Wednesday, April 11, 2007

Market Analysis

The early part of this week seems to be void of any major economic data releases. However, it is the beginning of earnings season (led by Alcoa’s $0.79/share gain, $0.03 ahead of analysts expectations) and a key inflation report is due on Friday morning. Last Friday’s job report reported an unexpected 180k increase in nonfarm payrolls and a 4.4% unemployment rate, which is low enough to raise concerns about insufficient labor supply and rising labor costs. Since inflation has been a key headache for fed officials, I thought it would be prudent to talk about inflation today.

The continually strong commodity prices we are seeing across the board from heating oil to wheat will certainly have an affect on inflation concerns. The trickle down effect of higher commodity prices may lead to higher inflation, a worried Federal Reserve and a multitude of other problems for the weakening U.S. economy. Before diving into the discussion, let’s take a look at some of the commodity price charts. There are quite a few, but just take a look at each of the price trends. I have taken monthly charts from a basket of commodities from the agricultural, metals and energy sectors.

Heating Oil
Live Cattle

As you can see, each of these charts points have the same trend over the pas 5-8 years; significantly higher. This basket of agricultural commodities, energy products, and base metals has increased substantially. Take a look at the price increases in percentage terms since 2000:
· Aluminum: +88.22%
· Copper: +357.41%
· Corn: +86.5%
· Gold: +135.52%
· Heating Oil: +210.50%
· Live Cattle: +43.37%
· Crude Oil: +132.32%
· KC Wheat: +65.86%

Those numbers make me wish I would have been invested in a basket of commodities from 2000-2007 during the time the S&P 500 has been flat. Either way, I believe these trends could continue in the near future because of strong demand, weather storms disrupting supplies and a general need for commodities. As commodities guru and world traveler Jim Rogers might say, “We are in the greatest commodity bull cycle our generation has seen”

The question is whether or not commodity prices and inflation can be linked. When considering the relationship between commodity prices and inflation, commodity prices have a positive correlation with inflation. Prices can be argued to be a leading indicator as they are quick to reflect economic changes in supply and demand. The resulting higher prices we see today compared with even 2-3 years ago is tremendous and will eventually be reflected in the final product purchased by consumers; and therefore, higher inflation.

Arguably, crude oil prices (and therefore energy prices) have a robust history of influencing inflation measures the most. As all of the commodities I looked at are currently priced within the top quartile of their six year highs, it makes me wonder how much further prices can reach before negatively affecting the economy (that is, more than it has already). Crude oil will be the most influential as prices seem to be supported be a continuation of global tensions with oil exporters and world demand increases.

The Produce Price Index (PPI) will be released on Friday morning. The consensus estimate is for a 0.8% increase in the headline number and a 0.2% increase in the Core PPI. With that said, I would not be surprised to see the core PPI come in slightly hotter than expected given the deluge of higher commodity prices across the board. As the Federal Reserve seemingly reiterates its hawkish tone on inflation, this number could signal a short-term direction for the market.

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