While business media has stayed fixated on tech returns and what Robinhood options traders are doing, the Fed made a big announcement that moved markets for August yet with little mainstream fanfare, but Warren Buffett took note, and may have made a move based on it.
To take a look at how this played out with investors, it helps to look at the monthly returns by asset class for August. 
You will note that the “risk on” trades continued as investors climbed back into riskier assets such as small caps, oil, emerging markets and high yield bonds. The S&P didn’t do bad itself, having its best August in 20 years. Usually August is a light month with little significant market movement but this past August saw the S&P rally almost 8%, an impressive monthly return by any standard.
The other takeaway though is the continued strength of commodities both soft and hard. Metals and agricultural funds have been rallying as of late and silver is having one of its best years in 4 decades.
The years leading up to the last financial crisis saw a rally in commodities fueled by endless Chinese appetite as well as weakness in the USD due to low interest rates and a huge increase in government spending. We find ourselves again in a similar situation now, with massive government stimulus and interest rates back to essentially zero. When this happened during the last crisis, commodities saw an almost V-shaped rally but the rally then fizzled off. Slower Chinese growth as well as investors attention turning to tech around 2015 helped to stifle a commodity rally and the sector has been in the doldrums ever since.
Source: St. Louis Fed
The pandemic and the subsequent fall in the dollar has brought commodities back to the forefront though, both in terms of diversification and a hedge against inflation. The latter part seems to show that much of Wall St. has a long memory and hasn’t forgotten the days of high inflation.
So what would precipitate this new interest in commodities except for the prospect of hedging against future yet to be defined inflation?
One reason could be both the debt level in the US, which I have discussed before, but also how the Fed decides to tackle and manage inflation going forward. In that sense, the Fed made some big changes last week that should provide the gasoline (no pun intended) to further fuel a commodity rally.
What the Fed Said
The Fed essentially has a dual mandate: to maintain the maximum sustainable level of employment and to maintain price stability. The former has followed what the Fed thinks is the “natural” rate of unemployment and adjusted policy up and down based on its interpretation of this.
What this means is if the natural unemployment rate was determined to be 4.5% and the national unemployment rate was 4.0%, the Fed had good reason to raise rates with the expectation that unemployment which is too low for too long could spur inflation.
This is a an outdated interpretation of unemployment versus inflation which was characterized by the Phillips curve and broke down with the stagflation which the US experienced in the 70’s. This breakdown was characterized by both high unemployment and high inflation so it’s a wonder that people were still talking about such a relationship when it was shown to have broken down over 40 years ago. In that sense, it was brining policy up to date with reality.
The Fed has been trying to increase its transparency, offering long term guidance to its policy stance and position on rates, so the conference in August was significant as it updated the Fed’s “30,000 foot view” on policy. It had previously issued this type of guidance in 2012 via the Statement on Longer-Run Goals and Monetary Policy Strategy in 2012. The updates from last week can be found through this guide.
The old statement said the Fed would adjust policy based on “deviations from its maximum level.” The new one says the Fed will base its decisions on “assessments of the shortfalls of employment from its maximum level.” The change in wording “may appear subtle, but it reflects our view that a robust job market can be sustained without causing an outbreak of inflation,” Chairman Powell said.
What this essentially means is that the Fed will not raise rates immediately even when it thinks unemployment is too low. Ultra low unemployment, which has been more prevalent during good times in the past few cycles, is thought to be disproportionately beneficial to low income and minority groups. In this sense it seems the Fed is softening its tone towards critics that claim that it doesn’t do enough for these communities.
The other big announcement was that the Fed would be willing to endure periods of inflation above its 2% target in order to bring target inflation in line with the 2% annual figure. Again, this seems subtle but the period above 2% was left intentionally vague and provided no upside cap other than the average figure of 2%. This has consequences for investments based on inflation expectations as well as the dollar versus other currencies.
The dollar index continued its slide on the news and both the long ends of the yield curve on both US and U.K. bonds saw a 30bps to 40bps uptick on the news as investors adjusted expectations.
Whether this will filter further down to other products which trade at a spread to 10 year treasuries remain to be seen. 30 year fixed mortgage rates, for which 10 year treasuries are a proxy, dipped yet again and remain below 3% for those with strong credit.
Source: Freddie Mac
The other impact may be to prolong the further commodity rally in the thinking that “this time is different”. Despite no evidence of inflation climbing higher than the target during the last phase of QE, it seems that investors remain deeply skeptical of the Fed and the US government to keep inflation low. Besides the Fed’s adjustment, there is a strong incentive for the Federal government to inflate away some debt to chip away at the current debt los which is about to climb higher than even the debt level during WWII.
Buffett’s Purchase
Both the long lull in commodity returns as well as the prospect of the Fed having the stomach for some reflation May have been the motivation behind Buffett purchasing Japanese commodity traders such as Itochu and Sumitomo.
Why Japan and why these firm in particular? For one, Japan has been pretty reasonably priced for some time. It took about 25 years to recover from one of the biggest stock bubbles in history, but in the past 10 years valuations and stabilized and traded at a discount to other developed markets.
Source: Hennessy Funds
Add to the fact that the Japanese trading companies kind of fly under the radar. They have a nationalistic interest in securing natural resources for an urban island nation, they have a long term view (making them risk averse) and they aren’t embroiled in the emerging market scandals that many other European traders like Glencore often find themselves.
Buffett has also made a purchase of Barrick Gold Corp after famously shunning gold for decades. Notice he didn’t buy gold itself, he bought a gold miner, which tend to make money digging it up and refining it when prices are high.
These don’t seem like big splashes however, they are only about $6 billion, which is a small part of the $150 billion cash pile that Berkshire is sitting on. Rather they seem like a small hedge just in case inflation does perk up.
Reason for Skepticism
There is reason to have doubts about the rally in commodities and whether inflation actually will perk up. Some economists have pointed out at the looser inflation target doesn’t matter because the Fed hasn’t been able to push inflation up above 2% during sluggish times before, so it shouldn’t expect to now.
In fact we can look at Japan again for an example of how hard this actually is.
Source: St. Louis Fed
Despite the “3 arrows” of Abe when he came to power, inflation only made it above the stated 2% target in 2014 and has hovered close to 0% since then. Not low rates not QE no the will of policy makers has been able to bump up inflation which is thought to be needed to spur the economy along.
So despite the caution and hedging of Buffet and other commodity investors, there is good reason to think that for now, the Fed can say what it wants but as long as it only controls rates, which will likely stay at 0% for years to come and the purchases of treasuries, there is reason to think they just won’t have the necessary tools to realize the target rate they are hoping for. Then again, Buffet would love to prove others wrong, we will see in the coming years if he’s right.
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