In August I wrote an article about the trend that was developing in Steel (HERE). At the time, the trend was still in the early stages and took a while to really get going. Now however, the move has begun and it is clear that the coming inflation this trend was forecasting is now upon us. Fortunately, it has just started and there is still ample time to position portfolios accordingly.
I find the inflation argument very interesting. Basic economics tells us that, during a rising rate environment such as we’re in now, the Fed’s actions of tightening the money supply is anti-inflationary. In fact, what most people don’t understand is that the Fed does not have a knob that it turns when directing Fed Funds rates; but rather, it influences its target by either introducing or removing money from the money supply.
By altering supply, the thought is that this will influence demand; and, with less money in the system, it will cost more to borrow. Again, this is basic economics and is what is taught in the classroom throughout the US.
So, why is the US Dollar declining if the Fed is, in fact, raising rates?
There are many who will debate the specifics of the above decline; however, one big variable I believe to be influencing this is that for the first time in several years we’re seeing monetary stimulus in our country that is not just recapitalizing the banking system (QE1 – QEinfinity) Recent tax reform and the corporate actions such as bonuses, higher wages, repatriation of capital etc., is much different than our previous stimulus activities and results in money flowing directly into consumers’ hands and thus into the economy.
While many can debate why the dollar decline is happening, none can argue with the fact that it IS happening and the result is higher material asset prices.
In addition to the declining dollar giving a boost to raw material prices, we have insatiable demand for these raw materials due to a global economic expansion. This pent up demand has been aiding the rise in all hard assets and basic materials such as: iron-ore, copper, aluminum and coal. Recently, Oil joined the party, but the former was indicative of the building phase we’re seeing domestically and abroad, significantly increasing the demand for these products and thus influencing their prices.
For my university students, it is a this point I use the whiteboard to lay out my complex model of inflation as a result of higher raw material input costs. Joking aside, it is more like one big lateral arrow with raw materials on the far left hand side.
I walk them through the simple example of constructing a building, just as we’re seeing in our local community of Lexington, Kentucky. During the planing and financing stage, the contractors estimated the cost of their building based on raw material costs at that time. In order to raise capital and make this a viable business opportunity, they forecast what they would need to charge in rent in order to create the desired return.
Now however, these folks are inevitably faced with higher input costs that will result in a higher price for the overall completion of the building. The question I then ask my students is the following, “With the higher cost of the building, do you think these investors and contractors go home and sulk at the fact that they will now be making less money because of these higher expenses?” Of course not! With the higher input cost, these folks simply adjust the revenue models to reflect…..you guessed it….higher rent!
Since the entire building costs more, they will no longer be able to charge $12 or $13 per sq. foot for rent. They now have to charge $14 or $15. (I’m making up numbers here but you get the idea)
Then I ask the students the following, “Let’s say that a restaurant owner was planning on occupying the first floor and calculated the cost will be on average $15,000 per month. Now, this amount has increased to $20,000. Do you think the owner will go home and sulk at the fact that their rent is higher and thus the restaurant will not generate as much money?” Of course not! They raise prices!
By now you’re probably getting the idea; but, let me continue. With higher rents come higher prices and in an environment where we have had little to no wage growth in several years, it is these prices that finally spark that ‘tough conversation.’ You know the one…’Um, excuse me, Sir. I’ve been working here now for 5 years, and I realize it has been a tough environment, but I’d like to request a raise since everything I am spending money on seems to be going up in price.’
Here’s a news flash! The environment has not been tough, and your boss has been minting money with very little, to no, raise in expenses, sans health care, and will gladly give you a raise. It is much cheaper than going out and looking for a replacement; and, you’re right, it’s been 5 years since you got any increase at all.
So now I ask my students the following. “Do you think that boss goes home and sulks because his wage expense just went up?” Of course not. What does he do? He raises prices!
This, my friends, is the deadly cycle of inflation and it is coming – and it is coming quickly. Raw material asset prices have begun to rise, and we’re now seeing the early signs of increased inflation creeping into the price of goods and services.
Now, if you missed the early Steel trend, as mentioned in August, fear not. You still have an opportunity to add inflation hedges that will also appreciate during a rising inflationary time such as Gold and Silver. The following are the charts and trends that, as you can see, are just starting to develop.
We’re in the very early stages of this move, and it’s moving fast. Educate yourself, and make sure you’re allocated appropriately. There is great opportunity here for those who just care to pay attention.
Until next time!
As of the time of writing I am personally long SLX, GLD & SLV in addition to these both being held in client accounts.
The above article is my personal view on the stock (or stocks) mentioned and not a recommendation for you to personally own it as I don’t know your individual financial situation. All information presented is understood to be accurate at the time writing via any sources referenced. Be sure to do your own research, verify all information, consider your own financial situation, and consult your financial adviser before investing in any security or listening to any opinion on the internet.