Commodity Prices, Growth and Inflation
The U.S. economy, formerly the growth engine of the world, has been sputtering recently. That’s causing most economists to push back their targets for the strong, self- sustaining recovery that was supposed to have started already…according to the earlier forecasts of these same economists. Europe and Japan are hardly in a position to take up the slack. So the question for us is, “Can commodity prices continue to rise in this environment?” To offer a preview: Yes.
Over the long term, it is clear that during periods of strong economic growth, commodity prices tend to rise, and during periods of weakness, prices tend to fall. But the CRB Index of commodity prices tracks nominal GDP more closely than it does real GDP. This fact is not too surprising, given that the CRB simply measures the nominal price of a basket of commodities. In other words, inflation may be more pertinent to the recent commodity price trend than GDP growth, per se.
Over the past year or so, for example, the rallying CRB Index has had little to do with GDP growth. In the last few quarters, the Economic Cycle Research Institute (ECRI) leading indicator of economic growth has shown clear periods of improving or deteriorating economic growth. Yet, commodity prices have maintained their upward trajectory regardless of the economy’s up-and-down growth prospects. The CRB Index has advanced steadily to post a nearly 30% gain since the beginning of the year. Meanwhile, actual and expected rates of inflation have been heading higher, even as the economy remains weak, and that’s what is showing up in the CRB. Inflation seems to be the message from the commodity pits.
Commodity Rally: CPI Jump
The Treasury’s inflation-indexed bonds tell a similar tale. The inflation rate “anticipated” by the 10-year inflation- indexed bond has increased by about 30 basis points to nearly 2%, in just the last few months. And you wouldn’t know it by reading the papers, or listening to our chief inflation-fighter at the Fed, but actual inflation has been rising, too. On a year-over-year basis, the CPI has gone from 1.1% last June to the latest reading of 2.6%. Not quite a repeat of the stagflationary 1970s yet, but not deflation either. The recently released ISM prices-paid index jumped to 65.5 from 57.5, surpassing its long-term average of 62. And after two months of declines in the Producer Price Index, the January PPI jumped 1.6%, boosted by a 4.8% rise in energy prices.
One central bank, at least, has already glimpsed the near future. The Bank of Canada raised rates another quarter- point this week, taking the overnight rate to 3.25%, up from 2% since the start of 2002. Canada’s inflation rate is running at 4.5%, a 12-month high, due largely to high oil and natural-gas prices.
Net-net, the current commodity rally seems to be about resurgent inflation, rather than resurgent economic activity. And if Fed Governor Ben S. Bernanke has his way – remember, he’s the one who promises to crank up the “printing press” to fight deflation – this commodity rally has a ways to go. What is more, one aspect of the current commodity rally is not widely appreciated: it is not just oil that is powering the rally. Nearly all commodities are in “rally mode” to some extent.
Curiously, the stock market is full of skeptics about the ongoing commodities rally. Very few resource stocks have kept pace with their related commodities. And that bizarre divergence may present a terrific investment opportunity, even for the most cautious of commodity bulls. If we are to “trust” the CRB rally, numerous resource stocks are a strong buy (and, by the way, long-term bonds are a screaming sell). Over the last several months, the XOI, XNG and XAU – indexes for oil, natural gas, and gold and silver, respectively – have barely budged, despite substantial rallies in their related commodities.
For example, let’s take a look at the XNG Index of natural gas stocks relative to the price of natural gas itself. Natural gas prices have soared more than 260% over the past year and a half. Amazingly, however, the XNG Index – which consists of 15 major gas producers – has actually declined by more than 8% over the same period! A similar divergent pattern is seen in the oil markets. The benchmark WTI crude oil price has nearly doubled since late 2001. Even so, the XOI Index of oil stocks has dropped about 13%.
Commodity Rally: The XAU Index
Likewise, the XAU Index of gold stocks peaked in May 2002, and has dropped more than 14% since then, while gold itself has increased by 7%. “That is a real historic anomaly,” says fund manager Paul Stuka, quoted in Barron’s, “because [gold] stocks should appreciate about two to three times the rate of metal itself. There is something really odd going on.” Unfortunately, for some gold investors, the XAU has suddenly found some leverage on the way down – the gold price has dropped about 5% in the past month or so, while the XAU has lost 12% (and the unhedged Amex Gold BUGS Index has dropped 13%).
