A theme we have highlighted in our economic commentaries, and Morning Markets YouTube series over the course of this year, is how inflationary pressures within many different economies across the globe have been building.
Previously we cited supply chain issues coming out of covid lockdowns limiting the supply of goods. For example, semi-conductors being in short supply causing bottlenecks for the likes of electronic goods and auto producers.
This shortage phenomenon is now manifest across the commodity complex. Regions within South America, which are large producers of soft and hard commodities, have seen a surge of covid infections occur, meaning stricter lockdown restrictions. This has reduced the supply of commodities just as demand for them is bouncing back.
As a result, commodity prices have increased dramatically, as seen below in our commodity performance chart. Interestingly, one of the most dramatic increase witnessed over the period is US lumber prices which have increased by a whopping 175%! This is an indicator of a very strong market for new house building activity.
Commodity Performance (based at 100)
Source: Bloomberg, data as of 10/06/2021
The Super Cycle Theory
Given the scale of the rebound in commodity prices some market commentators are forecasting a prolonged period of continuously rising prices. This environment is known as a commodity super cycle.
There is no universally agreed upon definition of a super cycle, but it is generally thought of as a sustained period of between 10 and 40 years, where prices keep rising above their long-term averages. This usually applies to a broad basket of items i.e. in this case a wide range of commodities.
There are already several factors supporting commodity price rises in the short term. Current demand for commodities is high and supply cannot respond immediately. It takes time to extract untapped reserves. A step up in production requires more complex infrastructure to facilitate safe extraction and this can take many years to complete; also requiring substantially higher capital budgets to finance these new projects. Meantime supply cannot match demand, a situation which may in fact worsen with economies reopening and keeping demand elevated.
There are some offsets fighting against the supply imbalance. One of them is political pressure from China. It is in China’s interests to exert a degree of control over iron ore, copper, corn and other major commodities because their five-year planning cycle is based on their expectations that they will have sufficient supply to meet their needs. They occasionally and unexpectedly release reserves causing speculators to get wiped out, and then dive back into the market once prices fall back. For a period afterwards this helps reduce, but does not eliminate, commodity price volatility.
However, the longer-term factors are what many believe underpin the commodity super cycle view. What has become clear is that to stimulate economies following the Covid crisis governments have deployed supportive fiscal policies in the form of planned infrastructure spending. The projects these plans create will help drive employment for those seeking work and should also drive better productivity. Such productivity gains, it is hoped, will stimulate future non-inflationary growth.
The US has already committed $2trn to infrastructure spending and European fiscal stimulus is expected to add further to the total amount spent on infrastructure. Clearly, large quantities of industrial materials will need to be acquired to complete such projects, inspiring yet more demand for commodities.
The other long-term structural driver of higher commodity prices is the politically inspired move to achieve carbon neutrality. Many governments are pursuing policies to reduce or eliminate the use of traditional combustion engine vehicles, to be replaced with electric powered vehicles. In the UK, new petrol and diesel car sales will be banned by 20230. Battery powered vehicles use copper and lithium as key ingredients to their production and requiring infrastructure in the form of charging points to make transitioning a success.
Inflationary Impact
Commodity prices have a large impact on consumer price inflation (CPI) which is something to be watched closely. The price hikes from higher commodity prices are initially passed on to goods producers. We can see this for example in the producer price index (PPI) data from China. The Index in June showed a month-on-month gain of 1.6%. The year-on-year gain is 9.0% and becoming quite meaningful for producers as can be seen below:
Chinese Producer Price Index
Source: Bloomberg, data as of 10/06/2021
Rising producer input costs provide businesses with a difficult decision to make. They can either look to pass on these higher costs to the consumer, by increasing their prices, or they can absorb the higher input costs which reduces their profit margins.
Typically, only those businesses producing high quality goods can pass on higher input costs to customers. Those producing inferior goods are forced to accept the lower margins. If more producers can successfully pass on their higher costs of production to the consumer than those absorbing them, higher consumer price inflation is to be expected. Therefore, this is a situation closely monitored by Central banks. They are tasked with raising interest rates if the judgement to be made is that inflation is in danger of spiralling out of control. The debate continues to rage and we will continue to revisit this topic in the months ahead.
Conclusions
Commodity prices have risen sharply, and supply cannot be stimulated quickly.
Fiscal policy supporting higher infrastructure spending, increasing demands for carbon-friendly policies and loose monetary policy are all driving commodity demand upwards.
The interplay between goods producers and consumers is a critical aspect for future inflation expectations.
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