COMMODITY
PRICES, GROWTH AND INFLATION
By Andrew Kashdan
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.
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%.
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.
Best regards,
Andrew Kashdan
for The Daily Reckoning
Editor's note: Andrew Kashdan is a top analyst at Apogee
Research and a contributing editor to Outstanding
Investments.
 |
Previous Notes |
 |
|
 |
 |
|