Clearly, all three of these equity indexes for natural gas, oil and gold are pricing in a significant downward reversal in the prices of their related commodities. In other words, the indexes, especially the XNG, seem to be discounting a worst-case scenario. That’s funny; because we think we are looking at a best-case scenario for natural gas and most other commodities. A temporary pullback in natural gas prices would hardly be surprising, given the spectacular recent rallies. But we think that the natural gas bull market is the “real deal”. Therefore, we suspect that the shares of many natural gas companies are too cheap because they are pricing in a worst-case scenario that is highly unlikely to occur.
The weak performance of natural gas stocks, and resource stocks in general, relative to their related commodities looks like a golden opportunity. Investors may be getting a great chance to climb aboard a powerful long-term bull market in commodities, and to do so at deeply discounted valuations.
Given the low valuations of many resource stocks, coupled with an inflationary threat that most investors have failed to notice, and a favorable long-term supply and demand outlook for raw materials, the resource stock party may be just getting started.
for The Daily Reckoning
March 14, 2003
Et tu, dear reader?
Daily Reckoning readers are canceling their subscriptions. Not exactly in droves…but at least a large enough number to cause us to take notice. We write today with more disturbing thoughts…and brace ourselves.
Readers are cross with us because they don’t like our attitude toward the war against Iraq…they do not think we take the matter seriously enough…they don’t like the comments we hear on the street or at dinner parties and pass along to you…they don’t think we have any business having opinions about politics…and they especially don’t like the fact that these opinions pullulate in what they regard as the devil’s own den – Paris, France.
“Dear Editor,” begins one letter, politely. “U seem to be overlooking a few Natural facts concerning the U.S. Economy…Confuscious says: He who has the biggest Gun, makes the rules…the difference between right and wrong is an opinion and since the U.S. has the biggest gun then the U.S. opinion is the only one that counts.”
Another correspondent describes our humble notes as “drivel”…
“Leftist politics,” says yet another (never before have we been so accused…!)
“You better come home…your brains have been taken over by socialists…”
“Hopefully, America will drop a few smart bombs on you on their way to the middle east…”
Strange and dangerous things are happening, dear reader. In the past, Americans have gone to war reluctantly; now they seem to look forward to it. The rest of the world – which seemed to go to war so readily in the past – seems overwhelmingly opposed.
What both sides have in common is dollars…which is what attracted our interest in the first place. The dollar rose sharply yesterday…and the price of gold dropped more than $10.
Stocks took off. Investors panicked, just as we worried they might, but in the wrong direction! The Dow rose an astonishing 269.
The Dow depends on the economy. And the economy depends on the dollar…and on the rest of the world’s confidence in it. At least in the near-term, the dollar’s value seems linked to the war effort. In the long term, we think the dollar is doomed…as all paper currencies sooner or later disappear to worthlessness. (For key reasons why, see our special report:How To Seek Profits From The Dollar Breakdown)
The short term may produce surprising twists and turns. War news now seems to drive investor sentiments. One day, bad news sends the dollar and Dow down…the next, a rumor causes them to soar.
Like it or not, we have a war to reckon with.
Faith in the currency is faith in the future…and faith in the economy and the system behind it. Three years ago, Americans had almost unlimited faith in their stock market. Here at the Daily Reckoning, we mocked the bubble; U.S. stock prices rested on illusions and lies, we pointed out. Many readers didn’t want to hear it.
They wrote to complain and cancel.
Now they cancel when we scratch their almost unlimited faith in U.S. military superiority, the dollar, and American consumer capitalism. Stocks peaked out 3 years ago. The bull market in confidence has migrated from stocks to arms…from the comedy of markets to the tragedy of politics. People welcome war talk as they once welcomed statements from their brokers; they seem to think that U.S. military might can not only protect the homeland…but protect its dollar and its economy, too.
