Weekly sound bite: Doha's failure revealing that inflation is far from dead

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On Sunday in Doha, major oil exporting countries failed to come to an agreement with respect to limiting production. Despite the collapse in talks, oil has bounced back from its initial sell-off early Monday. It appears that Doha's failure is actually giving our theme that growth may surprise on the upside a boost. With oil production still going full-steam ahead outside of the United States, there must be something at work to keep prices from collapsing. Perhaps it is just speculation and short covering. Alternatively, it might well be stronger global demand, at least in nominal terms.

If we are correct that growth is going to be higher than expected, it still remains to be seen if it will be higher nominal or real growth. However, for commodity and bond markets, a jump in nominal growth may be all that it takes to push prices and yields higher.

If oil prices don't turn down soon, it will support expectations of higher global inflation which could boost nominal growth rates around the world. There are a number of factors that could be driving up nominal growth. In particular, money supplies have seen increases in double digits in the key international economies of China and India. That alone could drive a psychological impetus to at least hoard, if not consume, more commodities.

Right now there are a number of signs suggesting that growth prospects are improving:

  • The heavily resource-tilted S&P/TSX Composite is up 2.1% in the week versus a 1.6% gain for the more defensive INK Canadian Insider Index (as of Tuesday).
  • The Materials Select Sector SPDR ETF (XLB*US) is up about 5% over the past week, beating the broad market up about 2.5% (as of Tuesday).
  • Canadian stocks continue to outperform US stocks year-to-date.
  • The Gold/Silver ratio off its highs meaning silver is getting relatively more expensive, a positive development for metals in general.

Meanwhile, the investment case for the commodities space may be getting a second look, even from the sceptics. Since the start of the Fed's great experiment with non-conventional monetary policy in 2008 (which included QE, forward guidance, and zero interest rates), the response of investors around the world was to hoard asset ranging from NASDAQ biotech stocks to London/Vancouver real estate. Initially commodities benefited but they faltered once the Fed started to focus on long-term rates at the expense of further short-term rate easing via Operation Twist. Now, with more than seven trillion US dollars worth of government securities requiring a payment (i.e. negative yields) according to Bloomberg, the case for holding long-dated government maturities is not only fundamentally weak but also fraught with risk. At some point, even the most status-quo biased institutional money investment committee will have to give greater consideration to the risk that inflation could wipe out substantial value from their bond holdings. As much as they may hate to consider boosting exposure to commodities, their consultants will point out that historically commodities offer diversification benefits, regardless of what one may think of their outlook.

The bottom line is that we believe we are close to, if not past, the bottom in investor sentiment towards commodities. If this coincides with higher global inflation or real growth, it would not be good news for bonds and other "reach-for-yield" assets such as REITs, and some types of preferred shares which would likely need to fall in order to boost their yields. In contrast, commodity-related stocks and capital-markets financials that would benefit from a steeper yield curve, such as banks and insurers, could do much better.

Of course, we have had  false-starts on the reflation front before. Last year, growth looked set to move higher as Chinese stocks surged and US labour market conditions expanded. However, the Fed dithered on rates, and the Chinese stock market subsequently collapsed and the Renminbi fell. Nevertheless, right now bonds and fixed income look vulnerable as that 10-year US Treasury yield cannot seem to make new lows, despite the gloom coming from Madame Lagarde at the IMF and others.

Listen to Ted Dixon on Roundhouse Radio FM 98.3 every Thursday for his weekly financial markets commentary at 7:30 am Pacific Time. If you missed the live interview this week, catch the replay here

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