The battle against inflation
09 mars 2023
With COVID-19 restrictions behind us, our team has been hitting the road, meeting over 300 companies in the past two months at conferences and onsite, from India to Chile, from Florida to Whistler. One of the conferences we attended was the 32nd BMO Global Mining & Critical Minerals Conference that took place in Florida from February 26 to March 1.
The largest conference of its kind, it brings together over 350 companies including all the majors: Rio Tinto, BHP, Vale and Freeport-McMoRan. We met over 30 companies and attended various panels.
New this year was inviting critical minerals companies that explore and produce lithium, cobalt, graphite, and other metals. These will be key on the journey to decarbonization, either via battery-electric vehicles or renewable power.
It is always interesting to attend a mining conference. The optimistic nature of management teams, the promotional aspect of companies trying to raise billions to find metal in a pile of rock in a remote area and then building the mines, roads and infrastructure to bring it to production. There are many interesting characters to say the least.
What were some observations and how does it relate to our commentary this week about the battle against inflation? One main takeaway is that the two megatrends of urbanization and the need to reduce carbon emissions to limit the temperature rise are very much intact. China at 64% is probably two-thirds of the way in terms of people moving to cities. As a comparison, the U.S. is at 83% whereas countries like India are only at 36%.
Share of urban population worldwide in 2022, by Continent
Urbanization comes with the need to build new infrastructure as well as replace aging infrastructure, some dating as far back as the 19th Century.
An interesting fact is that since the beginning of the Copper Age around 4500 BC, almost 7,000 years ago, 700 million tons of copper has been mined until today. In the next 25 years alone, the world will need another 700 million tons.
Where will we find it? How much will it cost to bring it into production? We can assume it will be a lot more, in other word, inflationary.
Copper price 1989 to today
This is a long introduction to this week’s commentary. Are the central banks winning the war on inflation?
Earlier this year, market participants thought we had made good progress as we started to see inflation numbers come down from their peaks. We started assuming interest rates had peaked and would even start to decline in the second half of 2023.
Since then, economic data out of the US, Canada, Europe and China has shown:
- a resilient economy,
- a confident consumer,
- strong job creation. And surprise!
- an increase in inflation from December to January.
US Personal Consumption Expenditure Core Price Index YoY
Obviously, bond and stock markets have retraced much of their positive returns.
Where is inflation headed now?
Let’s focus on the US.
Components and weight in CPI calculation (source Bureau of Labor Statistics)
|Food and beverages||14.40%|
|Housing||44.4% of which owner equivalent rent of residence is 25.4%|
|Transportation||16.7% of which 8.1% is new and used vehicle|
|Education and Communication||5.80%|
|Other good and service||2.80%|
In aggregate, commodities including food and beverage is approximately 41% and services is 59% (includes rent).
Graph of US CPI Owner Equivalent Rent YOY
So, as can be seen from the weight of the various components and the chart above, rent will go a long way in terms of determining the direction of inflation. Although we have recently heard of rent peaking, we are still looking at high single-digit increases on a year-over-year basis. Since this data normally lags about six months, we do not expect a large decrease in this measure to bring down inflation. Furthermore, looking at the graph above, it has mostly been above 3%, except the period following the global financial crisis of 2008.
Last December, we were of the view that inflation would still be above 5% at the end of 2023, a view that was not widely shared. Now in March, the data seems to validate our view.
The Fed needs to continue raising rates. How high will they go?
The market now expects a terminal rate at around 5.5% and many funds are buying options where rates may reach 6%.
We still believe the only way to break inflation expectations — which is what the Fed is focused on — is to see slack in the labour market.
That probably means an unemployment rate above 6% and we are far from that level.
With Delta Airlines announcing this week there will be an increase of 34% for its pilots for the period 2023-2026, we are far from seeing wage increases at 2%.
We also need to see home prices decline by 20% or more. Prices are still going up year-on-year and should register their first modest decline by April of this year.
As we wrote last week, the recent rally has been of poor quality. Like in the summer of 2020, unprofitable companies with weak balance sheets have been the best performers.
Our portfolio is well positioned for a more difficult environment in 2023, i.e., much lower economic activity and even a recession combined with higher interest rates.
Toward the end of the first quarter of 2023, we expect a rotation to higher quality companies with little or no debt and the ability to gain market share. We are already seeing green shoots with small cap and international markets outperforming this year.