By David Schassler
Head of Quantitative Investment Solutions
Are We Heading for a Recession?
Yet again, inflation has surprised to the upside. The Consumer Price Index (CPI) was up 1.3% month-over-month and 9.1% year-over-year in June. The most disturbing aspect of the latest CPI report is that inflation is clearly becoming more entrenched, as evidenced by persistently elevated core inflation. Consumers do not need a PhD in economics to understand that inflation is broad-based and extreme. The latest CPI report showed them just that.
The root cause of inflation, extremely accommodative monetary policy, is now working in reverse. One way the U.S. Federal Reserve is attempting to battle inflation is by shrinking the money supply. Eventually, we expect a recession and a subsequent decline in inflation. Based on previous inflationary regimes, the prospect of a “soft landing” seems unlikely. A recession would likely result in more accommodative monetary policies and increase inflation once more.
Commodity Corrections May Present Buying Opportunity
Fears of a recession contributed to the decline in commodity prices from early June highs. In our view, this reaction is misguided. The 1970s taught us that real assets have the potential to outperform during periods of high inflation and declining economic activity, otherwise known as stagflation. Corrections of 20% or more can be expected. Commodity prices were up 130% since the COVID-19 crash. Then, between June 9 and July 6, commodity prices fell nearly 20%, panicking investors.
Investors should take a deep breath, look at history to gain perspective, and consider that this drawdown may be an excellent entry point. This is especially true for those that are not allocated to inflation-fighting assets, such as real assets. The last time we had an inflation problem of this magnitude was in the 1970s, and commodity prices significantly outperformed both stocks and bonds. However, there were many bumps along the way. The diagram below demonstrates corrections in commodity prices during that decade.
It’s Not Always a Smooth Ride: Bloomberg Commodity Index Drawdowns During Bull Markets
Source: Bloomberg. Past performance is not indicative of future results.
The first significant correction in commodity prices during that era was in 1973. That year, from January 1 to August 14, commodity prices were up over 130% before falling 23% from August 15 through October 30. Commodity prices then went on to outperform both stocks and bonds as the inflationary environment endured. Selling commodities early in the 1970s inflation cycle was clearly the wrong decision then, and we believe that it will be the wrong decision in the current cycle.
Is Oil Actually Cheap?
Turning back to today, WTI crude oil prices have retreated from a recent high of $122 on June 8 to below $100 per barrel based on fears of a recession. The average price of oil over the last five years is approximately $60 per barrel. However, the value of the unit of exchange, in this case the U.S. dollar, must be carefully considered when making assumptions as to the relative cheapness or richness of current oil prices. The U.S. money supply has increased by 42% since March of 2020. The chart on the left below demonstrates that oil is actually cheap after adjusting for the change in the U.S. money supply.
Another perspective is to examine the price of gold, which, given its finite supply, is de-linked from the debasement effects on fiat currencies. The chart below on the right demonstrates that oil is, again, historically cheap per ounce of gold.
Money Supply and Gold Place Oil Price in New Light
WTI Crude Oil Price
(as a % of U.S. M2 Money Supply)
WTI Crude Oil Price
(as a % of an ounce of gold)
Source: Bloomberg. Past performance is not indicative of future results.
Profitability Signals Opportunity
High inflation has been kind to oil companies. Higher oil prices and a renewed focus on profitability have resulted in high free cash flow (FCF) yields. We recently analyzed the top 10 companies in a well-known energy index and found that free cash flow yields currently averaged over 11%! The diagram below demonstrates that, based on history, purchasing oil companies, when they have high free cash flow yields, may offer an attractive entry price.
|Current Free Cash Levels Suggest Favorable Path Forward|
|FCF||Observations||2-year Avg. Return||3-year Avg. Return||4-year Avg. Return||5-year Avg. Return|
|0% – 2.5%||41||12.37%||15.99%||19.20%||13.69%|
|2.5% – 5%||116||15.63%||14.92%||19.21%||20.89%|
|5% – 7.5%||79||7.01%||15.40%||29.21%||38.45%|
Source: Bloomberg. Note free cash flow yields representative of the top 10 holdings of the Energy Select Sector Index. Returns are of the index itself. Past performance is not indicative of future results. Not a recommendation to buy or sell any security.
The future path of inflation cannot be known with certainty. If history is any guide, high inflation often persists for an extended time. During such periods, traditional stocks and bonds have proven vulnerable. Diversification into inflation-fighting real assets has been and continues to be an effective portfolio protection strategy. As such, the recent correction in real asset prices may also offer an attractive entry point for investors seeking both diversification and inflation protection.
Now is not the time to underestimate or ignore inflation protection. Explore the VanEck Inflation Allocation ETF (RAAX), an adaptive strategy offering a diversified portfolio of inflation-fighting real assets.
Originally published by VanEck on July 21, 2022.
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Consumer Price Index is an index of the variation in prices paid by typical consumers for retail goods and other items. Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and non-agency). Bloomberg Commodity Index is a broadly diversified index that tracks the commodity markets through commodity futures contracts and is made up of exchange-traded futures on physical commodities, which are weighted to account for economic significance and market liquidity. S&P 500 Index is widely regarded as the best single gauge of large-cap U.S. equities. The index is a float-adjusted, market-cap-weighted index of 500 leading U.S. companies from across all market sectors including information technology, telecommunications services, utilities, energy, materials, industrials, real estate, financials, health care, consumer discretionary, and consumer staples. Energy Select Sector Index seeks to provide an effective representation of the energy sector of the S&P 500 Index. The Index includes companies from the following industries: oil, gas and consumable fuels; and energy equipment and services.
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