Inflation is a concern, for now, but in recent years it hasn’t been widely evident in the economic data. After its most recent meeting, the Federal Open Market Committee (the FOMC which is the operations arm of the Federal Reserve) confirmed that in a statement.
The FOMC noted, “Inflation on a 12 month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee’s 2 percent objective over the medium term.” This has been their outlook for months, but more recent data brings that conclusion into question.
The consumer price index (CPI), when food and energy are excluded, was at 4.4% in December and has been moving higher for months.
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Source: Federal Reserve
Other market data confirms the potential for a surprisingly high level of inflation is lurking beneath the surface of economic data.
Commodities Delivered in 2017
Commodities had a strong year. Below is a chart of the S&P Goldman Sachs Commodity Index (^GSCI) which gained more than 11% in 2017.
The widely tracked S&P GSCI is recognized as a leading measure of general price movements and inflation in the world economy. The index is designed to be investable by including the most liquid commodity futures, and provides diversification with low correlations to other asset classes.
Commodities in the index are weighted by their global production. It is rebalanced annually. In 2017, more than half of the index (56.2% of its total weight) was in the energy markets. Although the weight of energy varies from year to year, it is generally more than half of the index.
Agricultural commodities represent about 19.2% of the index while livestock accounts for about 9%. Industrial metals also account for about 9% of the index and precious metals make up the rest (4.9%).
Overall, most commodity indexes will be overweight energy because those markets are liquid and the products are so critical to the world’s economy. However, despite that potential disadvantage, the indexes are among the best ways for individual investors to gain exposure to commodities.
A Possible Trend Reversal
Last year’s double digit gains in GSCI was the second winning year in a row for the index. In 2016, GSCI was up 27.8%. Prior to that, the index recorded three consecutive years of losses. Over the past ten years, the index shows an average annual return of a loss of 3.2%.
Source: Standard & Poor’s
There are a number of reasons for investors to expect the trend in commodities to continue.
First is the underlying trend in inflation. While the headline number for CPI is in line with the Fed’s target, underlying trends are not as favorable. Business inventories have also been tightening and that leads to concerns that prices could be rising as suppliers test their pricing power.
According to Bloomberg, the latest inflation reading “has left the market pricing in higher odds of a March rate hike and the odds of more rate hikes in 2018 have increased as well,” said Gennadiy Goldberg, a strategist at TD Securities in New York.
He added, “We’re seeing the market move toward the Fed so we should see more curve flattening and more pressure on the front-end.
Second is concerns related to tax reform. As with any political issue, tax reform has proven to be controversial. However, there is general consensus that almost all employees will see their take home pay rise soon.
The IRS is releasing new rules for withholding from pay checks and announced that employers should begin using the new withholding tables as soon as possible, but not later than February 15. House Ways and Means Chairman Kevin Brady said in a statement that nine out of ten taxpayers “will see a boost in their take-home pay within the coming weeks,” he said.
There are concerns that this could be inflationary. But, the Fed is expected to counteract this change in fiscal policy with tighter monetary policy. Traders in the bond market reacted by boosting interest rates.
The two-year Treasury yield jumped above 2% recently, marking a rebound to a key psychological level last seen just as the U.S. sank into the depths of the financial crisis in September 2008.
The last time investors saw two-year Treasuries yielding 2% was September 30, 2008, about two weeks after the collapse of Lehman Brothers Holdings Inc., which sparked a global flight to safety. On September 15, the day of the bankruptcy filing, the yield plunged 50 basis points, driving it below 2% on an intraday basis.
The yield closed below 2%t at the end of September 2008 and remained below that mark until January 2018. In September 2011, it set a record low of 0.143%.
Investing in Commodities
Higher interest rates mean bond prices will fall. This increases the risks in fixed income investments. This could also push stocks down. The two-year note provides investors with more income than dividends on the S&P 500 Index and could make stocks even less attractive.
This all means investors could find the best returns in commodities. One way to do that is with exchange traded funds (ETFs) that track broad commodity indexes. iShares S&P GSCI Commodity-Indexed Trust (NYSE: GSG) is one alternative.
An alternative is PowerShares DB Commodity Tracking ETF (NYSE: DBC). The underlying index for this ETF is also heavily weighted towards energy with a weighting of about 55%. Agricultural commodities make up about 22% of the index, industrial metals about 12% and precious metals about 10%.
The most significant difference between GSG and DBC may be the weighting of livestock markets. DBC has no exposure to this sector while GSG carries a 9% weighting in these markets.
Investors could also buy stocks in companies in the individual markets. This is a less direct trade on commodity prices. Although at first glance the commodity company should move in line with commodity prices, deeper reflection indicates that may not always be the case.
Stocks of all companies carry a risk of management. In this sector, for example, it is possible commodity prices could rise and the stock of a poorly managed company could fall. While these risks can be addressed, the truth is the trade in a commodity company is not exactly the same as a trade in the commodity.
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