I believe that inflation is here to stay, rationale as follows.

 

Monetary policy:

-          The Fed is in a tough spot and is forced to keep rates low. Despite a rational decision to weight ‘non-core’ inflation more heavily, there will remain political/lobby pressure to continue easing in the midst of the ongoing credit crisis. The deep pockets for which a bail out would help are far more influential than voices calling for a wiser, long term monetary policy.

-          The Fed can ‘afford’ to let inflation run a bit because of the acceleration in the credit squeeze, and because food (15% CPI)/energy is still a relatively small percentage of total American consumer spend (not the case elsewhere). Increasing recession risk will force the Fed’s hand, regardless of whether it is viewed that current recession fears are inflation, credit or business cycle based

 

Tight commodity supplies are driven by record demand [from secular shifts], despite record production:

-          Agriculture inventories remain low despite a record 15 year fair weather run and record yield improvements (better GMOs, technology, science) from all producing countries except for Australia. For wheat, inventories were so tight that 1% drop in supply lead to a doubling of price; once bad weather hits or there's a crop failure, prices will skyrocket again

-          Mining consolidation demonstrates that its still too costly (capital and time) to develop greenfield projects! This is extremely bearish for supply growth and provides support for sustained pricing

-          Backwardation assumes the world will be flooded w/cheap supply of metal, not realistic if you look at demand vs greenfield/mine expansions

-          US Farm/Biofuel policy promotes

 

Rising income = more and better food:

-          80% of the world population lives on less than $3,000/year, incremental growth will be allocated to improved diet ahead of everything else

-          Meat consumption still has a long way to reach parity (kg/person/year):

o         NA: 125

o         Developed world: 85

o         LatAm: 62

o         China: 50

o         World: 40

o         Asia: 30

o         Africa: 17

 

Investor/management psychology:

-          Investment managers will increasingly view commodity stocks as inflation hedges, driving multiples for miners/oil majors (where previous capital appreciation was earnings driven). We will likely see new money into the names (as volatility and inflation spike), and consolidation has decreased the investable universe.

-          Inflation is a positive feedback loop, partially a self-fulfilling prophecy. One example of this playing out is that a generation of just-in-time managers (trumpeted in MBA programs since early ‘80s) will realize the value of stockpiling, exacerbated existing demand pressures and tying up working capital (which will actually represent an intelligent use of cash in an appreciating asset) – the urge to hoard will be evident on balance sheets (and positively in earnings, though not ‘clean’ earnings, ex. XOM in ’79 had 35% of earnings from inventory gains).

-          Most commodities futures charts remain in backwardation, signaling investor and consumer doubt over high commodity prices. As inflation fears increase, we will see curves move towards contango – resulting in rapid revaluation of commodity equities (multiples and earnings estimates will rise)

o         FCX is the only mining major in the S&P and Newmont the only gold miner

-          Evidence that the Street still doesn’t believe in sustained metals/food prices – Inco/Fal, 2 of the 3 largest copper producers and public for ages, were sold to CVRD and Xstrata at (in hindsight) absurdly low multiples; if the street believed in inflation, they would’ve stayed public

 

 

Ways to play:

-          Primary beneficiaries will continue to be miners, ag stocks (fertilizer, equip and seeds/chem), and limited oil/gas names.

-          Everything we’ve seen indicates that farmer expenditures are proportionately tied to cash receipts, which are at record highs and unlikely to fall precipitously.

-          Need to focus on miners w/unhedged reserves rather than fixating on current earnings, otherwise may face same issue as oil majors

-          BMO’s Basic Points indicates that we’ve seen a phenomenal run in the past 5 years of these names, and the next 5 years may turn out even better, albeit with increased volatility and uncertainty across all securities