With inflation already surfacing in many parts of the emerging world, and slowly creeping into developed markets in the form of high commodity and rising food prices, is it time to join the crowd and invest in food, agriculture, and commodities in order to protect yourself from inflation that may continue? Or is it time for caution, as slowing economic growth and high speculation point to high levels of risk and potential for a sharp correction?
One of the major drivers of the markets over the past two years has been the "unstoppable" and highly promising future of the emerging markets -- especially China. As millions of inhabitants in emerging countries begin to enter the "modern" world and middle class, their consumption and their effect on the economies of countries all over the globe increases. And as millions of people contribute to the growth of China, India, and other countries, they will require extra food, energy sources such as gasoline and oil, cotton for their increased consumption and clothing needs, industrial metals for their new cars and technology, and many other materials that a growing and evolving population needs.
The problem that may emerge, however, is that there is no guarantee that China and other emerging countries will actually meet our lofty expectations. Emerging markets have been growing at such a rapid pace (7-10+ percent compared to 2-3 percent for the U.S.) that their development may actually be setting them up for housing bubbles, high inflation, and uncontrollable growth.
We've already seen China and others raise their interest rates in order to curb growth and try to limit food inflation. Rapid growth is good -- but if it leads to very high input costs for food, energy, and materials, it may derail economic recoveries and put a sharp halt to economic growth. In other words, if the rapid growth we've seen in emerging markets continues to spiral out of control, the inflation that can follow in the form of high food and commodity prices may lay a heavy strain on their economies and could plunge them back into recession.
Moreover, with all the enthusiasm over the future growth of emerging markets, investors have piled into stocks and ETFs in hopes of capitalizing on the emerging markets theme. The reasoning behind these moves is that worldwide consumption of food, commodities, and energy will continue as growing and developing populations require more supply. And with more and more people expected to consume at an increasing rate, investors assume food and commodity prices will continue to rise.
Therefore, in order to profit from the expected continued growth in emerging markets, investors have thrown billions of dollars into emerging markets (NYSEARCA:EEM) such as China (NYSEARCA:FXI), India (NYSEARCA:EPI), Brazil (NYSEARCA:EWZ), and others; grains and agriculture (JJG, DBA, DAG, MOO, AGF); steel (SLX), copper (NYSEARCA:JJC), silver (SLV, SIL), tin (NYSEARCA:JJT), and other industrial metals; energy (OIL, USO, OIH, XLE); and just about anything else that could rise if global economies continue to expand.
The problem -- and it's a major one -- with this emerging markets theme that has dominated for the past two years is that all the expectations and projections investors have had may be way too optimistic. With China and others showing very troubling weakness and attempting to slow their growth in order to prevent economic turmoil, a huge economic dip is not out of the question. Add to that the possibility that all the growth is already factored into the commodity and stock prices (that investors have speculated tremendously in all EEM-related themes and that the current prices reflect future expectations), and any stumble or slower growth could send prices plummeting as they attempt to adjust to more realistic growth.
In simple terms, here is the scenario for emerging market growth that many investors have been relying on:
- Emerging markets are expected to grow at a rapid pace for the next 50 years.
- Rapid growth will require more supplies and more inputs.
- As demand grows for food, commodities, and energy, the prices of these inputs will continue to rise.
- The plan -- buy and invest in emerging markets and commodities in order to take advantage of this continued growth.
And here is the possible scenario that derails economic recovery and hurts emerging markets investors:
- Emerging markets have been set up with lofty expectations for growth that will not be achieved due to unsustainable commodity and food prices, as well as unsustainable growth rates.
- The double-digit growth rates that many investors have been relying on do not actually materialize. More reasonable growth rates of 5-8 percent do.
- Since prices have run up at such massive rates and steep angles, they must come back down to reflect the more reasonable growth rates that have surfaced.
- Prices for emerging markets, commodities, food, and energy drop considerably in order to better reflect current conditions and revised future expectations.
In other words, unless emerging markets continue to grow as expected, economies will suffer and investors will see heavy losses as reality sets in and expectations are missed.
