Higher, higher

I said in my last post that May is one of my favourite months and with the bank holiday weekend just gone, it is perhaps easy to see why. Summer felt like it arrived early and my family and I took full advantage, spending as much time outside as possible.

As we roll into the summer months demand for cooling will clearly increase and this year there is another catalyst: the US’ National Weather Service are forecasting ‘El Nino’ weather conditions to form soon. These conditions generally result in warmer conditions across America and given that some 90 percent of American households have some type of air conditioning installation, it wouldn’t be surprising to see energy consumption pick up through the summer there.

Of course, this also comes at a time when the conflict in the Middle East which has led to disruption to trade flows through the Strait of Hormuz, the reduced supply of energy products globally and resulting price increases. Meanwhile, Ofgem has just confirmed a 13 percent increase in the UK energy price cap from 1 July, driven largely by higher wholesale gas prices. These factors put a floor to inflation rates at exactly the time the seasonal demand dynamic is likely to push inflation higher.

But it’s not just energy prices which are at risk of moving up. Research done by the likes of the UN’s Food and Agriculture Organisation have already flagged that the current disruption could develop into a more meaningful food price shock, as higher energy costs and limited fertilizer availability work their way through planting decisions and possibly constrained supply when harvests are conducted in the subsequent six to twelve months. These second-order impacts are also at risk of being exacerbated by the impending El Nino weather patterns.

The other major commodity segment, metals, is also seeing a longer-term shift in demand. The build-out of AI infrastructure is increasing demand for energy (mainly for cooling, incidentally) but also crucially for key industrial materials. Copper has been the main metal that has been cited by several managers we’ve discussed this with over the last few weeks – and while the demand from data centre construction and electrification is self-evident, it was not obvious to me that copper supply is also restricted given low levels of capex made by the miners over the past decades.

Put all of that together and the inflation dynamics look pretty stark: seasonal demand, climate dynamics, geopolitical supply shocks and structural trends are all pulling in the same direction, at least in the near term. This seems quite jarring when considering how abruptly the market narrative has shifted in recent weeks. News flow around Iran has improved, a deal with the USA is expected ‘imminently’, and there is a growing sense that the worst of the disruption may be behind us. That has pulled market focus back towards disinflation, and you can see it clearly in inflation expectations, which have drifted lower.

And that really is the crux of it. Markets do not react to what happens in isolation: rather, they react to the difference between what happens and what was expected. If expectations are aligned with what ends up being realised then it will be very hard to make money, so looking for opportunities where the outcome could be quite different to what is anticipated is key.

The bank holiday sunshine has continued for a week but sadly it’s not likely to be a permanent state of affairs. In the investment world however, the longer-term backdrop does suggest inflation protection still has a role to play for multi asset portfolios on a more permanent basis. Looking at where we can allocate today, it is striking that there may well be an opportunity in those markets which are potentially underappreciating those inflationary risks.