Market Watch Ep.15: Will Inflation Be Transitory Amid The Commodity Boom?

Welcome to the Market Watch podcast by Amplify Live, where you can access the latest market insights with me, Anthony Cheung, the Head of Market Analysis, and joined by our Head of Trading, Piers Curran, getting you up to speed on what mattered in markets this week. Okay, so it is Friday morning, the 7th of May, and I'm joined as ever by our Head of Trading Piers Curran. And little do people know, Piers, when they're listening to these regular podcasts, that obviously we record this on Zoom and I can see you while we're talking. And you're looking like you're going out on date night. You've got a little milk tray man outfit going on here.

It's funny you say that because actually I'm doing two things today that I haven't done in more than 12 months. I'm very excited. Number 1, I'm gonna go on the London Underground.

Yes, is that— is that— I thought that was like a legacy thing that doesn't exist anymore.

I'm traveling into work on the tube. I have not been— I've lived in London, uh, I was just trying to, uh, I've lived in London since 1997 and I've used the tube every week for that entire period up until end of Feb 2020. And then I haven't been on it since. It's been a weird— so today, after this podcast, I'm going into the office and I'm going to go on the tube. Now that's number 1. Number 2, check this out. You might remember this from years gone by. I'm going out for some beers with some colleagues.

Oof. I'm not sure. What to do in those social situations.

Exactly.

Make it— make me nervous.

This is a very— I'm very excited. And, and to add to my, my kind of levels of happiness, Arsenal lost in the semi-final last night as well. It's like this is, this is a great day.

Well, you know, as some people will know, Sam North, who was a long-standing member of Team Amplify Anthony Cheung is no longer with us anymore. He's moved on to new things. So we can say what we want about Arsenal Football Club now. It's absolutely fine. Absolutely. But look, let's get to it. And really want to focus this discussion on one specific area. But I think it kind of then leads us on into a very, really important theme that's going to become increasingly so more in focus as we go through the coming months. And going to start it off with a little bit of a top overview of what's happening in commodities right now. All over the world, commodity prices are rising and sharply as the global economy goes through this reopening phase. Before I get into that, then subsequently, what does that mean for inflation? There's discussions at the moment about, you know, are the Fed seeing this right in regards to their calmness to stay true to that kind of transitory belief that inflation will come and pass or settle in time after the reopening is done. And then the communication challenges that come with that from a central bank perspective and subsequently a trading perspective. And so I guess kicking it off then with commodities, a couple of, couple of stats then. Um, for, for copper, we've obviously been up there at decade highs. Aluminium prices, uh, have approached the highest levels in multiple years. Palladium record high. Lumber is kind of like the new hot buzzword, if you like. And I know there's a few things to have a look at there. And one of the things I was looking at was as of March, new housing starts in the US now the highest level since 2006. And I was listening to a conversation that some analysts were having about lumber. I mean, lumber is something I would have never traditionally looked at. I'm not sure if you ever did over the years. But the market structure for lumber, and I think this is an important point for anyone who's investigating potentially trading or investing in commodity, is really understanding that product's market structure. And with lumber, it was quite interesting that futures market, cash market, lumberyards, sawmills, you've got to get out your stumpage fees. And then there's the home builders. So yeah, I mean, that's a big story at the moment. And so let's have a chat about that first, and then I want to kind of talk about what the ISM, the Institute of Supply Management, said earlier this week.

Yeah, I mean, when just commodities generally, I mean, it's, you know, that classic supply versus demand equation that, you know, anybody who's studied economics in their previous lives will of course know about, but it's, it's so true. And what's great, what I love about commodities is, all right, on the demand side, you could say there are some, you know, overarching general themes and drivers on the demand side, and a lot of those are just linked to economic activity, economic growth, right? But then when you, when you drill down onto the supply side, you know, every, every commodity has, has its own kind of unique supply structure. I mean, lumber is such a fascinating one at the moment. And as you said, it's the classic— when you get a price spike, and just to put it into context here, lumber prices. So well, firstly, what is lumber? I mean, lumber is wood that's machined and produces beams and planks. All right. And that forms one of the key building materials in the US. For example, I was surprised about this. So in the In the US, when they're building new homes, 90% of newly built homes are made from wood frames in the US. Do you know what the percentage is for the UK? What percentage of new homes in the UK are built using wood frames?

0.3%.

It's a rubbish answer. 30%. 30%, right?

I got my numbers wrong. There was a misprint in the decimal placing, so I was exactly on.

