Don Coxe - Grain Futures Contango/Inflation
Here are some interesting comments from Coxe:
Commodity contango – the fuel to feed inflation fears…
I believe that the next big change that is going to occur is that we are going to
start moving to contangos.
And in case you don’t think this is a big story, I think this could be the biggest
story yet, and it will affect everything else.
Here’s why:
Ben Bernanke is somebody who is a real student of economic history. He knows
that what really kicked-off the runaway inflation of the 70s, was the contangos
for nearly all the commodities, and it is when we switched, (in the 70s) from
backwardation to contangos, that was what fed inflation expectations.
Inflation is mostly a monetary phenomenon, as Milton Friedman won the Nobel
Prize for, back then when people were trying to blame everything on the Arabs.
The Arabs quite rightly, regarded this as a libelous statement – they didn’t cause
it.
They got a better price for their product, and their product (as we now know)
was not in unlimited supply.
But when you got into upward sloping curves of contangos, and as those
contangos steepened, it was because speculators (or people trying to protect
themselves against inflation) learned that that was the best way to make a bet
on inflation, apart from selling long-term bonds.
Back in the 70s when I was building an investment management firm for
Mutual Life, the slogan I used was, “The proper holding period for a long-term
bond in this inflationary environment, is the amount of time you hold a hand
grenade, after you have pulled the pin.”
A pure play on upward inflation…
The first thing you did in order to take a real inflation bet, was you bought outmonth,
or out-year futures, in a range of commodities.
You didn’t specify a commodity; you bought a bunch of the commodities futures,
way out the curve, and what you had was what amounted to a pure-play
bet on rising inflation.
That has not happened.
Backwardation indicates a benign inflation threat…
When Ben Bernanke answered the question, ”I don’t see stagflation coming”, (I
believe he was giving an honest answer; he got ridiculed for it in some quarters)
because the major commodities were all in backwardation, which meant it was
a relationship between supply and demand.
Oil was going up; it ran from $50 to $120, while staying in backwardation, so
there was not an inflation bet being made.
We had gone out of contango on oil, the one that we got after the effect of Rule
133 at the end of 2003. The oil was in contango for two years, (and you heard me
talking about it back then) and I used that as a core component for my theme for
why you bought the oil sands stocks, because I said, “You buy commodity stocks
on the basis of unhedged reserves in the ground in politically secure areas of the
world.”
Those reserves in the ground were rising fast, faster than spot prices were,
therefore it meant the underlying value of the companies that had 50-75 years
reserves in the ground, was rising faster than the market price of their stocks
was rising.
Hitting people where it hurts, will translate to fear…
If I am right in this, what is going to happen because of food price inflation,
that what that will do, is change the other part of commodity inflation, which is
expectations.
What happened in the 70s was despite large-scale unemployment, (lead by the
public sector unions) we had damaging strikes, with huge wage increases, and
that was what actually transmitted the commodity inflation into real inflation,
because wage rates are two thirds of the economy as opposed to raw materials
prices.
We have not seen anything like that happening, except what happened in Germany
with the engine drivers.
Therefore what the central bankers fear more than anything, is a transmission
mechanism that has average consumers changing their expectations of inflation.
I can tell you, having lived through those tough years, what happened was
consumer’s inflation expectations had been governed by years of experience,
so they still, in all the polls, showed inflation expectations of 4 and 5%, but
when the went out to shop, and found if they shopped twice a week, they could
compare their checkout tapes and see prices rising by the day, and that’s when
inflation expectations skyrocketed.
Central bankers are holding their breath…
At the moment at which Paul Volcker took over and drove interest rates up,
inflation expectations had reached double-digit levels, and that’s what Paul
Volcker had to destroy.
He drove the real yields on the 10-year Treasury note to 12%, producing the
deep recession in 1982, which nearly destroyed the Reagan recovery.
Contrast that with today, where the real yield on the 10-year note is negative by
about 40 basis points.
Therefore, there has been no transmission effect to date.
What Bernanke and the other central bankers must fear above everything is that
we will have the futures curves turn upwards.
Labor unrest may be the lynch-pin…
Food prices will continue to rise, and consumers will then change their expectations,
and we are now in a period where the labor shortages will start to show
up because of a collapse in the birthrate starting in 1971.
It will start first with the entrenched public sector unions who can enforce their
demands, and when that happens, the central bankers will be faced with a need
to raise interest rates dramatically, to head off inflation.
So from a standpoint of economic forecasting, the disaster area would occur at
such point as the inflation expectations are triggering strikes, dislocations, at a
time of low or negative economic growth.
That’s pure stagflation...
You may have seen today’s Wall Street Journal’s article about why the airlines
are in such trouble is because they don’t have enough skilled workers to do all
the repairs and checks needed.
When you have the best-run airline, Southwest Airlines, whose market capitalization
is greater than all the other airlines put together in the US, and they did
not have enough workers to do all the checks, so they had to stop their flights
for a while.
Remember that we’ve had lots of retirements because these industries have
very generous pension plans that allow for people retiring at a fairly young age,
or a young age.
A change in expectations will change market performance…
I can’t predict each part of the scenario, but I can tell you that this is a huge
point for all you people who are in diverse investment management organizations,
and a necessary part of your work is forecasting the overall change in
asset values in various asset classes.
In the 70s, it was the food price inflation, which drove everything else, and
drove down the stock market.
We had the worst bear market since 1929.
As of August 12th, 1982, the constant dollar Dow Jones Industrials were trading
at their 1929 levels.
It had been a terrible bear market; if you had bought the stock market in 1968,
in the next 14 years, you lost hugely on what was supposedly an asset that gave
you a good hedge against inflation.
I am not going to say it’s going to be as bad this time; what I am going to say is
that we are now more vulnerable to a change in inflation expectations, than we
have been for more than 20 years.
Unrealistic expectations…
Therefore the comfort level that people have in buying bonds, and in assigning
high price/earnings ratios to generalized stock indices, they are about to see, (I
think) a challenge to their valuation metrics.
I don’t believe these price/earnings ratios are sustainable in an environment in
which inflation expectations of the general populous are rising, and the central
bankers have had a free-pass on their ability to lower interest rates, because of
the fact that we are not getting the signal from the commodities markets and we
are not getting inflation showing up in the areas where most people see it.
We have been able to, almost amazingly, absorb an oil price increase of over
100% in 14 months, but everybody said, this is not inflation, and technically
they are right.
Food is different.
