If inflation returns, it will be difficult to protect against it

The twin inflation risks are well understood: supply shocks and demand shocks. A war in the Middle East could threaten energy supplies, and tax cuts in an economy near full employment should raise prices.

However, additional inflation threats do not fit either model. Tariffs and deportations would likely raise inflation but would also hit the economy. “Commodities don’t protect you from this,” says Christian Mueller-Glissmann, head of asset allocation research at Goldman Sachs.

The problem has already manifested itself in price movements since the elections. The market’s measure of expected inflation over the next five years, known as the breakeven, made its biggest jump more than a year after the result, already rising as traders bet on a Donald Trump victory.

However, prices for gold, oil and copper fell. Have they lost the ability to protect against inflation? To answer this question, think about three different causes of inflation.

Firstly, oil. Obviously, oil will still protect against one of the most common causes of runaway inflation: sharp increases in oil prices resulting from attacks on oil facilities in the Middle East. However, this has become much less likely. Shocks to global oil supplies are cushioned by large inventories and excess production capacity, as well as the United States’ status as a net exporter, a sharp change from the inflationary era of the 1970s. Not only has oil failed to soar as Israel has stepped up its fight against Iranian proxies and Iran itself, but it has remained stuck at $70 a barrel.

President-elect Trump’s promise to “drill, baby, drill” and his choice of a fracking executive as his nominee for Secretary of Energy and Oil Prices also suggest downward pressure on US prices.

Secondly, stronger growth. This should also raise inflation. Typically, oil and copper are good hedges against growth-driven inflation as demand for both commodities increases. But separating the US and Chinese economies through tariffs could block this effect. China is the largest source of commodity demand, but stronger economic growth in the US may not help it much or at all.

Third, Trump’s tariffs and plans to deport migrants. Both can increase inflation.

Tariffs have a mixed effect on inflation. The immediate result would be an increase in prices, similar to a sales tax, as well as a rise in the value of the dollar. In the long term, they should slow down the economy (again, like tax increases), which should reduce inflationary pressures. The mixed effects include higher inflation expectations in the short term but little change in inflation expectations beyond the next five years.

It is difficult to defend against this kind of action. Far from helping oil and industrial metals, tariffs could hurt them as trade wars threaten to weaken the global economy and, as a result, reduce demand. Gold may also struggle as tariffs push the dollar higher, which will tend to weaken the price of gold and reduce the likelihood of interest rates falling.

If the new administration succeeds in displacing the many millions of migrants who entered the country illegally, it will undoubtedly raise wages for the lowest paid workers as companies compete to replace low-wage workers. Since the poor tend to spend all of their income, this should stimulate spending and influence prices as companies try to recoup their higher costs and through the additional demand that creates higher spending. Again, this is the wrong kind of inflation for oil or copper.

The industry with the greatest exposure to illegal migrant labor is agriculture, so this should have the biggest impact on food prices, potentially making agricultural futures a way to protect against this. But farming is not a market for the faint of heart, with great volatility and the need to understand the details of each crop.

The only inflation hedge that is guaranteed to work is Treasury Inflation-Protected Securities, or TIPS. TIPS promise inflation-linked returns. But they are only guaranteed to work if they are held to maturity. When sudden shocks cause interest rates to rise, as in 2022, TIPS suffer from higher post-inflation rates and can fall in value.

TIPS look better today than they did during post-pandemic inflation because their starting yields are much higher. But as Salman Ahmed, global head of macro and strategic asset allocation at Fidelity International, points out, TIPS are better at protecting against several years of higher inflation than against sudden spikes in inflation.

All of this makes it difficult for a bullish portfolio to protect against inflation. Some TIPS to follow into adulthood make sense; gold could be a hedge against stagflation, although recently it has been driven by demand from foreign central banks that has nothing to do with inflation; Ahmed says he likes to own some energy stocks because they could jump if there’s a real oil price shock.

Like many things, Trump also introduces uncertainty into your portfolio regarding inflation protection.

Write to James Mackintosh at [email protected].