When High Commodity Prices Come Back to Haunt Us

by: Zhong Jin

Today, commodity prices are more sensitive to the monetary policy than consumer prices and employment. The current one year inflation expectation, according to the Cleveland Fed, is 1.36%, an increase of 0.46% from 0.90% before the QE talks. Over the same period, commodity prices measured by Dew Jones-UBS Commodity Price Index have shown a 9% increase.

The corporate profit margin is in danger of collapse as an unintentional result of the Fed’s QE program. Given that commodity prices move well ahead of any improvement in wealth growth, consumption, or employment, the production cost is rising faster than the retail price. To illustrate this point, look at the Figure 1 to see that the change in CPI minus the change in PPI gives us a broad picture of what's going on with macroeconomic conditions and corporate profit margins.

Figure 1. US CPI-US PPI

click to enlarge

The recessions around 1990 and 2000 accompanied the facts that the difference between the US CPI and the US PPI dropped into negative territories. However, after the 2000 recession, this margin proxy spent most of its time in the deeply negative territory even when companies were making huge profits. Though the negative margin around 2007 and 2008 can be seen as the negative profit margins during the latest recession, how can we explain the long period of negative values of this margin proxy between 2004 and 2006?

Here is where the emerging economies (especially China) come into the picture. Figure 2 shows the relationship between the US CPI minus the import price from China and the S&P 500 index.

Figure 2. US CPI-US Import Price from China and S&P 500

Although the series of the import price from China only goes back to 2004, it is clear that the US corporate profit margin has been supported by the abundant labor resources in China (and other Asian/emerging economies) until 2008, when CPI minus the US import price from China leaped into the negative territory. After 2008, the US CPI minus the US import price from China became a leading indicator of the S&P 500 index.

But, today, Asian economies can no longer fully absorb the growing commodity prices. Inflation in China has compelled the PBOC to raise interest rates after three years of unchanged and extremely low rates. The labor disputes and strikes in China at the beginning of 2010 also imply that the producer costs in China have little room to cut under current circumstance.

Figure 3 illustrates the curves of the US import price from China and the Dow Jones-UBS commodity price index. As Figure 3 shows, the US import price from China usually has a lag of one to three months behind the move in commodity prices. Today’s US import prices from China/Asia largely are based on contracts signed a few months ago. These contracts are aimed to serve the holiday seasons in the US. The sharp uptick in commodity prices in the past two months has not been reflected in the import price from China yet.

Figure 3.

With the increasing inflation pressure in the emerging markets and a slowing recovery in the US, the US corporate profit margins will grow at a much slower pace. Based on our proprietary model, commodity prices are close to the turning point when the cost pressure in the emerging market is going to negatively affect the consumer prices and corporate profits in the developed countries.

To play this macro-event, we first need to watch the inflation rate in China and import price index from China. When prices in China pick up the recent strength of commodities, that will translate into higher producing costs and squeeze the profit margins of multinational corporations. There are several commodities that are closely related to the China price, such as copper (proxy for most industrial metals), crude oil (China just hiked its retail gas prices), fertilizers (a good proxy for food, and the prices of fertilizers in China are spiking), and coal (energy related).

ETFs of these commodities (such as JJC - copper, PKOL - coal, USO, UCO - oil, POT, MOO - agriculture and fertilizers) are already near their multi-month high. But given the Fed's QE expectation, they still have room to rise, however limited.

The sectors to watch are those that would be impacted significantly by the hiking China prices and limited purchasing power in the US. Retail and Consumer Discretionary come to mind here. This sector is also close to its multi-year high and has already factored in a strong holiday season. ETFs for this sector, such as XLY, IYK, RTH, and XRT, are vulnerable to a cost hiking. Certain industries with extensive global supply chains also have exposures to such inflationary risk from abroad. Examples include automobiles (NYSE:F) and computer markets (DELL, HPQ).

Disclosure: No positions