Wheat Boom an Indicator of Inflation

Guess what is the hottest market these days? Gold, wrong. Platinum, too late. Oil, doesn't even count. It is Wheat. Where is this happening? Forget about New York, or Chicago or London. It is right in the mid-west of US, the Minneapolis Grain Exchange [MGE] in the Twin Cities of Minnesota, where wheat has been up to the limit almost daily since last month.

This Monday (2/25) was historical for grain trading. The March 08 wheat futures soared to $25 a bushel and closed at $24, compared to about $5 a year ago. At the same time, we have seen all grains at historical highs, with soybean hitting another all time high at $14.55 and corn roaring to nearly $5.40 a bushel; - the list goes on and on.

During the summer of 1997 when I was at business school, I did my summer internship at Cargill Capital Market Group. I like the Twin Cities a lot in the summer. At that time, no one paid any attention to commodities, especially agricultural ones. Even Cargill was the largest private company in the world then, everyone treated Cargill as if it were in the wrong business at the wrong time. And it is true, it was the period that only technology, internet and telecom counted as real businesses; other businesses were just garbage.

Who cares about growing crops? Farmers were actually losing money if they had no US government subsidies. Cargill's profit margin was worse than Wal-Mart's; actually they were  lucky if they didn't lose money. This is why they wanted to extend their business arm into the banking and trading area by establishing Capital Market Group which I was working for. Well, things have changed a lot in 10 years. I can't imagine how profitable they are these days with their huge global agricultural infrastructure from storage and processing to transportation. They must be making billions these days.

Back to wheat. 2008 will definitely be a legendary year in the grain history book. There have been several bull markets in grains for the last 35 years since early 1970s. The soybean market soared in 2004, mainly due to better-than-expected demand, and production problems in South America, especially in Brazil. The rise was short-lived, faded quickly and didn't wasn't joined by other grains. However, it turns out to be an appetizer for today's main course.

There was a grain spike in early 1996 caused by the worst drought in 30 years and many regions around the world were affected.  The 1988 corn boom  was again caused by drought. None of the above three spikes lasted very long, since issues were more temporary or local. An interesting one before all these was the 1970s boom fueled by US exports. As we know, Nixon abandoned gold standard and decoupled US dollar from gold in early 70s, resulting sudden devaluation of US dollar, which made grains cheap and so grain exports soared.

At the same time, with the signing of  the SALT treaty between US and the former Soviet Union in 1974, the Cold War calmed down and  the repeated drought situation in Russia forced the Soviets to became a large importer of grains, especially from US. This grain exports by US and Europe ended when US imposed grain embargo because of  the Soviet invasion of Afghanistan  in 1980.

The current grain boom combined with other markets make people feel more like it is a repeat of 1970s, when we also had surging agricultural commodities, energy shortage, soaring gold price, inflation and recession. Agricultural products, especially wheat, are the ingredients of almost all food products we purchase at supermarket every day, such as beef, milk, eggs. Their soaring prices will only lead to higher prices for all food.

In 1970s, wheat was a very good leading indicator to inflation. With all grains reaching historical highs, it is hard to substitute one for another. It is also hard to believe that inflation is not a problem in the future. Food and energy costs are the two main elements impacting people in their daily life. However, they are excluded from the core CPI, which also shows an alarming 4.3% yoy increase lately. If food and energy are included, the number would have been much higher.

This is why I always feel TIPs has substantially understated the real inflation impact creating a false illusion of full inflation protection. Inflation will also increase company cost base, not only from raw materials and wages, but also from financing point of view. With higher inflation, corporate bonds would need to pay higher interest and bond investors may have less incentive to purchase due to the long-term nature of these bonds, and all this is aside from the credit and liquidity issue we are facing today.

This is not good news for equity financing either; higher inflation means  a higher discount rate. Stock investors will value the same company with lower by discounting future cashflow and profits. It also reduces consumer willingness to spend, further pressuring top line growth in addition to the problem of  recession. The companies hurt the most are probably those which have limited power to raise prices, such as consumer staples, but whose cost base is impacted the most by inflation. Their profit margin will shrink substantially and will make today's low P/E ratio look very high tomorrow.

We know at the bottom of the bear market in the 1970s, P/E ratio felled to 7, compared to about 16 right now. I feel it was probably more due to inflation than recession at that time. So which battle  will the Fed fight? Will they raise rates to fight inflation or continue to reduce rates to fight for recession? Except in Paul Volcker's era, in every period of US history, the Fed has always chosen to fight recession.

This is very different mindset from ECB, originating from the fact that in 1930s, Europe was fighting triple digit inflation because of the Weimar Republic, while US was fighting depression here at home. So ECB has been kept a much closer eye to inflation while US Fed has always tried to defuse recession before it leads into depression. It has worked almost every time except, of course, the 1970s. Food inflation is one of the most politically sensitive issues in the World, especially for poor countries. People can live without money, people can even live with very low living standards  and without energy as our ancestors did,  but people can't live without food. Food inflation will cause political instability, social unrest and riots around the world. It is a much bigger problem than global warming.

About 10 years ago, Jim Rogers had correctly predicted the current agricultural commodity boom. As he stated, this is a super-cycle which should last until around 2020. I hope he is wrong. If we have this agricultural commodity boom going strongly like this all the way until 2020, the World might end before we can even see whether or not his prediction is true.

Comments

[dancing diva]

Malarky. Wheat's rise is not a sign of inflation. It's a sign the weather has been lousy AND more importantly, the biofuels push has gotten out of hand. In the US as well as many other countries the use of alternative fuels made from grains and vegetable oils has been LEGISLATED. This is an unnatural act. Get rid of these legislated programs and grain prices will be significantly lower within a year.

Grains, feeds and vegetable oils should be fuel for the body, not cars.