Published on April 4, 2008
With expectations that inflationary pressures will pose a global threat this year, Merrill Lynch has offered five ways to trade as commodity prices rise.
According to Merrill's global Economics publication last week, the bank expects global inflation to be 4.2 per cent, up from 3.4 per cent in an earlier forecast.
Its five recommended trades are:
Commodities as a hedge
Inflation risk is an important source of risk for financial institutions that have their liabilities linked to inflation. By adding commodity investments to a portfolio composed of traditional asset classes such as equities and bonds, investors can increase the risk-adjusted returns of the broad basket of investments.
More importantly, commodities tend to move broadly in line with inflation-linked liabilities such as materials, wages and retirement benefits. While moving in line with liabilities, commodities are also able to boost returns by yielding high returns in high-inflation environments. This is particularly evident in the current environment where the high level of demand for production input has been one of the main sources of inflation risk.
In addition, commodities are a good hedge against inflation volatility. This is because energy and food prices are typically a lot more volatile than other prices.
A long-term solution to inflation problems in emerging markets is to improve infrastructure in these markets. Decades of under-investment mean many emerging markets are struggling with a combination of poor physical infrastructure at a time of extremely strong economic growth.
Just recently, power shortages and transportation bottlenecks due to bad weather in China and power outages in South Africa caused a spike in inflation rates, a temporary loss of industrial output in both countries and no doubt contributed to the sharp increase in global commodity prices in February.
Merrill Lynch has previously estimated that infrastructure spending in emerging markets is likely to total US$1 trillion to $2 trillion (Bt31.5 trillion to Bt63 trillion) in the next three years. It continues to believe that both the need and ability to finance infrastructure spending remains very strong.
look at us inflation curve
For investors who believe the mix of high commodity prices and the weak dollar will keep US inflationary pressures high, the five-year sector of the US inflation curve looks attractive.
US break-even inflation rates have fallen sharply in the past two weeks and the five-year sector provides direct exposure to inflation expectations without the indexation complexities of the short end or the supply and demand distortions of longer maturity instruments.
The two most natural ways of gaining exposure to inflation are through government bond break-even inflation or zero-coupon inflation swaps. Bond break-even inflation currently looks cheap versus inflation swaps, as IL bonds have cheapened versus nominal on a swap spread basis.
Currencies and markets
Merrill's Global Currencies Strategy team looked at the impact of higher inflation risks on the currencies of a sample of inflation-targeting countries.
Looking at foreign exchange, the team tested whether a currency would strengthen following a higher-than-expected inflation surprise. Its strategists found that the best trading opportunities for going long in the face of higher inflation risks may surface in Central Europe, especially in the Czech Republic, Slovakia, Hungary and Poland.
Higher rates would be the expected response following higher-than-expected inflation surprises. Looking at directional rate trade strategy, Merrill strategists see the strongest potential for rates to go higher in Israel, Turkey, Chile and Slovakia.
As for curve trade strategy, Merrill's team found that the most compelling curve flattener trades after a higher-than-expected inflation surprise are Israel, Poland and the Czech Republic. For curve-steepener trades after higher-than-expected inflation, the strongest candidates are Colombia, Chile, and Hungary.
The more defensive consumer staples seem to suffer less during periods or rising inflation:
Retail (dominated by food), personal and household goods, healthcare and food are examples. The cyclicals bear more of the pain when inflation is rising. Interestingly, oil and gas tend to underperform during high inflation periods.
Merrill's analysis therefore concludes that, on the back of rising inflation, one should overweight retail (mainly food as non-food or general retail has been suffering from price deflation), household goods and healthcare.