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How should investors react to inflation from rising commodity prices?

As the world hopes for a rapid de-escalation of Russian hostilities for humanitarian reasons, the battle against inflation presents a tricky picture for investors.

| 7 min read

Financial markets have been eyeing the risk of rising inflation and interest rates for some time, but Russia’s horrifying invasion of Ukraine has seen those concerns intensify. That’s because of the major role these countries play in the world’s natural resources.

Russia is the world’s second largest producer of natural gas behind the US. It supplies about 40% of Europe’s gas, which has resulted in major upheaval in continental energy markets. Russia is also a big player in oil, responsible for about 8% of the global export market and around 30% of EU supply. Sanctions and boycotts stand to remove much of this energy from markets and prices have risen as buyers scrambled to secure enough for their needs. This may ameliorate as supply is ramped up from elsewhere, and perhaps as demand slows down in response to higher prices.

It’s a similar picture in other commodities markets. Russia and Ukraine are responsible for about 30% of global wheat production and 19% of corn. With Black Sea ports closed while war wages there are no exports. Russia is also the world’s largest exporter of fertiliser, the production of which from most other sources requires natural gas that is now much more expensive. Meanwhile, Russia’s significant deposits of industrial metals are unavailable to western industry. Key raw material inputs may be in short supply and cost more.

Squeezed supply and higher commodity prices could exacerbate an existing cost of living crisis. Recent data showed US consumer prices rose 7.9% year-on-year in February – a new 40-year high – and European and UK figures may come in higher still thanks to being more dependent on imported energy.

Higher prices at the pumps and on the shelves reduces propensity of consumers to spend on non-essentials and overall we can expect lower economic growth if commodities continue to climb. Bulging inflation numbers will also give more reason for central banks to put up interest rates, which acts as a further constraint on growth and makes servicing debt more difficult. As the world hopes for a rapid de-escalation of Russian hostilities for humanitarian reasons, an intensifying battle against inflation would pose difficult dilemmas to central banks. They will need to manage the normalisation of interest rates without tipping economies into recession. It also presents a tricky picture for investors.

Investment implications

As well as putting a significant dent in the spending power of cash in the bank or building society, high inflation is bad for many assets. Investors require a higher return on their money in an inflationary environment, meaning they tend to demand a lower starting value. The higher the inflation the more return they will want, effectively forcing prices lower.

Conventional bonds paying a fixed level of income are vulnerable as inflation and interest rates rise their capital value must fall to provide the required level of return to investors. Although sometimes referred to as ‘safe’ investments, capital values can be significantly eroded and less inflation-sensitive areas such as shorter dated or index-linked bonds are likely to offer better sanctuary in an era of persistently rising prices.

Equities – a balancing act

For shares, it comes down to how individual companies adapt to the rising costs of raw materials and labour as well as the level of demand they experience. Purchases of big ticket items may be curtailed whereas lower value, repeated purchases, especially necessities, stand to hold up better. So too businesses that are ‘capital light’ or digital in nature as they don’t use raw materials or even much in the way of manufactured products.

The key problem for investors, though, is that companies on the whole are adversely impacted by higher input costs, and possibly higher wage demands too, and there are relatively few direct beneficiaries. The most obvious are the energy and mining sectors, and the service industry surrounding them, where higher raw materials prices translate to growing profits. These areas have already performed well so far this year, so they have become more expensive, but should higher prices persist then they could make further progress. They should at least offer a hedge for those worried about soaring commodities, but if prices do recede then other parts of a diversified portfolio should provide better returns.

Various structural trends offer investors notable opportunities, and in the long run these can help investors outrun inflation in the long term. The all-important US consumer remains in pretty good health and the impact of digital technology continues apace, promising strong returns to innovating companies. More broadly, investing in efficiency is a way companies can fight against the negative impacts for inflation. In technology the market winners over the next five years might be relative unknowns today. Life sciences may also provide decent prospects, especially now valuations have fallen considerably over the past year. The imperative of confronting the Covid pandemic led to a dramatic shortening of the cycle of drug discovery and production. Finally, the commitment to both delay climate change and adapt to its impact, as well as build energy security, creates opportunities in energy transition.

Diversification is more important than ever

The refuge from equity market volatility and the diversification benefits of conventional bonds looks weaker in an inflationary climate. They are still an important component, guarding against recession and any future collapse in inflation amid economic stagnation, but integrating some areas of the bond market that are more resilient to inflation could be worthwhile. Unlike conventional bonds, index or inflation linked bonds provide an income that rises. They tend to offer some protection from an increase in inflation expectations, though they can become expensive when lots of investors are looking to protect themselves from this risk and drive up prices.

Meanwhile, some exposure to other areas such as commercial property, shopping centres, warehouses, offices and industrial units, can offer an attractive and ideally rising rental income and some capital growth over the long term – thereby outpacing inflation.

Additionally, infrastructure assets often have a certain amount of contractual inflation protection built in. They can potentially provide investors with an attractive, income-orientated return and welcome diversification from equity markets. There are a number of options for investing in this specialist area, which looks relatively well placed to generate consistent returns.

Finally, gold is currently proving itself a reasonable crisis and inflation hedge currently. In the short term price action can be fickle, and it is vulnerable to decline on more positive news for other assets, but keeping a bit of exposure, for instance via an exchange traded fund (ETF), is worth considering. We tend to prefer ‘physically-backed’ funds which own gold kept securely in a vault, as opposed to derivatives-based funds where there can be added risk and complexity.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

How should investors react to inflation from rising commodity prices?

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