Friday, February 22, 2008

Global inflation 0 comments

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It should be pretty obvious now what will be the key theme for 2008, if one just looks at the headlines being blared every other day, detailing concerns and attempts by governments across the world to rein in rising inflation.

Attempts to control inflation vary. Some attempt price caps and export taxes to increase domestic supply, such as Indonesia and China for their agricultural crops. Some provide subsidies for fuel, which apply to a wide swathe of developing nations across Asia where the majority of the populace are poor and the land size is large. Others try to do it via economic growth through which personal incomes rise to counter the debilitating effects of core inflation, such as our very own Singapore. And an increasing number of nations (with the prominent exception of the US) are now trying to maintain strong currencies to counter rising imported product and raw material prices.

Inflation is such an important issue because it can be politicised: nothing gets ordinary citizens going at the government than rising cost of living. China will never forget that the 1989 Tiananmen student riots happened because of high inflation. The US will never forget the 1970s years of stagflation when the central bank was forced to raise rates to >10%. The European Central Bank doesn't dare to lower rates now despite signs of economic weakness because of inflation. Yet the structural factors are aligned against them.

There are underlying demand-and-supply dynamics which will be hard to resolve in the short-term. These apply across the three main classes of commodities: energy, metals, agriculture. Energy and metal commodities are into their 5th or 6th year of bull market; agricultural into their 1st probably. Their prices are driven by the rise of new giant economies, especially China and India which together comprise more than one-third of the world's population. It is increasingly believed that oil production is reaching its peak soon, and this implies future imbalances widening and hence all energy commodity prices being pulled along upwards. Vast infrastructure construction across emerging Asia has driven demand for metals, together with mining industry consolidation which appears to raise the spectre of an OPEC-like cartel that will dictate (higher) prices in the future. Rising food consumption and trends towards higher protein consumption as vast populations become more affluent has brought agricultural product prices to forefront prominence over the past year, with competition for acreage between oilseeds and grain being the current battleground (and leading to skyrocketing prices for both sub-categories). All these commodities, hard and soft, are seeing the effect of under-investment over the past two low-inflation decades, and it will take years to bring new supply to market (especially agricultural commodities).

The next point will be more debatable but I think the now notorious sub-prime crisis might accelerate the commodity inflation process. While US end demand will soften, the rate cuts, or at least halt in rate hikes, around the world will lead to continued glut in capital that has shown signs of being diverted to commodities as an inflation hedge, hence driving up prices further. Furthermore, many commodities' demand tend to be driven by fixed-asset investment demand (metals) and inelastic population consumption (agriculture and energy), and these are likely to be less affected compared to say, discretionary consumer products (eg. electronics).

What this means is that pricing power moves up the value chain, as the bargaining power weakens for end-demand product distributors/retailers (due to softening consumer sentiment), but with little impact on upstream raw material suppliers whose bargaining power is undiminished. The headwind on the former, therefore, is immense: stagnating or declining selling prices, combined with rising raw material and sometimes (to a lesser extent) labour costs.

One might choose to avoid investing completely given that "inflation is bad", and that is looking at the half-empty part of the glass. Or he might adjust his investing allocation, for there are still opportunities in stocks in such an inflationary environment. Indeed, my argument is that it might be better to buy (the correct) stocks than to buy commodities directly now, simply because stocks have corrected so sharply across the board that the risk-reward looks likely to be better in (commodity-linked) stocks than pure commodities.

Generally, it looks like there're two main categories of stocks that could benefit from a global inflationary environment:

1) Upstream stocks. Not just commodity producers like miners or plantations, though they're the most obvious. But also service providers, say oil services providers, offshore logistics companies, bulk handlers/shippers (need to watch looming vessel supply), agricultural machinery/fertiliser/animal feed companies etc. Their margins are likely to be maintained or might rise.

2) Capital-intensive stocks. Depreciation costs are flat, while selling price (revenue) could be adjusted in-line with inflation; this in effect transforms the inflationary environment to the company's advantage. Asset owners belong to this category: owners of vessels, construction equipment, completed properties (especially those with short leases that are renewed routinely). Because these capital assets now cost more to build (due to rising raw material costs), they are also worth more now than implied on their balance sheets.

At the same time, stocks with domestic focus in strong economies underpinned by domestic reflation are also likely to continue to do well as long as they are not affected by foreign trade flows (ie. avoid exporters) or foreign capital flows (ie. avoid high-end properties even though they might benefit from the reflation trend).




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