Rising Inflation Rates Could Boost Metals Markets
The “I word” is back!
Inflation has returned from a lengthy sabbatical, and its return could wield a surprisingly large impact on the financial markets.
To be clear, this new inflationary trend is not of the crazy 1970s variety. So there’s no need to rush to your storage locker to dig out your bell bottoms, macramé wall hangings and eight-track tapes.
The inflation we’ve been seeing so far is still well below long-term average levels. But on the other hand, the current readings are well above the average levels of recent years… and are trending higher.
That’s a trend…
Let’s dive a little deeper to see where this trend will likely head next…
Not only is the North American economy humming along, but most economies of South America are rebounding nicely from recessionary conditions. Europe is also showing some spring in its step. Meanwhile, China and India are still posting solid growth numbers.
“The global economic upswing that began around mid-2016 has become broader and stronger,” the International Monetary Fund’s most recent World Economic Outlook reports. “Global growth seems on track to grow 3.9% this year and next, substantially above our October forecast.”
I’ve italicized the last part to emphasize that economic growth is ramping up much faster than most professional forecasters were expecting just a few months ago.
These buoyant conditions are contributing to “surprisingly” strong demand for commodities like crude oil. That’s a big part of the reason why the price of crude has doubled from $35 a barrel two years ago to about $70 today.
Yes, OPEC’s production cuts sparked this advance. But even with these cuts, the price of oil would not have doubled unless demand had been robust. Global consumption of crude and other liquid fuels has jumped by 3 million barrels per day during the last two years – from 97 million to 100 million.
Similar trends are unfolding in most other commodity markets. Global demand is overtaking supply to drive prices higher. The majority of the base metals markets are in deficit this year – meaning that global demand is greater than global production.
Aluminum, zinc, nickel, cobalt and copper are all in deficit. That’s why the prices of these metals are trading near multiyear highs. These rising prices are working their way through the supply chain – from raw production to finished goods.
A second wild-card factor that could deal an even stronger hand for inflation is protectionism. The recent round of eye-for-an-eye tariffs and sanctions between the U.S. and various trading partners is boosting the prices of some commodities to multiyear highs.
The prices of steel mill products, for example, have risen 5% during the last four months, while further up the chain, steel scrap prices have soared 27%. Almost none of these recent price hikes are showing up yet in the prices of finished goods.
But they will… and inflation readings will likely jump as a result.
The last major influence that could kick the inflation trend into high gear is labor expense. The all-in cost of labor has become one of the fastest-growing line items on many corporate income statements.
As the chart below shows, U.S. real wages gained no ground whatsoever between late 2010 and early 2014. But since then, wage growth has been making up for lost time.
Additionally, as a result of the Republican tax cuts, many U.S. companies announced sweeping pay hikes for their employees. These hikes are likely to show up in future readings of real wages.
Bottom line: The prices of goods and services are heading higher.
This new inflationary trend is still gaining momentum… and it’s creating new opportunities and risks for investors.
First, the risks…
The most immediate victims of rising inflation are always interest rate-sensitive securities like Treasury bonds, utility stocks and real estate investment trusts (REITs). As inflation gains traction, these types of securities typically slip lower.
(Remember, yield and price move inversely from each other. So when yields are rising – i.e., when interest rates are rising – bond prices are falling.)
A visible negative trend is already well underway in these interest rate-sensitive sectors. Bond prices across all maturities have been falling pretty sharply.
The same thing happens to the prices of “yield stocks” like utilities and REITs. Generally speaking, an investor buys these types of stocks because of the relatively high and secure dividend yields they offer.
So when rates rise, these stocks fall. Period.
As you can see in the chart below, utilities and REITs have both slumped more than 10% since last November… even though the S&P 500 Index is up about 5% during that time frame.
The conspicuously poor performance of utility stocks and REIT stocks is a classic sign that interest rates are likely to continue rising. These negative trends are likely to become even more negative as inflation readings rise. Risk is high in these sectors.
If the inflation trend strengthens, this sector should continue to flourish… at least long enough to make a few bucks.