I have been trading commodities and watching the raw material market since the early 1980s, and I have seen my share of bull and bear markets. Commodities are like any other asset class. Each asset within the sector has unique supply and demand characteristics that influence the path of least resistance for its price. However, the raw materials sector is one of the most sensitive when it comes to macroeconomic factors which often reveal themselves in the most liquid asset markets. Stocks, bonds, and currency markets are much larger and more liquid than the commodities sector. Commodities tend to have a much higher level of volatility than the other classes which leads many investors to stay clear of assets that can double and halve in price in the blink of an eye. For action seekers like myself, the price variance in commodities is what draws me to the market like a magnet. However, for most people, raw materials are too risky a business to approach. Therefore, there are times when changes in economic conditions begin to show up in markets, and most participants do not realize they are occurring until it is too late.
The Fed and ECB keep telling us that inflation remains below their 2% target rate, but markets across all asset classes could be signaling the exact opposite these days. Inflation eats away at the value of money, and from where I am sitting, things are getting more expensive.
Stocks- Financial inflation
The ascent of the stock market has been nothing short of spectacular. Stocks benefited from a perfect bullish storm of low interest rates, increasing economic growth which bolstered profits, and the prospects for and the reality of corporate tax reform at the end of 2017. The S&P 500 has exploded to the upside, along with the other major equity indices in the United States, and around the world. Source: CQG
As the quarterly chart of the E-Mini S&P 500 futures contract highlights, the index has moved from 665.75 in 2008 to highs of 2809.50 at the start of 2018. The latest new high came on Wednesday, January 16. The index has more than quadrupled over the past decade, with only one significant correction. Stocks have moved higher in the last thirty-three out of thirty-six quarters. Over the first six weeks of 2016, selling in the Chinese domestic stock market sent the index 11.5% lower. Since then, the bullish elevator has continued to take it to new highs. Historically low interest rates and growing optimism about the economy has lifted the prices of stocks as capital continues to flow into the equities market. Source: Shiller PE Ratio
As the chart of the CAPE ratio shows, the current multiple of stocks in the S&P 500 index stands at 33.68, the second highest level in history. Multiples are above the level seen before the stock market crash, and Great Depression of the 1920s and only the levels achieved during the technology bubble in the late 1990s stands in the way of a new record level for average valuations. One could argue that the current level of the stock market is a case of inflationary financial pressures as capital continues to push stocks higher.
Bonds- Rates are too low given economic growth
Following the financial meltdown in the U.S. and around the world in 2008, central banks slashed interest rates and put programs of quantitative easing in place. The Fed Funds rate moved to zero percent until liftoff in December 2015. At the end of 2017, the short-term rate only stood at 1.25% after five 25 basis point rate hikes. QE ended in the U.S. but remains in place in Europe where short-term rates are at the negative forty basis point level.
In late 2017, the Fed upgraded its characterization of the U.S. economy from “moderate” to “solid” growth. At the same time, the European economy has been growing at a moderate pace. All of the liquidity that central banks dumped into the financial system for a decade encouraged borrowing and spending while it inhibited saving to stimulate economic conditions. While the U.S. central bank has shifted from accommodative monetary policy to tightening credit, the process has been gradual. Some critics believe the Fed has not acted fast enough to prevent a resurgence of inflationary pressures. In Europe, the pivot towards a more hawkish approach to monetary policy has yet to occur. Both the Fed and ECB continue to point to data that indicates that inflation remains below their 2% target rate. However, inflation can be a tricky and deadly beast that eats away at the value of money. Critics continue to offer concerns that the two leading central banks of the world are too complacent when it comes to inflationary pressures that are beginning to show up in commodities prices. It is possible that the U.S. central bank is behind the inflationary curve and if that is the case, Europe is way behind given increasing economic activity, falling unemployment rates, and the potential for increasing wages as a result of corporate tax reform in the United States.
On Wednesday, January 17, the Fed released their Beige Book. While the central bank highlighted moderate economic growth across all parts of the United States, tightness in the labor market, signs of rising wages, and improvements in retail sales suggest that the Fed could find itself behind the inflationary curve.
Currencies- The dollar could be entering a long-term bear market run
The dollar is the world’s reserve currency, and at the start of 2017, the greenback was making new highs in a bull market run that began in May 2015 when the U.S. currency found a bottom at 78.93 on the dollar index futures contract. Source: CQG
As the quarterly chart of the U.S. dollar index illustrates, the bullish run took the dollar to a high of 103.815 in January 2017, and since then, it has been all downhill for the greenback. On Wednesday, January 17 the index reached a lower low at 89.96, and the path of least resistance remains lower. The bearish run in the world’s reserve currency has provided support for commodities prices and a significant break below the 90 level could ignite another significant leg to the upside in the prices of many raw material markets. The dollar is the benchmark pricing mechanism for most commodities around the world, and a weaker dollar typically means higher prices. As the value of the dollar falls, and commodities rise, the purchasing power of the reserve currency moves lower which is a sign of inflationary pressures.
Commodities- Sniffing inflation and moving higher
Economic growth and a lower dollar created what has been a highly supportive environment for industrial commodities prices. The best performing sector of the commodities market in 2017 was nonferrous metals. The prices of copper, aluminum, nickel, lead, zinc, and tin together posted more than a 20% gains. Palladium, a precious and industrial metal, was the best performing single raw material of the year moving over 56% higher. Lumber was 36% higher on the year. During the second half of 2017, the price of NYMEX crude oil moved from lows of $42.05 per barrel on June 21 to over $60 by the end of the year. Brent crude oil did even better as the premium of Brent over WTI expanded because of the mirage of OPEC production quotas and growing tensions in the Middle East between Saudi Arabia and Iran.
