All Roads Lead To Inflation
An Update On My Big Picture View, Interest Rates & A Look At Trends For Different Commodities
With some of the recent action in commodities, I figured this week was a good time to finally finish up this piece. I have had bits and pieces of this one done for a while, but I think we will probably see the next leg up for inflation over the next couple years. I’ll try to avoid carpet bombing you with graphs and pictures, but I have included a bunch of links to different articles and past posts. I have talked about inflation and market cycles before, but I think we are in the early innings of a long-term inflationary environment and a commodities cycle that will be driven by supply shortages across the sector. How long it will last is hard to predict, but I don’t think the inflation spike in 2022 was a one and done event.
The last CPI inflation print below 3% was in March 2021. That’s more than three years ago. It’s also the CPI, which is barely connected to real inflation and dramatically understates the actual increase in the cost of living over the last couple years. My point is that I think we are already in a cycle where inflation will be higher on average, and we will see periods where inflation surges like it did in 2022. I don’t think we hyperinflate for a variety of reasons, but I think we are probably in for a prolonged period of inflation or stagflation. This view is a big reason why I’m bearish on bonds and bullish on commodities.
By the end of this cycle, I think investors will look at TLT 0.00%↑ (20+ Year Treasury Bond ETF) as the toilet paper ETF. That will probably be a good time to buy, but we have a long way to go from here to there. Investors have continued to pile into TLT, with huge inflows for most of 2023. For decades, investors have been trained to buy the dip and that the bond side of the 60/40 portfolio will save them when the stocks are underperforming. The problem with that idea is that stocks and bonds become correlated when inflation is running hot, something we saw in 2022, the worst year for the 60/40 portfolio since 1937. The last asset you want to own during an inflationary cycle is long bonds, and our government’s current financial situation doesn’t exactly instill confidence that they are going to get spending under control.
Commodities tend to be a good diversifier in these periods, but I should mention that there is a difference between holding bonds long-term and trading them. If rates do come down later this year, like many investors expect, long term bonds will perform well, at least near term. I don’t know what path interest rates take from here until the election. If I had to guess, we stay where we are. I wouldn’t be surprised to see a 0.25% cut or two this year, but I would be surprised if we get a hike. I’m more confident about the path of interest rates longer term.
If you asked me if I thought interest rates would be higher or lower in 2030 than they are today, I think rates will be higher. I don’t see how markets can have four decades of declining interest rates, with about a decade of ZIRP as the cherry on top, and follow it with a couple years of increasing interest rates before going back down. The elephant in the room is the potential for the Federal Reserve coming in to cap rates with yield curve control, but we will have to wait and see on that. If we do go down that route, I think it will be a good time to own commodities and stocks in the sector.
The Metals
Gold has been on a tear to start 2024, so I’m feeling pretty good about my educated guess that we will see $2,500 per ounce by year end. Silver is above $30 an ounce and I wouldn’t be surprised if it follows gold higher over the next couple years. Copper has been on a tear and there was talk of a short squeeze recently, but it looks like we might get the pullback I was expecting if yesterday’s move is any indication. I’m still a long-term bull on copper, and I have started to dig into a couple stocks in the sector, but I’m not chasing (or buying) any of them yet. If copper prices continue to rise, I wouldn’t be surprised if we see more urban mining, like the recent theft of Tesla superchargers.
The supply side for silver and copper looks very favorable for long term bulls, and central banks have spent the last year buying gold in large quantities. Platinum and palladium are showing signs of life, and unless you think we are all going to be driving EVs by 2030, it’s going to be hard for supply to meet demand for catalytic converters moving forward. I think some of the recent moves for the metals are just the beginning, and I’m bullish on all the metals to varying degrees over the next two to three years.
Natural Gas
I have started to change my mind on the outlook for natural gas in recent weeks. This might be a case of the price changing my sentiment on commodity, which is up more than 50% in the last month. It’s still cheap below $3.00, but one of the things that I found interesting was how the natural gas producers held up in recent months compared to the spot price. Peabody Energy BTU 0.00%↑ and other thermal coal producers certainly stand to benefit if the nat gas rally continues, but I don’t think natural gas will be below $3.00 by year end.
There are two things on the horizon that are bullish for natural gas for longer term investors in my opinion. The first is increased demand from the electricity grid for AI and data centers. Nvidia NVDA 0.00%↑ (and their 10 for 1 stock split) will benefit from the continuation of massive capex spending from the tech sector, but I think if you look at the derivatives of the AI trend, energy is setup to be a beneficiary as well. We will see how things develop for the grid, data centers, and AI, but natural gas is the logical solution to fill a potential gap in power generation over the next couple years.
I have started to look at a stock that would benefit from this trend, but I need to do more research there. The other thing is the expected increase in LNG capacity on the horizon. There are several projects set to come online by 2027 that could vie for natural gas supply here in North America. I’m curious to see how these two trends play out, but I think natural gas has an interesting setup moving forward. One of the other things to watch for natural gas is the associated gas from the Permian Basin continuing to increase, but I think these trends will be keys to what happens with natural gas in coming years. We have had cheap energy from natural gas for most of the last decade, but that might change over the next couple years and bring inflation along with it.
Oil
This one has been interesting to watch in recent weeks. I still think investors are missing the forest for the trees on oil as far as supply and demand, but I think we are in the early innings of a flight to real assets, and stocks tied to oil look very attractive to me. With 2024 being an election year, we are going to see powerful people pull out all the stops to make sure we don’t see rapidly rising oil and gasoline prices. One recent example to prove the point is the draining and closing of the Northeast Gasoline Supply Reserve, conveniently timed to be finished by June 30, just in time for the 4th of July.
To be fair, the 1 million barrels they are releasing over the next 6 weeks are a drop in the bucket, but it’s emblematic of the short-term thinking from the political class. If we do see oil rally into the summer, I wouldn’t be surprised to see them tap the Strategic Political Reserve, applying a temporary solution to a longer term problem. If we do go down this path, I think we will look back on it in a couple years as putting a bandaid on a bullet hole. We will see what happens with the Permian Basin (I talked about some of the things to watch recently), but that is going to be the key for oil, and could potentially be a driver for inflation moving forward.
Conclusion
I’m pretty confident that we are going to see inflation or stagflation, and it’s just a matter of when and how much. Oil is going to be a driver, which is what makes the timing difficult. I don’t have a crystal ball for interest rates near term, but I think we are in a secular bear market for bonds, and I find commodities to be a much more attractive asset class. I have been looking at a couple new companies recently, but I want to add some exposure to gold, copper, and a couple other sectors. I haven’t found anything directly exposed to natural gas that has caught my eye, but my outlook on the commodity itself has started to change for the better over the last couple months.
Markets move in cycles and I think we have a long way to go in this new regime. When more investors will start to figure it out is up for debate, but I think more and more people are starting to wake up to changes going on in the market. Whether it’s the government debt situation, underinvestment in commodities, or changing market cycles, I have come to the conclusion that all roads on the current macro situation lead to inflation. If it looks anything like prior inflationary periods, commodities and stocks in the sector are going to outperform and see massive inflows in coming years. I’m curious to see how the rest of the year plays out, but it could be an interesting election year if inflation starts to rear its ugly head again.
Disclaimer
I own shares of Peabody Energy. I also own calls on Peabody. You should do your own research before making any investment decisions. Different investment strategies have different risk/return profiles which should be considered before making any decisions.