The Bank of England’s August Monetary Policy forecast made for a grim reading. The bankers in Threadneedle Street expect prices to rise by 13% next year.
But there is light at the end of the tunnel. By 2024, monetary policymakers predict that inflation will climb down again to 2% per annum, a forecast that is largely based on the assumption that oil and gas prices will start to normalise during the next two years.
This acknowledges that global commodity prices, rather than monetary policy or wages, may be a decisive factor behind the surge in inflation.
And September’s consumer price data suggest that the bankers are getting this right: UK CPI inflation dipped for the first time in a year, from 10.1% to 9.9% largely due to a reduction in petrol prices, which has pushed down transport costs. Nevertheless, rising energy prices continue to drive up housing, food and transport costs, as Office for National Statistics’ data shows.
Inflation forecasts missing the mark
But for institutional investors with a long-term investment horizon, the question is how realistic the Bank of England forecasts are. Based on futures trading data available in July, the Bank of England estimated that gas prices would peak at 420p per therm this year and fall to 327p per therm next year. It also predicts that oil prices would climb down from a peak of $97 per barrel to $93 per barrel.
But ICE trading data from the past two months suggests that it is unlikely that this optimistic scenario will pan out, at least for the gas markets. While the price of petrol has indeed fallen, gas futures were trading in excess of 500p per therm by mid-September. That, and the fact that other elements of the CPI index, food and services in particular, continue to rise, is leading most analysts to believe that the Bank of England will continue its trajectory of rate hikes and may revise its inflation forecast upwards.
Over the medium term, energy price caps such as the £2,500 limit could help to bring down inflation, but they come at a price, UK government debt issuance is set to increase by £250bn during the next two years and repayment costs will increase, given that interest rates are rising.
Climate challenges
There is a case to be made that the role of commodities as a driver of inflation is set to increase due to the acceleration of climate change and the depletion of natural resources. This argument is made among others by former White House reporter Bob Keefe in his book Climatenomics.
Keefe predicts that the rampant economic effects of climate change will continue to contribute to resource depletion and drive up prices. It also means that investors may want to brace themselves for the fact that rising prices driven by scarcity of resources will become a defining feature Anthropocene.
Commodities as inflation hedge
Many investors are already acutely aware of this challenge. A survey by Ortec Finance shows that 57% of institutional investors globally predict further dramatic increases in prices in the next year. Alongside inflation-linked bonds, commodities and infrastructure appear to be the most popular inflation hedges, with more than half of respondents stating that they have increased exposure to these asset classes.
But within the overall portfolio, this does not yet translate into a significant allocation. Only 4% of UK defined benefit schemes are invested in commodities outright and the asset class accounts for only 2% of their overall allocation, according to Mercer.
However, schemes are increasingly investing in companies that are set to benefit from the transition to a low carbon economy. For example, Border to Coast invested £1.35bn in renewable energy as part of its Climate Opportunities Strategy in April this year and Nest and GLIL announced a £400m strategic partnership with Octopus Energy to fund offshore wind power generation.
And there is evidence that investment in energy generation, rather than outright investments in commodities such as gold, stand a better chance of mitigating the effects of inflation. Data from the past 30 years shows that energy-related commodity indices, for example, the S&P GSCI or the Bloomberg Commodities Index, have shown the highest levels of correlation with inflation figures whereas the link between gold and inflation is less closely established, according to Morningstar.
With the climate crisis continuing to drive up prices across the globe, demand for these assets is likely to increase.
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