Commodities Might Undo Stocks

Montreal, Canada

Rising inflation and surging commodities prices might kill the ongoing stock market rally. It’s already hampering the once fast-growing MSCI Emerging Markets Index, down a modest 2.5% this year.

Mature economies, as measured by the MSCI World Index of major markets, now stand at their highest levels since July 2008 and have rallied 6.5% in 2011.

This year, the United States is one of the best performing markets in the world while the emerging markets largely struggle with inflation and central bank tightening.

Soaring commodities prices are posing serious short-term risks to the bullish macro story where hot money has flooded into countries like Brazil, China, India and others over the last 2.5 years; all three markets are struggling since last summer, with Brazil and India in negative territory this year. Some countries have imposed foreign currency controls to temper hot money flows.

Fund managers have started shifting money to bombed-out major markets at the expense of emerging markets – the first such shift since 1994-1995 following the Mexican peso crisis. This change began in January and is accelerating in February.

Sharply higher commodities are starting to impose on longstanding regimes in North Africa and the Middle East.

Tunisia and Egypt have both seen a toppling of longstanding rulers, and others in the region might follow shortly.

Facebook, the social networking giant, is another powerhouse largely responsible for passing the word across the disgruntled populace in these countries.

Combined with skyrocketing commodities like wheat, sugar, vegetable oils, coffee and other essentials, people are taking to the streets.

Food consumption in these and other developing economies represent more than 50% of most discretionary incomes and, in some cases, more than 90%.

Can world markets continue to rally amid rising commodities prices? Is there a tipping point?

From 1966 to 1981, the U.S. broader markets were essentially unchanged in nominal terms and declined after adjusting for rapidly rising inflation starting in the early 1970s. I’m not sure stocks are a great asset class when inflation is accelerating; most companies can’t raise prices in this environment to maintain margins. I prefer commodities, including gold and silver.

West Texas oil is now rapidly approaching $100 a barrel (London Brent is already more than $100) and other important raw materials like copper and the grains are off to the races since last summer. Bernanke is partly to blame as speculation has run wild since his QE II announcement. But severe crop shortages, government hoarding and rising demand are all fostering discontent in some countries and the risk is rising that it might trigger a wholesale bear market at some point.

Back in 1971, inflation was still under control but had commenced a secular rise starting in the late 1960s. Literally overnight, it rose sharply and, by 1973, had resulted in an economic “shock,” crippling the global economy. It’s history worth heeding.

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