Energy could be a decade's hedge for investors as inflation remains high

Energy could be a decade’s hedge for investors as inflation remains high

World War II

World War II

By Arthur Salzer

With underlying inflation at a 40-year high of 6.6% in the United States and even higher rates in Europe, many investors are finally starting to take the threat of inflation seriously. Due to the age of most lifelong investors and portfolio managers, the only point of reference they can gravitate towards is the 1970s. two digits. It was not until the now famous Paul Volker, as Chairman of the US Federal Reserve, raised short-term interest rates to 15.8% that inflation was shattered.

However, students of economic history have found the period after World War II to be more analogous to our current situation. Gross Domestic Product (GDP) growth is not negative, but is growing slowly at around 2%. Unemployment is low because many workers are now part of the service sector, which does not experience the same large fluctuations as the manufacturing sector. However, debt-to-GDP ratios for the developed world are at record highs.

The Fed and other central banks have raised interest rates (which has the effect of reducing borrowing and therefore the money supply), and interest rates generally need to be at or above the current inflation rate to control inflation. We are far from being there yet.

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

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

Interest rate caps were created by central banks entering the market to buy government bonds to keep interest rates below natural market conditions. This is problematic because investors do not have enough incentive to hold sovereign debt if the current yield does not sufficiently offset the risk of inflation.

Tightness of oil supplies

To overcome this challenge, governments require that a country’s pension funds and banks 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, because government bonds are “risk free”.

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

In the meantime, it is worth examining the cause of this inflation. This is largely due to governments’ response to COVID-19 lockdowns. Large sums of cash were sent directly to individuals and businesses by the government after their savings were locked down. The shutdowns have also devastated global supply chains and trade, which rely heavily on just-in-time production. Shipping and manufacturing has returned to pre-lockdown normal, but there is one sector that still stands out.

The energy sector, particularly oil and gas, has not benefited from sufficient capital investment over the past decade. This is due to a myriad of factors, including low prices, as investors are not attracted to this region to invest in new exploration and development, and no new refineries have been built in the United States since the 1970s due to NIMBY issues (not in my backyard). . Moreover, the environmental, social and corporate governance (ESG) crowd has not encouraged investment in carbon-intensive projects, opting instead for electricity generation from solar energy and wind turbine.

The challenge is that the production of fertilizers (urea and ammonia) comes from the oil and gas sector; tractors that plant and harvest crops run on diesel; and shipping to the end consumer relies on diesel. Reduced fertilizer use 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 are also driving up food prices. This, of course, has little correlation with interest rates.

The war against Ukraine has only highlighted the dependence of Europeans on Russia for their needs in natural gas and other hydrocarbons. Even if the war were to end, rising oil and gas prices are a certainty until sufficient capital and development enters the sector.

Finally, due to the 2022 midterm elections, the United States has flooded the oil market by selling large amounts of its strategic petroleum reserve over the past year to keep oil prices low. The sale has been so large that the reserve has returned to 1980 levels. Oil prices will skyrocket when these sales cease or, worse, the reserve has to be replenished.

As a result, tight oil and refined product supplies are likely to continue (with ebbs and flows) over the next three to seven years. In the meantime, this translates into higher energy and food prices and, therefore, inflationary pressures that cannot be resolved by simply raising interest rates.

From an investor’s perspective, what are the options? It’s possible to buy a diverse basket of oil and gas producing companies that have strong (and growing) dividends through an exchange-traded fund and hold it through this period of rising prices. A commodity trading advisor may be something to consider if you are looking for a more diversified approach and buy/short sell a basket of commodities including oil, gas and food.

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

Arthur Salzer is CEO and Chief Investment Officer at Northland Wealth Management. FPM

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