London, March 2010

On 4 March, SG Economics Research published its latest views on inflation: “Is inflation next?”. Three main factors point to a possible return of inflation. First, supply and demand conditions appear less favourable to price stability worldwide. Second, faced with the crisis, the fight against inflation has been relegated to the background. Third, state intervention and a more protectionist backdrop are fertile ground for a return of inflation.

Commodities & Inflation

Commodity prices are by nature closely linked to inflation due to their real-asset characteristic and the associated intrinsic value. Beyond the short-term measure represented by correlation, commodity prices and Consumer Price Indices (CPI) are co-integrated, which means that a long-run equilibrium exists between the two. This would imply that both variables should not drift away from each other but, instead, revert to their long-run joint equilibrium. Thus co-integration is much more powerful than correlation which often varies a lot over time.

Dynamic hedging portfolios can be built to hedge against inflation, based on gold and on enhanced commodity indices that cope with the contango issue of the commodities forward curves. Dynamic hedging portfolios outperform inflation on average, sometimes significantly, with volatility levels that remain low.

SG Cross Asset Research's three medium-term scenarios (5-10 years):

- Temporary deflation: probability 15%

- Asymmetric inflation shock: probability 25%

- Inflation: probability 60%

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Contact Penin Remy

www.sgresearch.com

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Commodities and Inflation

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