The changing dialogue in inflation expectations from “transitory” to “sticky” was the first of many signals that the Federal Reserve believes greater inflation is here to stay. In this short piece we document some of the forces that are currently exerting upwards pressure on prices and ask investors if they are properly prepared for the potential effects of inflation on their portfolios.
Shortage of minerals required for electric vehicle production
The sources of clean energy have been heavily debated recently and the Glasgow COP26 meeting once again raised the problem of vehicle emissions and their impact on the environment. A move towards electric vehicles has been suggested as a viable alternative, but there are pertinent questions as to whether this is really a long-term solution. The detrimental effects of mining physical resources are well-known and have rightly received heavy scrutiny. However, they are necessary in order to produce electric vehicles. Take for example a Tesla, that is powered with a 1,000-pound electric battery. This alone requires the equivalent of 90,000 pounds worth of material to be excavated by huge mining trucks that run on approximately 0.3 miles per gallon of diesel.
Additionally, there are currently 1.4 billion cars globally, with electric vehicles forming around 0.5% of this number. To replace all non-electric cars, we would need close to 300 million tonnes of lithium-ion batteries which require a number of different minerals such as nickel, cobalt or lithium. These requirements far outweigh the annual global production of each and in the case of cobalt, there is not a sufficient level of the mineral across all global reserves.
Table 1: The mineral requirements for moving to an all-electric fleet of vehicles [1]
The problem is worsened by approximately a factor of 10 times when you consider the wholesale adoption of lithium-ion batteries purported to be required to stabilise electrical grids globally for utility-scale storage. Whether or not this will be necessary is up for debate, but either way there is and will be significant further upwards pressure on the price of electric vehicles.
Chinese hoarding of grains squeezing food prices
Towards the end of 2021, it was widely reported in the press that provinces across China began rationing the use of electricity. This was due to a combination of commitments to restrict the use of coal energy and the resurgence in demand for Chinese goods driving up energy requirements for factory production. However, little attention has been paid to the apparent recent efforts to triage water use across China. If China has been undervaluing the price of water and starts to build in price rises in the future, as a major global exporter, most countries can expect to be impacted.
Concurrently, China has begun hoarding grains, reporting in November last year that “wheat stockpiles can meet demand for one and a half years”. Whilst it might not be the case that they are doing so to circumvent the immense quantities of water needed to produce food on this scale, the huge stockpiles were driven by colossal imports from the US, Brazil and other nations. In fact, the US department of agriculture estimates that by mid-2022 China will hold 69% of the world’s reserves of corn, 60% of its rice and 51% of its wheat [2]. Such an aggressive strategy only serves to put upwards pressure on already rising food prices.
Fragile energy supplies amid political unrest
Energy prices also rose sharply towards the end of last year as Russian natural gas supplies dried up. The Yamal-Europe pipeline that feeds into mainland Europe has seen a consistent downwards trend in the supply of the commodity. Aside from Poland, all countries in mainland Europe saw prices rise above €300 per MWh, with France and Switzerland nearing €400.
Then, tensions mounted in Eastern Europe during February before Russia invaded Ukraine with President Putin declaring a “special military operation” was necessary in order to demilitarise two regions – Luhansk and Donetsk, that he had previously recognised as independent states. The ensuing political unrest ensured oil prices reached their highest level in seven years, with Brent Crude moving above $100 per barrel. Given the importance of energy consumption in household spending, such moves in oil and gas will surely lead to further inflationary effects.
With concerns over environmental damage, food and energy supplies, inflation is here to stay. What matters now for a long-term investor is how they choose to protect their portfolio from its impact. Whilst it may be tempting to over allocate to equities, recent developments in Eastern Europe have demonstrated how fundamentally fragile equity markets can be and investors need to consider whether that changes the riskiness of their portfolio appropriately, aware of the potential for drawdown. Instead, should they consider capital protected and coupon paying solutions with lower risk profiles like structured products? In combination with the right investment strategy, they can provide downside protection and attractive growth opportunities.
Paravene Capital is a multi-strategy Investment Manager, that marries proven systematic trading strategies with downside protection structures to deliver uncorrelated, stable return streams. To find out more about us please visit our website: https://www.paravenecapital.com/.
[1] Source: Assessment of the extra capacity required of alternative energy electrical power systems to completely replace fossil fuels. Geological survey of Finland, August 2021.
[2] According to Nikkei analysis in the following article.