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. |
