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Energy could be the hedge of a decade for investors on high inflation

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Many are now taking seriously the risk high prices pose to their portfolios

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By Arthur Salzer

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With a 40-year record core inflation print of 6.6 per cent in the United States and even higher rates in Europe, many investors are finally beginning to take the inflation threat seriously.  Because of the age of most tenured investors and portfolio managers, the only reference point they can gravitate toward is the 1970s. This was a period of stagflation: no economic growth, high unemployment and double-digit inflation. It wasn’t until the now-famous Paul Volker, as U.S. Federal Reserve chair, increased short-term interest rates to 15.8 per cent that inflation was broken.

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However, students of economic history have been finding the period after the Second World War is more analogous to our current situation. Gross domestic product (GDP) growth isn’t negative, but growing slowly at around two per cent. Unemployment is low as many workers are now part of the service sector, which does not have the same large fluctuations the manufacturing sector does. However, debt-to-GDP ratios for the developed world are at all-time highs.

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The Fed and other central banks have been increasing interest rates (which has the effect of reducing borrowing and, therefore, the money supply), and it typically takes interest rates to be at or above the current inflation rate to tame inflation. We are nowhere close to that yet.

If interest rates were to be directed or allowed to climb to current inflation rates, most governments would not be able to service their interest payments over time and would, in effect, become either insolvent or need to “print more money” to make these payments. Total debt would continue to climb, especially as a ratio of GDP.

The 1945-to-1960 period is especially relevant to investors. Countries had incredible levels of debt due to the costs of paying for the war and the destruction the war created. If interest rates had been allowed to be set at the level the free markets determined, it would have been impossible for countries to service their debts. Countries would have become insolvent.

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Interest-rate ceilings were created by central banks entering the market to buy government bonds to keep interest rates lower than natural market conditions. This causes an issue because there isn’t enough incentive for investors to hold sovereign debt if the current yield does not sufficiently compensate for the inflation risk.

Tightness in oil supplies

To overcome this challenge, governments mandate that pension funds and banks within the country have a certain proportion of their portfolios or balance sheets invested in that country’s bonds. The argument is that this mandate is for their own protection as government bonds are “risk free.”

As the interest rates on these bonds are below GDP growth plus inflation, the debt-to-GDP ratio declines over time. This is a form of financial repression and has been successfully used in the past. The result is that investors in government bonds will lose money (slowly) after accounting for inflation and taxes.

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In the meantime, it’s worth examining the cause of this inflation. Much of it is due to governments’ response to the COVID-19 lockdowns. Substantial amounts of cash were directly sent to people and companies by the government after their economies were locked down. The lockdowns also devastated supply chains and global trade, which rely very much on just-in-time production. Shipping and manufacturing have been trending back to the pre-lockdown normal, but there is one sector that still stands out.

The energy sector, especially oil and gas, has not had sufficient capital investment for the past decade. This is due to myriad factors, including low prices as investors are not drawn to that area to invest in new exploration and development, nor has there been a new refinery built in the U.S. since the 1970s due to NIMBY (not in my backyard) issues. In addition, the environmental, social and corporate governance (ESG) crowd has not encouraged investment in carbon-intensive projects, opting instead for power generation from solar and wind.

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The challenge is that fertilizer (urea and ammonia) production comes from the oil-and-gas sector; tractors that plant and harvest crops operate on diesel; and shipping to the end consumer relies on diesel. Reduced fertilizer usage means lower crop yields and, therefore, higher food prices. Higher diesel prices for planting, harvesting and shipping due to a lack of supply and refining capacity also result in higher food prices. This, of course, has little correlation with interest rates.

The war on Ukraine has only highlighted the reliance of Europeans on Russia for their natural gas and other hydrocarbon needs. Even if the war should end, higher oil and gas prices are a certainty until sufficient capital and development enters the sector.

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Lastly, due to the 2022 midterm elections, the U.S. has been flooding the market with oil by selling vast amounts from its Strategic Petroleum Reserve over the past year to keep oil prices down. The selling has been so significant that the reserve is back to 1980 levels. Prices of oil will soar higher when this selling ceases or, worse, the reserve needs to be replenished.

As a result, the tightness of oil supplies and refined products will likely continue (with ebbs and flows) for the next three to seven years. In the meantime, this translates to higher energy and food prices and, therefore, inflationary pressures that can’t be solved by merely increasing interest rates.

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From an investor standpoint, what are some options? It’s possible to buy a diversified basket of oil- and gas-producing companies that have solid (and increasing) dividends via an exchange-traded fund and hold this through this period of increasing prices. A commodity trading adviser may be something to consider if you’re looking for a more diversified approach and buy/short a basket of commodities that include oil, gas and food.

As part of a balanced portfolio, these two options may form part of the inflation hedge that will be required for this decade.

Arthur Salzer is CEO and chief investment officer at Northland Wealth Management. FPM

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