Will the end of the war cause the dollar to rise? Will taking out Saddam make the world a better place? Those canceling their subscriptions seem to know the answer; to them it is as obvious that the war against Iraq will be successful as it was once obvious that stock prices would always go up.
How they can know what will happen tomorrow is anyone’s guess. We wish we could do it – but we have never mastered the secret. So, we fall back on the dusty tomes of history for examples…and a tattered old bunch of rules and principles for guidance. We don’t buy stocks when they are high; we say please and thank you; and we wait for the other guy to strike first.
But these are strange and foreboding times. And even this modest position is regarded by many people as if it were treason. “We Americans take action,” a reader reminded us. “We don’t waste our time with a lot of talk like the French.”
But the preference for action over reflection is probably episodic, not genetic. In the Napoleonic era, the French favored action. “Audacity, more audacity, always audacity,” Danton urged the generals in 1792. In just a few years, the bodies of audacious French soldiers were spread all over Europe, following the trail of Napoleon’s many wars.
Then came the Franco-Prussian war – and still the French were men of action. It was the French who went on the attack, not the Prussians. And once again, their lovely corpses were soon scattered all the way from Paris to the Belgian border. In short order, the Prussians had surrounded the French capital; Parisians had to eat cats, dogs and rats before finally surrendering.
What did the French learn from this? The doctrine of ‘élan’ – or fighting spirit – rose in the French military. “Let us go even to excess and that perhaps will not be far enough,” wrote Col. de Grandmaison, mad as a hatter. “In the offensive, imprudence is the best of assurances…”
At the beginning of WWI, the French got a chance to try to this new tactic. The aging Mr. Junot, with whom we dined a few months ago, recalled his own uncle:
“He was mounted, with his sword drawn…and he attacked the German machine guns!”
“Never have machine-gunners had such a heyday,” writes Alistair Horne in his history of the period. “The French stubble-fields became transformed into gay carpets of red and blue. Splendid cuirassiers in glittering breastplates of another age hurled their horses hopelessly at the machine guns that were slaughter to the infantry. It was horrible, and horribly predictable…that superb, insane courage of 1914…”
Within the first year of war, France lost more men than the U.S. lost in both WWI and WWII. The French began to think… and talk…
One day, Americans will, too. Of course, that could be many years from now…
*** More from George Soros, writing in the Financial Times:
“I see a parallel between the Bush administration’s pursuit of American supremacy and a boom-bust process or bubble in the stock market. Bubbles do not grow out of thin air. They have a solid basis in reality, but reality is distorted by misconception. In this case, the dominant position of the U.S. is the reality, the pursuit of supremacy the misconception. Reality can reinforce the misconception, but eventually the gap between reality and its false interpretation becomes unsustainable. During the self- reinforcing phase, the misconception may be tested and reinforced. This widens the gap leading to an eventual reversal. The later it comes, the more devastating the consequences.
“This course of events seems inexorable, but a boom-bust process can be aborted at any stage and few of them reach the extremes of the recent stock market bubble. The sooner the process is aborted, the better. This is how I view the Bush administration’s pursuit of American supremacy.
“President George W. Bush came into office with a coherent strategy based on market fundamentalism and military power. But before September 11, 2001, he lacked a clear mandate or a well-defined enemy. The terrorist attack changed all that. Terrorism is the ideal enemy. It is invisible and therefore never disappears. An enemy that poses a genuine and recognised threat can effectively hold a nation together. That is particularly useful when the prevailing ideology is based on the unabashed pursuit of self- interest. Mr Bush’s administration deliberately fosters fear because it helps to keep the nation lined up behind the president. We have come a long way from Franklin D. Roosevelt’s dictum that we have nothing to fear but fear itself.”
*** Enron…Worldcom…Fannie Mae!? Yes, St. Louis Fed governor William Poole mentioned all three in the same breath. Could Fannie Mae and Freddie Mac, which together own or guarantee 45% of the U.S. residential debt market – $3.1 trillion of it – go broke? Well, they could. We’ll have to wait and see if they do.
*** Welcome to the future: A candidate for president of Argentina proposed linking the peso neither to the dollar nor to the euro, but to gold.