large number of commodities are in short supply. We have to go back ten years to the Spring of 2011, to witness the kind of price increases we are seeing in at least 35 different commodities.

All of this has been occurring while most of the world’s economies are struggling to remain above water, thanks to the coronavirus pandemic.  But now we are in the midst of a worldwide vaccination program. If successful, we can expect a turnaround in economic growth. What will happen to commodity prices once global economies begin to grow again?

Demand will increase quickly, while supply will take much longer to revive. That is a recipe for rising prices. Inflation, therefore, is all about expectations. If buyers of copper, for example, expect prices to increase in the future, they will gladly pay the going rate today in order to avoid higher prices in the future. I believe we are experiencing just such a change in sentiment when it comes future inflation.

By the time this trend shows up in the CPI or the PPI, which could take many more months, inflation will be marching higher along with economic growth, so be prepared. If I were you, I would think seriously about putting some money to work in this area.

Posted in A Few Dollars More, BMM Articles, The Retired InvestorTagged , , , , ,