While the dollar’s decline is partially responsible for rising industrial commodities prices, economic growth increased demand throughout the year. At the October party congress in Beijing, Chinese President Xi consolidated his power and laid out a plan for the coming decades. To cut pollution around major cities, it is likely that production, refining, and smelting of metals and minerals will decline causing Chinese demand from producing countries around the world to rise. Increased Chinese demand will pressure global stockpiles, which will decrease supplies. Additionally, President Xi plans to increase the size of China’s middle class which translates to more infrastructure building in the world’s most populous nation. When it comes to the building blocks for construction, supplies will fall as demand increases over coming years if the economy remains healthy.
In the United States, with tax reform successfully under his belt, President Trump is likely to move forward on his plans to pass legislation that will rebuild the crumbling infrastructure of the nation. New roads, bridges, tunnels, airports, and a security wall along the southern border with Mexico will increase demand for construction staples. The bottom line is that it appears likely that the rally in base metals, energy, and other industrial commodities has not reached its peak and could still be in early days. The action in the industrial sector is a sign of inflationary pressures as prices are likely to continue to move higher in 2018 and beyond.
The one area of the commodities sector that is not signaling immediate inflationary concerns is agricultural commodities. However, each year brings a new adventure when it comes to the production of food as weather and crop issues can turn surplus markets into deficit conditions in the blink of an eye. Moreover, the long-term trend in almost all of the critical food markets shows that price action has been a function of creeping demand that has created an environment of higher bottoms for the better part of two decades.
Mother Nature could cause inflation to spike in 2018
After the fifth straight year of bumper crops in the U.S. and around the world, prices of agricultural commodities have been under pressure and have not contributed to rising inflation. However, each quarter there are twenty million more mouths to feed around the world at the current rate of population growth. At the same time, standards of living are rising. Therefore, each day, more people with more money are competing for food and other raw materials that are finite. There is only so many acres of arable land in climates suitable to produce agricultural commodities around the globe. As a result, most products are finding support on price weakness, and many prices are making higher lows, even during periods when supplies are higher than demand creating surplus conditions. Source: CQG
Even though there is currently a record amount of wheat in inventories, the chart points to the same pattern as in the corn market with higher lows over past decades. And, the same pattern exists in the soybean, sugar, coffee, cocoa, cotton, animal proteins, and almost all other agricultural futures markets on a long-term basis.
Each year, it is weather conditions and other factors like crop disease that determine the path of least resistance for prices. After five years of bumper crops, production, and surpluses the markets have become complacent about the potential for sudden and dramatic price increases. Consumers have been purchasing requirements on a hand-to-mouth basis as the past half-decade has provided numerous opportunities to take advantage of falling prices for agricultural products.
However, unfavorable weather conditions in 2008 led wheat to trade at an all-time high of $13.345 per bushel, and in 2012 the prices of corn and soybeans reached records at $8.4375 and $17.9475 per bushel respectively. Today, prices for the three primary grains that feed the world are appreciably lower, but that does not mean that the potential exists in 2018 for a weak crop year to lift prices to even higher levels than seen in 2008 and 2012. The same goes for all commodities in the agricultural sector as the planting season for many has not yet commenced.
When it comes to inflation, there several factors that can ignite the economic condition that eats away at the value of money in 2018. A bad crop year could cause grain, meat, and soft commodities prices to explode to the upside costing the consumer multiples of current prices. A continuation of the bear market in the dollar would also put upward pressure on raw material prices across all sectors.
There are currently signs of inflationary pressures all over markets. Stocks have risen to levels where profits will need to boom to meet earnings expectations. Bonds have displayed signs that inflationary pressures will cause rates to climb. Industrial commodities prices have been rising for the past two years since finding bottoms in late 2015 and early 2016. The recovery in many of these markets has become a bull market. When it comes to the most significant commodities indices, a bull market in agricultural markets would be a cherry on top of the already positive price trend in the sector. I believe that central banks are underestimating the potential for inflation and that it may already be a lot higher than their two percent target rate. At the same time, another unsettling risk for markets is a geopolitical event or massive correction in the stock market that causes recessionary results while commodities prices continue their ascent. While inflation can be difficult to tame, stagflation is an even more difficult beast for the world’s central bankers.
Right now, at the beginning of 2018, stocks, bonds, and currencies are telling us that inflation is rising. These signals have made me very bullish on the commodities asset class for the coming year. For those who do not trade individual commodities, DBC is my favorite vehicle when it comes to participating in the sector, and it is currently a lot closer to lows than highs since 2006. Source: Barchart
As the chart shows, DBC has traded in a range from $11.70 to $46.63 since 2006. At $16.91 per share on January 16, this ETF product with around $2.2 billion in net assets offers lots of upside and limited downside prospects from a risk-reward perspective. Any well-rounded commodities index could offer investors an inflationary hedge given the current environment.
To profit from commodities, you have to stay ahead of the trade. As a veteran commodities market watcher, I’m uniquely qualified to help you do that. My Marketplace service, the Hecht Commodity Report, offers a comprehensive weekly outlook on over 30 individual commodities markets, including U.S. futures. One of the most detailed commodities reports available, The Hecht Commodity Report provides weekly up, down or neutral calls on each market and highlights technical and fundamental trends. I also make timely recommendations for risk positions in ETF and ETN markets and commodity equities and related options. The Hecht Commodity Report is a must-read if you want to profit in commodities, so subscribe today. And, there is an active chat section in the service where I reply quickly to answer all questions.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The author always has positions in commodities markets in futures, options, ETF/ETN products, and commodity equities. These long and short positions tend to change on an intraday basis.