Volatility has plagued the markets so far in 2022 as steadfast inflation at almost 8% (a 40 year high), geopolitical strife from the Russia-Ukraine war, commodity price appreciation from agricultural products to industrial metals (because of inflationary pricing and geopolitical sanction hurting supply), and the Federal Reserve’s quantitative tightening agenda (to tame inflation) have been risk-on trades for markets, highlighting macroeconomic uncertainty and projecting a possible slowdown in GDP growth globally.
The Opportunity Set in Commodities
Looking at this environment from a different perspective, it appears that the stagflation-driven economy is upon us, as seen by worsening supply-side inflation. Oil prices reached concerning levels at around $120/barrel (and have aggressively retreated) on the heels of the Russia-Ukraine war and the evident supply shortages that could proceed. As the war continues, alternatives to Russian oil supplies surface and geopolitical oil planning (Iran nuclear deal resurgence) have enabled oil prices to consolidate around $100/barrel, giving a slight stagflation breather. Regardless, the Russian-Ukraine war has created a unique global macro landscape. Almost a year ago, we discussed in Are Commodities on the Brink of a “Supercycle” that the commodity supercycle appeared to have legs amid an asymmetric economic rebound, strong demand, inflation, and cognitive arbitrage (behavioral shifts in the consumer that creates investing opportunities due to its’ impact on supply and demand economics); however, increasing inflation, an eastern European war, and poor equity and bond performance have culminated into a perfect storm for commodities to sustain outperformance.
As indicated in the 2022 Market Outlook: The Hunt for Stabilization, the risk of inflation and the increased demand profile for consumer staples positioned soft commodities (such as coffee, cocoa, soybeans, corn, sugar, wheat, fruit livestock, and other agriculture products) to outperform. Oil, wheat, corn, and soybeans appear to have been the most direct recipient of higher prices amid the Russia-Ukraine war, with cocoa, coffee, sugar, and cotton remaining rangebound despite some weather volatility in Brazil. Many soft commodities appear to have squeezed out much of their relative premiums due to hyperbolic price increases at the beginning of the year. Thus, remaining selective in soft commodities and intrinsically understanding that the tactical near-term price appreciation of wheat, corn, and other soft commodities will likely remain temporary continues to remain essential narratives. For instance, even though Ukraine is one of the largest low-cost wheat producers in the world, other countries such as India can help offset any long-term supply disruptions from the war.
On the other hand, industrial metals and precious metals have also experienced positive price movements amid supply shortages, as seen by the nickel short squeeze last week (Russia is one of the largest exporters of the metal) and palladium’s aggressive price appreciation (Russia is 40% of world trade). Aluminum (an energy-thirsty metal), copper, and gold (haven/risk-on trade) also saw price appreciation since mid-February amid similar narratives. In short, commodities tied to Russian supply all experienced price increases (i.e., crude, natural gas, grains, fertilizers, metals (aluminum, nickel, copper, palladium, etc.) as the sanction and geopolitical headwinds intensified. Nonetheless, it appears that though hard commodities have been tactical winners throughout the Russia-Ukraine war, the base case for these hard commodities will likely normalize towards the latter part of the year as the demand will likely dwindle as GDP growth slows globally and supply shortages recalibrate. However, hard commodity volatility may persist in the near term, with precious metals and industrial metals maintaining some near-term relative outperformance. Thus, commodities remain attractive, but actively managed futures and actively managed commodity funds can help weather the dynamic macro environment.
The Fed’s Next Steps and Inflation Outlook
With that said, the other market catalyst is the Fed’s quantitative tightening and visible interest rate increases. Currently, the Fed remains poised to raise interest rates on Wednesday, but their velocity and the tone of their agenda remain most important. The Fed’s hawkish or dovish tone can depict the inevitable outcomes of the market and foreshadow if a recession is looming. The current bear steepening of the yield curve (long-term rates increase faster than short-term rates) has displayed the inflationary pressures experienced throughout 2021 and 2022. Since the beginning of the year, the 10-year treasury and 30-year treasury have increased 41.37% and 29.64%, respectively. Amid the current economic situation domestically and abroad, the Fed appears to be potentially hamstrung in their action to tame inflation, resulting in likely a more dovish tightening approach. As we have discussed in the Case Study: Capitalizing on Stagflation, the Fed’s ability to rein in supply-side inflation (stagflation) remains limited (as the Fed only can control the demand side of the inflation equation) and the Fed’s tepid approach to interest rate volatility in relation to domestic economic health ( and now the Russia-Ukraine war) remains constrained. Amid the current situation, a potential soft landing (or a cyclical downturn-Fed raising rates- that avoids a recession) can occur (though it has only happened once in history under Alan Greenspan); however, the statistical probability of a successful soft landing remains low as the current market environment does not appear as supportive compared to the mid-1990s. Though the analogies to the 1970s continue to have legs, the potential macro situation may be defined by volatility, speculation, and uncertainty, as seen in the late 1970s to early 1980s. Though we do not think that a recession is evident, it remains something that investors should begin to plan for amid the current leading and lagging economic indicators.
Therefore, inflationary pressures will likely persist for longer than initially anticipated as the velocity of Fed tightening will be slower, and supply-side inflationary pressures may linger well into the end of the year and into 2023. However, that does not mean that markets will remain in the current state of underperformance. Instead, most of the inflation, uncertainty, and geopolitical tensions appear priced into the equity markets. Some selective asset classes and companies have been unfairly beaten down from the start of 2022. Therefore, the search for economic margins and relative growth outlooks in selective stock and bond picking can provide alpha to stagnant portfolios. Additionally, though bond markets remain in open waters, some asset classes offer attractive risk-adjusted returns and remain fundamentally well-positioned to weather macro-headwinds. For instance, non-agency RMBS, short-term corporate bonds, and floating rate bonds (bank loans, CLOs, etc.) can provide alpha to traditional portfolios.
Positioning Portfolios in the Current Environment
In short, the current market and economic environment have caused traditional 60/40 (60% equity and 40% fixed income) portfolios to underperform relative to history. Therefore, for investors to mitigate extensive cross-asset underperformance, the 50, 30, 20 (50% equities, 30% fixed income, and 20% alternatives) portfolio allocation appears ideal amid the current dynamic economy and market landscape. Equities and bonds have both experienced poor performance amid the combination of rising interest rates, inflation, geopolitical risks, supply shortages, or in short, stagflation. Therefore, to weather stagflation, the 20% allocation to alternative products and investments could provide relative diversification to market downdrafts while also enabling upside capture when markets eventually normalized or revert to their’ statistical mean.