I was quite shocked at the difference. I was quite shocked it's so high in America, and I was quite shocked it's so low here. But one of the key things about wood frame homes is that it's actually— timber framed housing has the lowest embodied CO2 of any commercially available building material. So given in the UK, given obviously, and not just the UK, these global commitments to try and reduce greenhouse gases and etc., then actually in the UK we're expecting that percentage to rise quite significantly in the coming years. So anyway, it just gives you an insight. 90% of newly built homes in the US have wood frames, right? So that gives you one hint at where some of the demand comes from. And it just so happens that as you've as you said, new home building stats are through the roof, 15-year highs or what have you. And so, you know, from the demand point of view, it's red hot. And the thing is, just as demand is red hot, we've got quite unique and unprecedented supply constraints across the system. And of course, this is leading to prices spiking. Well, we drew up over $1,600 um, uh, yesterday. And that, like, did— to give you an idea, so $1,600, right? Um, just a year ago is only $260. Um, and then pre— if you kind of— that was the depths of the kind of pandemic, right, when it first hit. But if you kind of take the pandemic out of the equation, then the previous all-time high for lumber was $650, which was back in 2018. So $650. So not only have we smashed $650. It's now trading at $1,600.

So I suppose there's this reaction anticipation at the reopening, but then underlying a lot of these commodities, there are other themes like palladium and US vehicle sales, used as a metal, a key component in catalytic converters. There's a newly approved— the Chilean lower house that we all know so well, approved introducing progressive taxes on copper sales. And obviously Chile's the most important for the supply of copper, and it's going to be the most heaviest levies in global mining essentially. And that's going to stall investment is what people are saying. And this is already coming at a time when there's, there's pent-up demand coming, and now this is coming in as well. And then And similarly, with the drying up of existing home inventory, one of the things I was reading is about demographics and millennials. Now they don't have a choice. They have to go new construction, which further— it's like a double whammy, isn't it, at the moment?

Yeah. Well, that kind of Chilean example, I mean, it's just— don't forget that these governments, their finances are in desperate, desperate straits given the pandemic. And it's like, desperately trying to find some new revenue streams or increasing revenue streams through tax. And obviously for Chile, it's all about copper, and copper demand's through the roof, and copper prices are through the roof. So actually, right, as a government, let's tap in on some of that action, please, because we're on our knees here. But with regards to those homes, just kind of back to that lumber thing, because it's having quite— the dramatic nature of the— and talking about inflation, right? The dramatic nature of this price rise, to give you— to put this into context in terms of how much it costs to build a house, and then how much this rise in lumber prices has an impact on that cost. So right now, it's costing $24,000 more to build a single-family home. A family home in America, a normal single-family home is averaging around about $315,000 at the moment. if you want to buy one— the price to build it has gone up $24,000 in the last 12 months just because of that lumber price change. And so obviously, that price rise to the homebuilder obviously gets passed on in the end. All these price rises, in the end, all get passed on to the doormat of the consumer. And so in the end, it's the consumer that's got to pay for all of this. But it's quite interesting with— it's the irony of all of this. Because, right, they're trying to— obviously, there's a desperate situation for supply of lumber in America. They're trying to bring more in from Canada. But Trump, unfortunately, Trump's come back to haunt us a little bit, because Trump increased tariffs on Canadian lumber coming over the border. So that's not helping. And then just at the worst time, there's a big mountain pine beetle in Canada devastating some of the lumber supply. Yeah. I mean, you can't even script this. Stuff. Um, so you've got this quite— and, and actually, unfortunately, in the kind of Southern America where a lot of this lumber is harvested, a lot of these trees are harvested, and then you produce lumber, right? There's actually a big spike in the demand— in the supply of trees, because apparently they— I didn't realize— they went through in the 1990s, they went through a planting craze to plant more trees, and all these trees are now big enough that it's right, let's chop them down. But the bottleneck is in the sawmills So actually, the price for buying logs is really low because the supply is so high, and yet the price for the planks that are produced by the sawmills are a record, record ever high. So your massive bottleneck is bang in these sawmills, and if you own a sawmill at the moment, it is happy days. You are buying logs really cheaply and you're selling these planks for crazy money.

When you were explaining that, I was just thinking, God, if I was a hedge fund manager with billions of dollars at my disposal, I'd go to the Galápagos Islands or something, find some exotic beetle that just loves eating a certain type of pine, and I would develop it in a lab, grow them, and then I would drip feed them in while I build up a humongous position.

Craft.

And I'd be like, okay, feds, see what you— what have you got on me now?

Like, I mean, who knows?

