It’s a Materials World

Story Highlights:

• Materials prices are steadily increasing and causing fears about inflation.
• Today's raw materials price increases are likelier a symptom of growing demand tied to infrastructure investment and a lagging supply.
• The supply imbalance won't ease any time soon, and prices will likely remain firm—even increase—but this doesn't necessarily signal inflation.

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As Madonna, a recent inductee to the Rock & Roll Hall of Fame, aptly sang years ago, "You know that we are living in a material world." How sage. There's no question ours is a Materials world: Materials insulate our houses, channel electricity to our lamps, make up the pages of our favorite books, and provide the infrastructure and the fuel for our cars. But surging Materials prices have investors fearing our addiction to material goods will only keep prices, and inflation, rising.

Signals Show Investors Want Cover against Stagflation
By John Plender, Financial Times

Should we fear Materials prices rising forever, propelling inflation into astral territory? While we should expect commodity prices to remain firm and continue to rise in the foreseeable future, higher commodity prices today aren't symptomatic of runaway inflation and aren't cause for panic. Commodity prices are driven by imbalances between supply and demand—like any freely traded good—and with today's demand drivers and supply constraints, recent price increases shouldn't shock.

Raw materials are kept in high demand due to rapid and major infrastructure build-outs in emerging markets and an increasing global consumer base. In the last five years, China has become the world's largest consumer of iron, steel, copper, and aluminum to build dams, skyscrapers, even entire cities. Russia, Brazil, and India are spending trillions of dollars combined on infrastructure. Developed nations supplying raw materials are expanding their own production and transportation infrastructure to meet growing demands elsewhere. Australia is spending billions of dollars to rebuild ports, roads, and other networks to ensure its place as Asia's chief supplier of raw materials.

As demand surges, supply is lagging—making prices rise. The supply imbalance exists partially because Materials producers are playing catch-up: Because of years of low global demand, they under-invested and consequently are at low supplies. Although raw materials producers are now heavily investing in new mines, oilfields, refineries, drilling, exploration, etc., demand from a growing emerging market still outstrips supply. Another supply-limiting factor: Government. Protectionism, retribution, intervention, and taxes all put undue pressure on supply.

The supply imbalance won't ease any time soon, and prices will likely remain firm—even increase—if demand doesn't radically drop in the near-term. The limited number of raw materials producers could perpetuate this supply imbalance. It isn't cheap getting raw materials out of the ground. The capital costs of an iron-ore mine is so great, just three iron-ore mining companies control three-fourths of the sea-borne supply. Their near-monopolistic power helps them set price and supply levels—prices of iron-ore (a primary input for steel production) have risen 350% from 2003 - 2008—while their economies of scale keeps costs low and maintain high barriers to entry. And because the sector is currently rife with mergers and acquisitions, the number of suppliers is more likely to shrink than grow.

Still, it's easy to understand why surging commodity prices are seen as inflationary. Last month, the world's largest iron-ore producer announced a price increase of 65% with some steel producers. Higher iron costs could translate into higher prices for steel-based consumer goods like cars. The prices of copper (electrical wiring), nickel (cookware), zinc (batteries) and aluminum (airplanes) have increased an average of 20% in the past month. And rising gold prices are commonly regarded as an inflation indicator.

But investors fearing rising commodity prices as a symptom of inflation miss a couple key points. Not all commodity prices move in lock-step. Today's commodity boom is only in areas seeing increased demand and production constraints. In 2007, gold and oil prices rose while commodities such as hogs, lumber, and sugar dropped. Overall, 8 of the 19 major commodity futures had negative returns for 2007 (based on rolling contract returns of the RJ/CRB index).

Inflation isn't just a rise in some prices. Inflation is an increase in money supply not absorbed by the economy, causing average prices overall to rise. Prices for certain individual goods might rise—even rise lots—but that won't necessarily make average prices rise overall. Oil or gold price increases don't automatically mean we're experiencing inflation—it might just mean demand's higher.

Today's high commodity prices aren't alarms—they're simply symptomatic of growing demand and restricted supply. In fact, don't be surprised to see prices remaining firm or rising with continued demand. Rising prices aren't automatically bad! They can translate into increased profits for raw materials suppliers and producers—and a good time to reassess your Materials allocation to make sure your portfolio benefits. Risks to the Materials sector certainly remain: Falling economic growth in emerging markets, political instability or intervention, a rising dollar making dollar-priced commodities more expensive for most of the world. But as long as the world keeps building infrastructure and consuming, demand should keep chugging along fine. And as Madonna taught us, there's no shame in being a Material Girl (man or woman).