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Are commodities an inflation hedge or the opposite?

Looks like we’re at the sellout stage where analysts are going Homeric. Here’s the latest from Goldman Sachs’ commodities counter:

Today’s macro markets face a navigation challenge worthy of Odysseus. In Greek myth, Odysseus chose to risk his ship sailing close to the rocks of Scylla rather than risk being pulled under by the whirlpool Charybdis. In our view, policymakers are trying to navigate between the Scylla of current high physical inflation and the Charybdis of supply constraints that could slow future growth. While it would appear that much higher rates are needed today to lower demand and inflation, they could also lead to a decline in capital expenditure and investment that would reduce the structural undercapacity in physical commodities and thus this environment of high headline inflation and lower inflation. growth in the 2020s.

We believe that promoting higher investment in capacity – and bearing Scylla’s costs of higher physical inflation today – can help policymakers avoid the Charybdis of stagflation.

As in myth, staying close to Scylla’s cave is mild as Odysseus would suffer minimal damage (i.e. keeping rates lower, keeping prices higher to encourage investment); however, if his ship is sucked by Charybdis (a decade of stagflation after high rates killed the capex cycle), he would lose his entire ship. It is important to emphasize that policymakers can solve the core inflation problem without completely solving the general inflation problem, given the importance of sustained wage inflation in driving core inflation.

Goldman’s commodities team concludes that Goldman’s customers should buy commodities. A decade of underinvestment in carbon extraction means the complex “can still generate returns even if core inflation returns to more normal levels,” it says:

Investors should remember that Fed-induced slowdowns are simply a short-term reduction in the symptom – inflation – and not a cure for the problem – underinvestment. More generally, when macro imbalances are physical and supply-driven, a financially based macro-demand macro policy cannot resolve them, only a coordinated investment policy. With central bankers focusing on the costs of high inflation, there is a risk that the long-term costs of too deep a recession will mean the end of the capital investment cycle and the inability to increase enough capacity to get the system out of the way. When Volcker raised the Fed Funds Rate to 20 percent in 1980, it was after a decade of rising capital spending, which allowed the subsequent decline in demand in space to undermine global supply chains.

In the current environment, the capital-intensive capital cycle has only just begun and is at risk f out of a recession or resumed only through a return of physical inflation after growth resumes. Crucially, because the Fed aims to lower inflation at the lowest cost to the economy, most Fed-induced recessions are mild and perpetuate the investment cycle, as was the case before Volcker in the 1970s.

The counter-argument comes from Albert Edwards of SocGen, whose notes can often make Greek tragedy look like a light relief. Predictions of a Fed-led shallow recession are a “normal mock milestone that we pass at this stage of the cycle before all hell breaks loose and both the economy and markets collapse,” he says.

As evidence, Edwards cites the New York Fed’s own June 17 forecast briefing that put the odds of a hard landing at “about 80 percent

Perhaps the more interesting question is not how deep the recession will be, but how big the drop in yields will be? The recent rise in inflation has broken the close link between real economy data and bond yields. Will a recession (temporarily) allay inflation fears and significantly lower bond yields?

A hard landing for the US economy would force the Fed to capitulate, although skyrocketing inflation would make a full policy reversal unlikely. But what if inflation disappears quickly? Edwards points to copper 15 months low and highlights that cyclical carbon feedstocks were laggards during the GFC:

If (when) the oil and agriculture complex enters this bear market, headline CPI inflation could quickly collapse below zero, much like it did in 2008/9 when aggregate CPI fell from +5% to -2% in just 12 months . A similar drop in negative inflation would likely drive bond yields down significantly, even if core CPI remains tacky above 2%. While a return of less than 1% over 10 years seems perfectly plausible to me, I suspect we won’t see a drop below the March 2020 low of 0.3% now, as the secular ice age trend of lower lows and lower highs in each cycle is interrupted. The new secular trend may now be for higher inflation and higher yields, but a cyclical recession shock awaits.

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