Maybe that's not sure why— not sure why my mind works like that, but that was the first thing I thought was, how do I harvest these beetles and then just unleash them on some kind of key component? But yeah, there was a good summary here, was from the ISM. The reason why wanted to comment on them was because we've had the PMI numbers from the Institute of Supply Management this week. So manufacturing services— on the manufacturing side, the survey committee members reported that companies and suppliers continue to struggle to meet increasing rates of demand due to coronavirus impacts limiting availability of parts and materials, as we've discussed. They said recent record-long lead times, wide-scale shortages of critical basic materials, rising commodity prices and difficulties in transporting products are continuing to affect all segments of the manufacturing economy at the moment. Because actually the manufacturing employment component, which obviously we look at because payrolls is coming out later today, that was pretty much the only area in US employment that fell against the prior month.

Interesting. Yeah, I mean, talking about the ISM manufacturing components, as you're saying that the prices index rose to— well, it's 11 months straight it's been rising, but it's actually now up to the highest level since July 2008. And I was listening— another big event like over the last week has been the Berkshire Hathaway AGM, and Buffett was talking and he got asked about inflation because you got— and Berkshire Hathaway, by the way, are great, but they're in a great position to be able to measure real inflation, you know, inflation right out there on the ground, so to speak. And And, you know, Berkshire Hathaway, they own obviously loads of companies, and they own railways, and they own low-cost housing, and they own metal fabrication businesses. They employ actually nearly half a million people, believe it or not. But Buffett was asked about inflation in the AGM, and he said, and I quote, "We are seeing very substantial inflation. It's very interesting." And he said that you know, we as a business, we are raising the prices of the goods that we're selling. And he said that's because people are raising prices to us, raw materials, and we've got no choice but to accept those prices. And then of course we're passing those on. So, you know, and back to home builders, because Berkshire Hathaway, they own 9 different home building companies, um, as well as, you know, um, you know, manufacturing houses and operational side of things and and stuff. So actually, they're the largest in the country in terms of kind of home builders and stuff. So they're right at that kind of coalface, if you like. And for him to really step out and make a point of saying that and mentioning that definitely means it's there, it's real. You can see it in all the price charts, and it's feeding through to inflation. And we've got some key inflation data next week, of course, with the US, um, the April inflation numbers that are going to be announced on Wednesday.

So then this leads us on to the next point, which is, um, there's quite a few traders this week that I've been talking to who are just kind of sat there waiting for this equity market to burn. Um, you know, you just can't change bears like you can't change bulls, I guess. And, you know, we had that wobble at the beginning of the week. It's Tuesday, the market sold off quite aggressively. I say aggressively, it came off like 1% or 1.5% off the 100% rise that we've had. But it's so interesting, obviously being exposed to the day trading environment, that is increased volatility against the general norm. But this, what you've just discussed, that last point is exactly what's fueling appetite for these bears to think, I think the Fed have got this wrong. And actually the mismanagement of them believing that this inflationary pickup will be temporary of nature is incorrect, and they're going to have to accelerate and respond and tighten faster or communicate that. And thus equities are going to have some downside. What's your take on this whole kind of transitory idea that the Fed have And why do the Fed feel confident and comfortable to stay committed to that?