But there still may be a way to hedge your bets and find a way to profit from both scenarios. In order to do so, you could either avoid the high-flyers that would suffer the most if emerging markets get derailed (such as cotton (NYSEARCA:BAL) and corn (NYSEARCA:CORN)) and invest in the lagging themes that will benefit from continued emerging market growth (such as energy or agriculture).
First, compare the performance of oil, grains, gold, and silver over the past year:
[Click all to enlarge]
Click to enlarge
As you can see, silver (NYSEARCA:SLV) has been a heavy favorite and has tremendously outperformed the other three. On the other side, oil has heavily lagged behind the rest and has only surged since mid-February. Looking at this chart, on a relative-strength basis, may be signaling to us that either silver will continue to rapidly rise or that oil has some room to catch up. Since the cautious investor should usually avoid high-flyers after a rapid rise, I would advise taking a small risk on oil rather than a big risk on silver.
If silver is too risky, and oil is lagging, what about grains and agriculture?
Click to enlarge
As you can see, over the past three years, sugar (NYSEARCA:SGG) and corn are highly outperforming the overall grains and agriculture space. Maybe it's time for agriculture to catch up?
Compare the same ETFs over the past year:
Click to enlarge
Corn and sugar are still leaders, but not by as wide of a margin as on the three-year chart. Sugar is also showing weakness by failing to set new highs since early February. Moreover, it seems that if one were to make a bet on the broad agriculture and grains sector, JJG would be the best bet, as it has outperformed DBA, MOO, and AGF.
Finally, compare the broad agriculture and grains ETFs to individual companies:
Click to enlarge
Caterpillar (NYSE:CAT) has been a heavy favorite for many investors, as emerging markets require machinery and equipment for growth. At the same time, Monsanto (NYSE:MON) has been a heavy laggard. Other companies such as Potash (NYSE:POT) and Mosaic (NYSE:MOS) have more than doubled over the past eight months, and could provide very good returns if the agriculture and grains space continues to rise.
How we are currently investing:
Bearish Gold and Rare-Earth, Bullish Energy and Diamonds. On a relative basis, we are currently bearish on Gold (NYSEARCA:GLD) and precious metals and bullish on energy (OIL, GAZ). We think that gold may be in a bubble and should, at the very least, be avoided -- if not shorted. We also think oil may be a little overextended here, but that energy consumption is expected to continue growing. We would therefore rather invest in oil and natural gas than in precious metals. Also, to hedge our bearish bets on gold and rare-earth elements (Molycorp (MCP)), we are betting on the outperformance of diamonds through Zales (NYSE:ZLC) and Blue Nile (NASDAQ:NILE).
Skeptical and Short Emerging Markets, But Long Vietnam. We are skeptical about emerging markets and commodities in the short term (a few months to a few years). We think China and others may have gotten a little ahead of themselves and may be set up for a correction. We therefore are currently short emerging markets through EDZ, short China through FXP, and short Gold Miners through the GDX. To hedge our emerging market bet, we are currently long Vietnam (NYSEARCA:VNM) as long as it stays above $23.
Very Skeptical of Cotton, Corn, and Agriculture. We are also currently staying away from grains and agriculture, both through broad agriculture ETFs and through individual fertilizer names such as Potash or Mosaic. We think the slowing economic growth and interest-rate hikes in China and other countries do not bode well for a continued rapid rise in food prices. We would rather invest in a name like Potash over a meteoric-riser like cotton, but we're waiting to see if the slowing growth continues to hit prices. With potential reversal patterns in many of the agriculture ETFs and individual names, we would not recommend investing in agriculture right now. It can be very dangerous to jump into a very popular theme such as agriculture and commodities after such a rapid rise in prices -- especially if the fate of these stocks and themes relies heavily on continued emerging market growth.
Disclosure: I am long GAZ, ZLC, NILE, VNM, FXP, EDZ
Additional disclosure: I am short MOO, SLV, GDX, and MCP