Snowmen and the Inflation Genie — Evidence in the Commodity Markets

Snowmen and the Inflation Genie — Evidence in the Commodity Markets

And away we go for another year of Reckoning! 2021 is already throwing out fireworks. There’ll be plenty more coming up too.

What are the big themes of the year?

Right now, it’s the tussle whether inflation is coming…or if the current chatter is just another false signal. There’s been a few of those over the last 10 years.

We have a front-row seat here in Australia. That’s because what’s inflationary for the rest of the world can look like boom times for us.

How so? Commodity prices, of course! Take the price of natural gas right now. It’s rocketing up on the world market. One reason for that is Europe and China are locked in a bitterly cold winter.

Even my regular haunt in Spain is buried in feet of snow. The family is sending videos of people skiing down the village streets and making snowmen.

Those higher heating prices became a cost for the consumers. But higher gas prices lift revenue and profits for gas producers the world over…including ours here in Australia.

It’s not as if gas is an isolated commodity that’s moving either. You know that iron ore is roaring.

Zinc and nickel are very perky right now. Uranium and rare earths always grab the speculators.

The market is pricing in a big lift coming for lithium. Even oil is up 40% over the last quarter.

The Evidence in the Commodity Markets

What is inflation but higher prices? The evidence in the commodity markets is right in front of us.

All these translate into higher costs for users. Those get passed on down the production chain if they stay high.

This might all sound rather obscure…but the ramifications are many.

Last year I made the case to avoid bank stocks. I missed the rally.

One reason for their strength, in hindsight, is the market pricing in a more favourable interest rate environment.

Sustained inflation lifts the ‘long’ end of the yield curve. That gives the banks better margins, all else being equal.

But rising rates also erode the value of bonds with fixed payments. And bond prices have been extremely high over 2020. These could cut down if inflation lifts unexpectedly.

Inflation expectations are already rising. Just how big does the lift have to be to cause a dislocation in the markets?

I can’t tell you right now. But it’s a theme we’ll be following in these pages as we work our way into the year.

More practically, the action in the stock market is in commodity stocks right now. Take your pick of your favourite and start getting active.

There’s been some cracking rallies in the lithium space, for example. They might need to consolidate for a bit from here.

It’s tempting to nibble at some of the oil names. This is a hated industry. That means, in general, the stocks don’t carry a big growth premium.

But the cash flow is there with oil and gas prices lifting. A colleague of mine, Steve Sjuggerud, has a mantra for all his investments. He looks for what’s ‘cheap, hated and in an uptrend’.

That looks a lot like oil (and coal) stocks right now. The one thing you have to concede here is that these industries will never carry a big ‘multiple’ anymore. The market will pay a certain price for the dividends and not much more.

If you’re looking for wild capital growth, that can only come from stocks breaking open new markets in a powerful way. Tesla is proof of that.

That leads us back to technology names. I saw some evidence last week that the two best sectors to own in an inflationary period are technology and energy.

The world never sits still. In the days of yesteryear, energy stocks protected you in an inflationary environment because oil and gas prices rose and compensated for the shift.

Solar energy, however, is a deflationary force. So you have to be clear, if you’re investing along these lines, about which energy stocks you hold.

What’s interesting is that any upward pressure on oil and gas prices, nominally excellent for producers in the short term, hastens the demise of both industries because solar becomes even more appealing under economics alone.

Oil and gas companies are mostly in Zugzwang. That’s a chess term meaning that any move you make leaves you in a worse position. Would I trade an oil firm? Yes. Will I hold one for five years? No.

Best wishes,

Callum Newman Signature

Callum Newman,
Editor, The Daily Reckoning Australia

PS: Our publication The Daily Reckoning is a fantastic place to start your investment journey. We talk about the big trends driving the most innovative stocks on the ASX. Learn all about it here.