So this comes right down to the crux of it. If you go back to, you know, our podcasts like episodes 1, 2, 3 or whatever months ago now, then it was very easy to predict at that point that inflation was going to build and it was going to start to ramp quite sharply higher as we hit the spring. Okay, we were saying this, you know, everyone— I'm not saying we had some kind of crystal ball, everyone was saying this. It was very easy to to predict, given that the financial— sorry, the pandemic crash was in April of 2020. As soon as we hit April of 2021, then the year-on-year price comparisons are going to be at their widest, and this will feed through into inflation measurements ramping and jumping higher. We were talking about this months ago. The real difficult— and we were saying, yeah, yeah, it's going to be transitory, and we'll talk about why in a second. But you can have these theories. But then when it actually— when the moment arrives, this is where it really tests your mettle, if you like. It really tests your conviction of your analysis. And we're right now in that sweet spot where it's going to be super difficult for people to stay, hold, stay on track, stay with your beliefs. You'll start to get more irrational as inflation spikes. So we're right into the beginning of that, because inflation is not going to— it's going to catch carry on ramping higher, and these commodity prices will probably carry on ramping higher for a while yet. So it's really going to test people. I'm definitely still in the camp of this is all as expected and it's going to be transitory. And this is a, this is a temporary spike, and that come the second half of 2021, all of this stuff will start to calm down, and certainly towards the end of the year. It'll start to calm down. Now, my reasoning for that is that essentially inflation— if you go back to the last time we had inflation, sustained inflation spikes, it was in the 1970s and the 1980s. I mean, most people listening to this weren't alive during that period. To have a sustained inflation spike, it needs to be driven by an underlying consistent wage growth. In the end, if inflation rises, the only way it's going to continue to rise is if wages go up consistently along with that inflation, meaning that consumers are able to afford to buy these products at these ever higher prices. If you get inflation going up and wages do not go up, Well, then in the end, you get a recession. And that's because people just can't afford the higher prices, so they can't buy as much stuff anymore. Consumption drops, and you end up with a recession. So what's happening at the moment is we're in this artificial limbo period— furlough. You've got God knows how many millions of people on furlough schemes. So fine, their wages— that, well, by the way, their wages have gone down. But maybe it's like 80%, right? But my point is, at least they've got most of their salary still coming in, okay? And if you add on top— certainly in the US, if you add on top those stimulus checks that are hitting the doormats, then you've kind of got this artificial situation where you've got people's incomes being temporarily artificially propped up, okay? Now, as we see this recovery— and look, some of the growth forecasts have been amazing. Like yesterday, the Bank of England in the UK, for example, again stepping up 2021 UK GDP growth forecast to 7.5%. It's quite just extraordinary. In the UK, they're predicting that the UK will be back to pre-pandemic levels in terms of the size of the economy by the end of this year, which is astonishing. But the point is, that's great news, right? But it also means we're getting ever closer to the government pulling away that artificial scaffolding. And when they pull away the artificial scaffolding, only then will we be truly be able to kind of see the damage that this pandemic has caused. And it's going to lead to unemployment going up. It's one of the only times I've ever seen growth forecasts dramatically rising and then unemployment forecasts also going up at the same time, which kind of seems counterintuitive, and that's because we're in this weird situation. So in the end, you're going to see no wage growth to sustain a long-term inflation rise. And so either inflation drops back down or we get a recession, in which case actually inflation drops back down anyway. So that's my— that was my belief 3 months ago, and I know it's harder to sustain that belief now when inflation is ramping on the up, but I'm still staying true to my thesis.

Well, you're supported by a guy, I guess, who's got an okay, I guess, respect in the market and a fairly substantial job title, the head of the Federal Reserve.

Oh yeah.

So you and Jerome Powell seem like besties. JP. JP is as you like to refer to him when you're down the pub with JP. But in all seriousness though, this is the challenge though coming for the Fed, right? Which is they do need to start, as you mentioned there, like when the stimulus checks kind of stop and when the foot comes off the gas a little and we do reopen and things, touch wood, do turn to normality. Well, then there's no need for this incredible stimulus that we've seen in monetary support and fiscal support. And so timings-wise, then this is like the next big discussion is, is when do they make that, that kind of hint towards tapering, the discussion on the discussion of tapering, and then eventually then the timeline of rates. Um, and yeah, an interesting thing that's happened this week is Janet Yellen, again, very well-respected individual, just given She formerly was in charge of the Fed for many years. And she was actually— this is an interesting talking point because traders love to talk about conspiracy theories. Because Yellen was the vice chair under Bernanke during the financial crisis. She's been around a long time.

Oh, yeah.

And she made a, quote, blunder. And I'm like, just Yellen make blunders? I find that hard to believe. I mean, I know now she's surrounded by politicians, so now she's got a political agenda semi-tied to her. She doesn't need to be so independent, I guess. But she was talking about— she kind of made an offhand comment that the economy's picking up, inflation's going to rise, we might need to hike rates. The market then— that was in the midst of the sell-off we had at the beginning of the week, and it kind of further fueled the flame. Then she walked it back, came out later the same day and said, just to clarify, I didn't mean we need to hike rates. And it was just a bit embarrassing, I guess, to a certain extent. But the point being, though, is that those discussions are going to have to happen on a Fed level. What's your idea about timing? A lot of people are penciling in June because that's when the next economic projections of the Fed come out and obviously would have progressed in vaccines and the reopening. Or people have said Jackson Hole. Which is August, which is kind of coming towards then. I guess we're just further down that road then with more, more kind of information about the inflation situation, things like that.

Yeah.

What do you think?

Um, firstly, on, on Yellen, she's about the safest pair of hands you're ever going to get, and she's super dovish normally. So I know, all right, she's got— she's— the constraints of the central bank are off, and perhaps she can speak a bit more freely, but there's no way she made a gaffe there. That was incredible. She's a very intelligent person and she knew exactly what she was doing. I don't know what their agenda is. Maybe they're worried about asset price bubbles. I don't know. But anyway, that's one point.

