Marlborough’s Stacey Ash: Protectionism, inflation and commodities

History shows how protectionist trade policies can stoke inflation. Such policies were a very recent memory when in 1994 Peter Sutherland, soon to become founding director general of the World Trade Organisation, said: “Virtually all protection means higher prices.”

Donald Trump will, of course, have heard this argument, but he appears intent on delivering on the rhetoric of his election campaign, during which he called for 45 per cent tariffs on goods imported from China and threatened heavy penalties for car-makers producing vehicles in Mexico.

Economists believe that global trade matches excess supply with excess demand, holding down prices and keeping a lid on inflation.

Tariffs, they argue, do the opposite – driving up prices. That is exactly what happened when the US tried to protect its car manufacturers and steel producers in the 1980s with a form of quota known as a voluntary restraint agreement (VRA). US consumers ended up paying on average $2,000 more for Japanese cars, while US manufacturers increased their prices by an average of between $750 and $1,000 per vehicle. A VRA designed to protect the US steel industry also resulted in higher prices, with the price of imported steel climbing 4.5 per cent while the cost of domestically-produced steel also rose.

As US President George Bush noted in his 1992 economic report to Congress: “Trade barriers not only raise the price of imported goods to consumers, but also the price of domestically produced goods that compete with these imports.”

It has been a similar story in global agriculture and the textile and clothing industries, so if Trump pursues his protectionist agenda there is good reason to expect inflationary pressure.

Infrastructure investment

Trump is also planning large-scale investment in infrastructure to accelerate economic growth. In the UK too, Theresa May’s government has signalled a scaling back of austerity and has its own plans for investment in infrastructure. These measures may also be inflationary.

Investors will observe these developments with great interest, and no-one will be watching more intently than those of us investing in commodities. Commodity prices and inflation are, after all, positively correlated. It is a complex, multi-factored relationship, but essentially, when companies expect rising inflation they will try to protect against price increases by stocking up on the commodities they need. Investors too will buy them. This increase in demand drives up commodity prices.

Equally, when demand for commodities rises – for example when infrastructure investment increases – without a corresponding growth in supply, commodity prices rise, feeding through into the wider economy and fuelling inflation.

Inflation hedge

Importantly, that correlation also means commodities can play a valuable role as a hedge to protect investors’ portfolios against the corrosive effect of inflation.

Many investors have reduced exposure to commodities in recent years. The global economic environment has not been kind to the asset class. Quantitative easing was very positive for bond prices, but kept inflation low, which did not help commodity prices already depressed by a range of factors including a glut in oil production and a slowdown in Chinese infrastructure investment.

The picture improved markedly for commodities last year though, primarily due to the prices of many commodities falling below the marginal cost of production. That meant some higher cost operators ceased production, reducing supply so any pick-up in demand had a positive effect on prices.

In addition, Saudi Arabia and its OPEC associates gave up the squeeze on shale oil producers in the US. Unrestrained oil production, which drove down prices, was simply costing them too much money.

The World Bank is forecasting strong gains for industrial commodities such as energy and metals this year, because of tightening supply and increasing demand. That has already attracted the attention of many investors. In our view the importance of commodities as a potential hedge against inflation should also not be underestimated. In an unpredictable global environment a properly diversified portfolio is essential – and commodities have an important role to play in that.

Stacey Ash is co-manager of the Marlborough ETF Commodity fund