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commodities and inflation protection

23 Mar

It’s clear from the commodity price increases experienced over the past couple years (see this post) and anecdotal evidence — but not official government numbers — that inflation has returned and that price increases will be making their way through the economy. Several consumer staples companies have already raised prices 5-7% (P&G, Kimberly-Clark, and Fruit of the Loom, for example). This is just the beginning.

Often, money moves into commodities as an inflation hedge, but do commodities actually protect one’s purchasing power after the onset of rising consumer prices? Based on the last time we saw this in the U.S., the answer is “mostly, no”. Commodity prices, not surprisingly, tend to lead increases in actual inflation. But once inflation emerges, their ability to purchasing power protection diminishes. Thus, commodity ‘investors’ (aka speculators) who get in near the end of the pricing uptrend do not tend to fare as well.

The above charts illustrate this phenomenon over the same period I discussed in the last two posts, 1964 through 1988. They show commodity prices (Commodity Research Bureau spot price index) rising prior to a major jump in CPI inflation, with the bulk of the price spike clustered into just a couple of years (up 22.1% in 1972 and 59.8% in 1973), while actual annual inflation was just around 4.0%. From 1964 through 1973, average annual inflation was just 2.5% while commodities rose 8.4% per annum. After 1973 and through year-end 1988, annual inflation averaged 7.1% while commodity prices rose just 1.9%. Today’s commodities investors might be disappointed in their future returns while consumers may similarly be displeased with future price increases.

I do not want to be fatalistic and state unequivocally that inflation is inevitable, but I am not optimistic that it can be avoided at this point. The longer commodity prices remain high, the more they lead to higher structural costs for the economy as a whole. Once companies raise prices, they do not tend to lower them. Likewise with wages.

The final chart illustrates commodity prices versus actual inflation since 2000. To me, this looks similar to the period from 1964 through 1974, when commodity prices rose ahead of actual inflation in the face of inflationary government policies (namely, deficit spending). We see similar policies in place today, coupled with unprecedented monetary intervention that isn’t likely to abate anytime soon, especially in the face of a still-stagnant economy. And our national balance sheet is in worse shape. Are the mistakes that led to stagflation in the 1970s being repeated? Unfortunately, it appears so.


stocks and inflation (part 2 of 2)

22 Mar
(This is an update from yesterday’s discussion on inflation’s effect on markets.)
To augment the information presented in yesterday’s post, I wanted to add additional perspective with respect to earnings. Stock prices can be reduced to two components: (1) earnings and (2) a multiple against those earnings. Yesterday’s post dealt with the latter without much discussion of the former. So, I’ve added the chart below to address this oversight.

Readers will note that earnings (dark blue) more than kept pace with inflation over the twenty-five year period from 1964 through 1988. Certainly, if it were possible to invest in corporate earnings alone during this period, an investor would have fared quite well. This is the crux of the argument made by those who believe stocks will keep pace with inflation — that corporations will raise prices and earnings will largely keep pace. Unfortunately, it’s the ‘multiple’ component that hurts investors during inflation – if ending valuations are meaningfully lower than beginning, an investor may not fare well even if earnings grow nicely. And over this period, they certainly did — real earnings were 50% higher in 1988 than in 1964.

predicting economic data points

7 Jan

As usual, they got it wrong. According to the Wall Street Journal, economists in Dow Jones Newswires’ survey had forecast payrolls would rise by 150,000 and the jobless rate would fall to 9.5%. The actual numbers came in at 103,000 and 9.4%, respectively, meaning they were off the actual number by nearly one-third. In typical fashion, CNBC spent most of the morning speculating about the release. The repartee between two folks is classic “time filling” television when the number is only an hour or so from release.

This offers a case in point on why it’s best to ignore prognosticators, especially on metrics like jobs. These numbers may move one way or another, but there is no point in trying to trade on such information because we can’t know beforehand. Forecasters tend to be within a tight range of each other, so when there are big numbers they are just as surprised as the markets might be.

Of the 103,000 jobs created (statistically, at a 90% level of confidence) this month, 113,000 of them were private. About half the decline in the rate was due to folks leaving the labor force, the other half was actually increases in payrolls. Service-providing industries were by far the largest area that saw job creation, up 115,000. We can quibble over 10 or 20 basis point down tick in the headline number, but 16.7% is the number on which to focus. This is the so-called U-6, and it represents unemployed but also those who are working part time but want full-time work. Thus, it’s more comprehensive.

To get back to the point: it’s mostly pointless to focus on predictions, which tend to introduce noise into an investment process. Remember this the next time economic data is close to release and the media fills time with speculation.

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