Actually, what— just on that, the Fed released last night their Financial Stability Report. Funny you should say that, because they said in that report rising appetite for risk across a variety of asset markets is stretching valuations. and it's creating vulnerabilities in the US financial system. Right. And so just keeping it true. And an interesting thing is the market a few months ago was— sorry to jump in, but the market a few months ago was yield-obsessive inflation expectations and everyone was panicking. Then everyone's now bought back into the Fed, volatility's dropped very low now. And then it almost felt like Yellen was just like, don't get complacent here. I'm just going to drop this in. And then the next day, the Fed come out in force, several speakers just realigning it. Is this just not just tactical management? Yellen involved?

Fully coordinated. I'm sure Powell was talking to Yellen. Look, the Fed have got this very difficult challenge where they've got asset price bubbles, pockets of prices are really dangerously bubbling. And that's a risk, right, to the financial system and therefore the underlying economy. So they want to calm that down. But at the same time, they don't want to then destroy or risk confidence within the broader economy just as we're emerging from lockdown. So you kind of— you're caught between a rock and a hard place. So I know, why don't we get our old mate Yellen, who's not in the Fed, to flash up a bit of a hawkish comment from, from nowhere, and then we can come back in and kind of counter that and defend that and stay dovish, and we try and achieve our dual aim of calming down price bubbles whilst also sustaining confidence at the economic level. So I'm sure it's all very strategic and coordinated. I mean, one, one thing I would say about the Fed— and will it be June when they start the discussion of maybe we should think about tapering? One thing to note that's different this time than any other Fed cycle is what Powell said earlier this week, and he said that the Fed will not remove the punch bowl he didn't say these words exactly, but will not remove the punchbowl until the labor market's worst off have seen their prospects improve. There's a very different Fed now, and it's about the lower income bracket. It's about the worst off. It's about the rich-poor divide. Now, for the worst off, the lower income, they got hit the most by the pandemic. So they're going to wait and keep policy ultra-accommodative until the worst off start to see their conditions improving, which means they're going to— I would say they'll delay their exit more than they would have done, let's say, in previous crises, which is why I think June is still too early.

And technically, from a numbers point of view, we've got payrolls out in a few hours. The headline's expected just short of a million, which is a high number in terms of the recovery of jobs in the US, but that would leave employment about 7.5 million below its peak in February of 2020 before the pandemic hit. So in terms of that gap to fill, um, interestingly, there was a comment here just to kind of close from, uh, Stephen Englander. Um, you might have heard of him, Piers. He's, he's fairly well followed. He's the global head of FX research at Standard Chartered, but he's, he has got some good, good pieces out. And he was talking about today's payroll, and he was suggesting that you're going to need a number north of 2 million today if you were going to see the Fed potentially reconsidering that view about tapering talk being too premature. And he was actually talking about— the consensus today is actually 978,000. He actually was saying that, in fact, if we see anything below 1.5 million, so still strongly above consensus, The market will just swallow that. The Fed will stay. And actually, it just further feeds that positive narrative that things are moving on in the right way. And the kind of gravy train continues, so to speak. And in fact, looking on other asset classes, anything that comes in between 1.5 million, he sees as sufficiently significant positive surprise for, for what, not being a significant positive surprise for bond investors. So therefore, actually, yields might fall.

Yeah.

Even if we get a 1.2, 1.3 million reading today, and actually T-notes might rally.

And that right there sums up the incredible moment in time that we're living in.

Yeah.

I mean, I agree, it's got to be north of 2 million. That, that feeds back into that the lower income bracket properly recovering, because you're going to need super strong job creation for it to properly feed down to that bottom level. And it's only then that the Fed will start to sit up and take note. So I agree, you're going to need a monster reading north of 2 million for the Fed to even kind of flicker, I would say.

Yeah. Well, if that does happen, just look out for Source comments this afternoon. That's all I'm saying. Absolutely. All over the weekend, I'm sure they'll be all over the weekend press. But with that, Piers, safe journey back on the tube.

Yes, looking forward to it.

And I did see the actual invite, but I, I won't be able to attend because I'll be doing work while you're enjoying your curry. In true British style. Oh dear.

Yeah, well, we'll, we'll catch up with you later in the month, I hear. So, you know, it's about time you dragged yourself out and showed your face.

Yeah. All right, with that, with that pleasant view for everyone, or not so pleasant, we wish everyone a great weekend. Good luck for payrolls, and we'll see you next week. Thanks, Pete.

Bye!