By Tim Pickering

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There was in the summer what we called a “misguided level of comfort that governments and central banks were communicating” given year-over-year inflation had recently fallen: the consumer price index in the United States had dropped to 3.2 per cent (increase) after peaking in June 2022 at 9.1 per cent. What’s happened since? We are still at 3.2 per cent.

Bloomberg recently captured the sentiment, “U.S. consumers are shouldering a burden unlike anything seen in decades — even as the pace of price increases has slowed.” Importantly, prices are still increasing, albeit at a slower rate — little comfort.

The real inflation consumers feel is higher than the narrow view of CPI. Per Bloomberg, “Groceries are up 25 per cent since January 2020. Same with electricity. Used-car prices have climbed 35 per cent, auto insurance 33 per cent and rents roughly 20 per cent.”

Perhaps we need to accept a new normal, which is an inflation level more typical (that is, higher) by historical standards, closer to the average four per cent since 1970. We are not advocating that inflation and thus interest rates are headed to levels we had in the 1970s, but we can all agree this inflation is not transitory, the narrative by central banks and politicians.

Its persistence is up for debate, but we know that central banks raising rates does not solely make inflation go away. Cost-push inflation driven by commodity prices and wages point to a structural shift based on supply and demand after a decade of declining capex (investment) in commodity supply and a series of generational catalysts. We believe what we are experiencing is typical with inflation migrating through the system and showing up in unexpected ways.

Catalysts and the 3 Ds

Decarbonization, deglobalization and demographics are inflationary drivers that weren’t present just a few years back.

Consider decarbonization: though the desire to “build back better” is noble, we are constantly reminded how critical fossil fuels still are today. The transition away, while presenting potential long-term benefits, comes with tightening supply and increased prices and volatility at a time when the developing world is increasing consumption. This push towards decarbonization became forefront post-COVID-19 and presents long-term inflationary pressure.

Deglobalization and the trend towards protectionism is also new, largely on the back of the war in Ukraine, COVID-19 and U.S./China tensions. It leads to a global economic environment that’s regional and less competitive, causing prices to rise — a type of structural inflation that central banks can’t control by raising rates.

Demographics, particularly labour force changes, are also shifting from deflationary to inflationary. For example, the ratio of people 65 and older to people 15 to 64 (the dependency ratio) in Canada is projected to increase by more than 20 per cent over the next two decades. Even with substantial immigration, the labour force will grow at a significantly slower rate over the next two decades than during the post-war period.

Basic economics tells us that unless demand shrinks (and we enter a deep recession), a decrease in supply results in higher prices (wages).

A new leader: India

While the last decade was defined by plentiful supply of labour and commodities, so prices trended lower, this decade may be defined by a scarcity of supply at a critical time when we have a new global consumption leader in India.

This buyer is now the largest population, with half its population under 30, has the fastest-growing middle-class and is willing to spend a disproportionate amount — 20 per cent — of its gross domestic product on infrastructure. Importantly — it is the middle classes that drive commodity consumption — we saw this with China in the early 2000s, the U.S. in the 1970s and we are seeing that today in India.

At a time when the supply of commodities and labour is becoming scarcer, countries such as India have shown a propensity to weaponize commodity supply. In 2023, India restricted exports in wheat, sugar and rice, the latter two sending global prices higher. As such, global growth and inflation are likely to be more volatile, and we expect commodities to play a more central role in driving economic growth.

The Cantillon effect

Inflation is difficult to anticipate because it shows up at different times, effectively migrating through the system. The Cantillon effect was first described by 18th-century economist Richard Cantillon (who inspired political economists such as Adam Smith) and states that money is non-neutral.

Creating an abundance of cheap money via quantitative easing (QE) doesn’t mean that demand for everything will simultaneously rise. Instead, history shows that certain assets take favour over others, leading to rising prices in some areas and falling prices in others.

Once the money supply is increased, its first stop is bonds. They are bought by governments and investors and interest rates drop. It then goes to stocks, private equity and even alternative investments and real estate.

Prices go up. But this is not inflation; this is asset price appreciation. We saw this in the last decade with QE. Real estate may rise, but with real demand, new building occurs, driving input costs such as copper, lumber and then wages. It then gets to headline commodities like oil and eventually to cheaper energy such as natural gas and uranium. Indeed, there was a surge in uranium prices while crude weakened during the fourth quarter.

What you are witnessing is money migrating through the system. When people think inflation is over because the price of a good or a commodity stops rising, money is often just “migrating” somewhere else.

Consider some of the headline commodities since 2020:

• H1 2020: Gold rallied and captured investor interest as COVID-19 weighed on risk assets including most commodities.
• H2 2020: Commodities broadly rallied (except gold)
• 2021: supply of commodities and “green” markets captured interest and made highs, only to trade down since.
• 2022: supply of commodities and grain markets rallied in the first quarter with the Russia/Ukraine war.
• 2023: Agflation presents itself in agricultural markets, arguably less affected by interest rates and more driven by local supply: coffee, sugar, orange juice and cattle all rally. Energy rallies in the third quarter before softening while in the fourth quarter, iron ore rallies alongside sugar and cocoa — just in time for Christmas.

Broadly, through all the volatility, prices remain significantly higher, and we expect this trend upwards to persist.

We are not alone. Goldman Sachs Group Inc. is predicting a strong commodity market in 2024, just as it similarly predicted in late 2019 before the first wave: “We recommend going long commodities in 2024, as we expect somewhat higher spot commodity prices, strong carry and see hedging value against geopolitical supply disruptions. We forecast a 21 per cent GSCI 12-month total return.”

We believe we are on the doorstep of a shift where inflation is clearly not transitory nor persistent, but structural.

The inflation migration has likely only started in commodities following generational catalysts. It is being led by scarcity of resources and workers as demand by the developing world and “build back better” of rich nations exceeds the delicate and narrow supply margin.

Whereas China dominated the narrative of the early 2000s commodity cycle, the three Ds and India will likely lead this decade’s cycle. The demand for commodities and wage pressures is a longer-term shift that can’t be ignored. For investors, products with direct investments in commodities (not commodity stocks) may prove essential.

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