There are many reasons for the current rise in inflation but persistent commodity price increases are a key catalyst. Costs of significant raw materials such as iron ore and aluminum and production energy costs (such as coal and natural gas) will continue to impact costs of production equipment and components. The main issue is whether the upswing in energy and commodity prices, represents enduring global demand and supply development and therefore a lasting shift in process to higher levels.

If commodity prices keep rising headline inflation could remain elevated for longer, lifting people inflation expectations and putting upward pressure on wages as households increase resistance to the erosion in purchasing power. In such a scenario, inflation could become more generalized and entrenched.

Some factors could pave the way towards a higher inflation environment over the longer term:

Global money supply growth: Strong global economic growth and the resulting effect on inflation arose from overly expansionary monetary policies in industrialized countries, particularly during 2002-04. Credit expanded rapidly in many countries spurring aggressive demand for assets, goods and services. The availability of relatively cheap credit until recent times also contributed to highly speculative buying in assets and commodities markets. With monetary policy remaining accommodative and real interest rates being eroded by inflation inflationary trends might not subside.

Energy supply challenges: Supply of traditional energy sources has suffered a variety of disruptions caused by weather anomalies, geopolitical instability, insufficient investment in capacity through out previous decades and rising costs for commodity producer. The rising cost of oil and gas is also spurring increasing interest in bio-fuels and other alternative sources of energy. However, many of these are produced from grains, which are in turn escalating in cost.

The food price shock: Food price inflation is likely to endure longer than many people expect, with agricultural commodity process expected to stay high for the foreseeable future.

Central banking policies: Central banks may have little choice but to live with inflation levels above their targets and governments with relatively sluggish consumption growth for years to come.

Shifting demographics: There may be relatively more consumption and less savings worldwide in the years ahead. Disturbingly the pattern of per capita oil consumption versus per capita income in emerging markets is closely tracking that if industrialized countries – and similar patterns are emerging in food consumption.

Socio-economic threat: While the pace of urbanization in larger emerging markets had a dis-inflationary effect in the past, there are warning signs that this situation is likely to recede in years ahead. China has been a significant influence, with its urban population level steadily increasing since pro-market reforms began in the late 1970s. This contrast with India’s urbanizations rate, which is just 29%, compared with the 75% average across the industrialized world.

Investments implications:

Returns from equities and bonds suffer when inflation surges. Upswings in commodity prices raise the cost of materials, curb corporate profits and push inflations and bond yields higher.

However high inflation can provide opportunities for those with sales exposure to high growth sectors in emerging markets such as infrastructure and consumer goods, those in regulated sectors that let revenues increase in line with inflation and those with links in real assets like hard and soft commodities precious metals oil and gas and real state.

Quality companies with moderately high levels of debt and strong cash flows and interest cover are likely to benefit from an inflationary environment. During periods of high inflation, the value of outstanding debt is eroded if there are sufficient cash flows to support the debt structure, such companies can efficiently use capital for investments.

An examination of global asset class performance from 1972 to early 2008 show real (inflation adjusted) returns from energy, precious metals, agricultural commodities and gold easily outperformed those of traditional equities, bonds and cash during periods of high and rising inflation.

Investors entering the market have reaped substantial rewards over the following years. Such an opportunity may exist following the most recent equity market sell off.
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