Inflation resurgence and its effects.
The resurgence of inflation presents a complex challenge for safeguarding against its effects. The robust state of the economy, coupled with an incoming president’s pledges of tax reductions and tariffs, has understandably raised concerns among investors and analysts about the potential resurgence of inflation. Regrettably, a conventional strategy for mitigating risk—investing in commodities, particularly oil—provides diminished safeguards compared to historical norms.
The dual threats of inflation are clearly recognized: disruptions in supply and spikes in demand. The conflict in the Middle East poses a significant risk to energy supplies, while tax reductions in an economy operating at near-full employment are likely to drive prices upward. The additional risks to inflation do not align with either framework, however. The implementation of tariffs and the increase in deportations are poised to elevate inflationary pressures while simultaneously exerting a detrimental impact on the economy. “Commodities will not serve as a safeguard against that,” asserts Christian Mueller-Glissmann, who leads asset allocation research at Goldman Sachs.
The issue has already manifested in price fluctuations following the election. The market’s gauge of anticipated inflation for the next five years, referred to as the breakeven rate, experienced its most significant increase in over a year following the announcement, having already escalated as investors wagered on a Donald Trump victory. Nevertheless, gold, oil, and copper are all experiencing declines. Have they forfeited their capacity to safeguard against inflation? To address this, consider three distinct factors contributing to inflation.
To begin with, oil. Oil remains a crucial safeguard against one of the primary drivers of rampant inflation: escalating oil prices triggered by disruptions at oil facilities in the Middle East. However, the likelihood of that has diminished significantly. Global oil supply shocks are being mitigated by substantial inventories and surplus production capacity, alongside the United States’ position as a net exporter, marking a significant departure from the inflationary period of the 1970s. Despite Israel intensifying its conflict with Iran and its proxies, crude oil prices remain stagnant at approximately $70 per barrel. The incoming administration’s commitment to aggressive fossil fuel extraction, coupled with the appointment of a fracking industry leader to the energy secretary position, indicates a likely decline in oil prices within the United States as well.
Secondly, enhanced growth. It is likely to contribute to an increase in inflation. Typically, oil and copper serve as effective hedges against inflation spurred by economic growth, given the increasing demand for both commodities. However, the imposition of tariffs could hinder the decoupling of the U.S. and Chinese economies, potentially dampening this effect. China stands as the largest consumer of raw materials; however, it may derive little to no benefit from an uptick in U.S. economic expansion.
Third, the plans for tariffs and the deportation of migrants proposed by Trump. Both factors have the potential to elevate inflationary pressures. Tariffs exert complex influences on inflation dynamics. The immediate consequence is an increase in prices, akin to a sales tax, alongside an appreciation of the dollar. In the long term, they are likely to decelerate economic growth—similar to the effects of a tax increase—thereby alleviating inflationary pressures. The divergent impacts manifest as elevated expectations for near-term inflation, while projections for inflation beyond the next five years remain largely unchanged.
This type of action presents significant challenges for effective protection. Tariffs are unlikely to benefit the oil and industrial metals sectors; rather, they may exacerbate challenges as trade conflicts loom, potentially leading to a weakened global economy and diminished demand. Gold may face challenges as tariffs are likely to strengthen the dollar, which typically exerts downward pressure on gold prices and diminishes the likelihood of interest rate reductions. The potential removal of millions of undocumented migrants by the new administration could lead to an increase in wages for the lowest-paid workers, as businesses strive to fill the gap left by the absence of low-cost labor. The propensity of the impoverished to expend their entire income is likely to stimulate consumption, thereby influencing price levels as firms endeavor to offset increased costs and respond to the augmented demand generated by this heightened expenditure. Once more, this represents an inappropriate type of inflation for oil or copper.
The sector most susceptible to illegal migrant labor is agriculture, suggesting a significant impact on food prices—potentially positioning agricultural futures as a hedge against this issue. Agriculture is not for the timid; it is characterized by significant volatility and requires a nuanced understanding of the specifics of each crop. Treasury inflation-protected securities, commonly known as TIPS, represent a reliable safeguard against inflation. TIPS offer returns that are indexed to inflation. However, their efficacy is assured solely if they are maintained until maturity. In the face of abrupt shocks that trigger interest rate hikes, as observed in 2022, TIPS experience the adverse effects of elevated after-inflation rates, resulting in a decline in their value. TIPS present a more attractive proposition today compared to the post-pandemic inflationary period, primarily due to their significantly elevated starting yields. Salman Ahmed, global head of macro and strategic asset allocation at Fidelity International, highlights that TIPS are more effective in safeguarding against prolonged periods of elevated inflation rather than abrupt inflation surges.
The current landscape complicates efforts to safeguard a generally optimistic portfolio from the pressures of inflation. Holding TIPS to maturity presents a rational strategy; gold may provide a buffer against stagflation, although its recent surge has been largely fueled by demand from foreign central banks rather than inflationary pressures. Additionally, Ahmed expresses a preference for energy company stocks, which could experience significant gains in the event of a genuine oil-price shock.
