With the economy growing strongly and the incoming president promising tax cuts and tariffs, investors and economists are rightly concerned that inflation could return to the U.S. Unfortunately, one of the standard ways to protect against inflation — buying commodities, especially oil — will offer less protection than it used to.
The twin risks to inflation are well known: supply shocks and demand surges. A war in the Middle East threatens energy supplies, while tax cuts for an economy near full employment should boost prices.
But the additional threats to inflation now don’t fit either model. Tariffs and deportations of illegal immigrants are both likely to push up inflation but also hit the economy. “Commodities don’t protect you from that,” said Christian Mueller-Glissmann, head of asset allocation research at Goldman Sachs Group Inc.
The problem has already been evident in post-election price action. The market’s measure of inflation expectations over the next five years, known as the breakeven inflation rate, saw its biggest jump in more than a year after the results were announced, having already risen as traders bet on a Trump win.
Yet gold, oil, and copper are all falling. Have they lost their ability to protect against inflation? To answer this question, consider three different causes of inflation.
First, oil. Obviously, oil still stands up against one of the most common causes of runaway inflation: a surge in oil prices caused by attacks on oil facilities in the Middle East. However, the likelihood of this has been greatly reduced.
Large inventories and excess production capacity, along with the United States’ position as a net exporter, have dampened shocks to world oil supplies, a sea change from the inflationary 1970s. Far from surging as Israel intensifies its fight against Iranian proxies and Iran itself, crude prices have languished at around $70 a barrel.
In a sign that U.S. oil prices are also facing downward pressure, President-elect Donald Trump has pledged to increase oil production and picked a fracking industry executive as his nominee for energy secretary.
Second, stronger economic growth. This would also raise inflation. Normally, oil and copper are good hedges against growth-driven inflation, as demand for both would rise. But the impact of tariffs on great power relations could hamper that effect. China is the biggest source of demand for raw materials, but strong U.S. growth may help China little or not at all.
Third, Trump's tariffs and illegal immigrant deportation plans. Both are likely to exacerbate inflation. Tariffs have a subtle effect on inflation, with the immediate effect of raising prices, like a sales tax, while also pushing up the dollar. But in the long run, tariffs should slow economic development - just like a tax increase, thus reducing inflationary pressures. This mixed effect is reflected in higher inflation expectations in the near term, but little change in inflation expectations over the next five years.
Tariffs shouldn’t help oil and industrial metals, but could hurt them, as a trade war would lead to a weaker world economy, which would reduce demand. Gold could also struggle, as tariffs would push up the dollar, tending to weaken gold prices and making rate cuts less likely.
If the new government is able to remove the millions of immigrants who have entered the country illegally, it will surely push up wages as businesses compete to replace low-cost workers. Since the poor tend to spend all their income, this should boost consumption and pass through to prices as companies try to cover their higher costs and higher consumption creates additional demand. This is also a false inflation for oil or copper.
Agriculture is the industry most exposed to illegal immigrant labor, so this has the biggest impact on food prices - which could make agricultural futures a way to protect against illegal immigrant labor. But agricultural markets are not for the faint of heart, with high volatility and requiring detailed knowledge of each crop.
Inflation-Protected Securities (TIPS) are an inflation hedge that is guaranteed to work. TIPS typically promise returns tied to inflation. But they are only guaranteed to work if you hold them to maturity. When a sudden shock causes interest rates to rise (like in 2022), TIPS are hit by the post-inflation increase in interest rates and their value falls.
TIPS look better now than they would in the post-pandemic inflationary period because they start with much higher yields. But as Salman Ahmed, global head of macro and strategic asset allocation at Fidelity International, points out, TIPS are better at protecting against rising inflation in the coming years than against a sudden spike in inflation.
All of this makes an otherwise bullish portfolio less likely to protect against inflation.
It makes sense to hold some TIPS until maturity; gold could provide a buffer against stagflation, even though lately it’s been driven by demand from foreign central banks and has nothing to do with inflation; and Ahmed said he likes owning some energy company stocks because they could take off if there was a real oil price shock.
Like so many other things, Trump creates uncertainty about the inflation protection in your portfolio.
Article forwarded from: Jinshi Data