The inflation trade
The commodity sector has been one of the best performing sectors in the Indian stock markets in past 6 weeks. A number of brokerages have upgraded their outlook for steel, cement, gas, and chemical etc producers. Many have argued this to be a sustainable and durable trend and once in a decade opportunity to trade the inflation. For example, the brokerage firm Edelweiss expressed exuberance over steel prices and said, “Going ahead, we expect a blockbuster Q3FY21 with record margins in store. Furthermore, structural shortage of steel implies the rally in ferrous stocks has more legs despite their recent run-up. We remain positive on ferrous”.
I spoke with some steel and cement dealers, in Delhi, UP, MP and Bihar, in past two days. All of them appeared bewildered by the rise in prices. All of them cater to the small private construction segment, and none of them confirmed any sign of demand pick up in that segment. Being in trade for many decades, they were sure that demand is certainly one of the key factors driving the prices of steel and cement higher. They guessed, it could be a mix of supply chain disruptions, import restrictions, large inventory building by China and most importantly, the “understanding” between the domestic producers that could be driving the prices.
On the other side, Chinese Yuan has appreciated dramatically in past couple of months. This CNY appreciation has come along with first contraction in the Chinese consumer price index, since global financial crisis. At this point in time, it is tough to say how much of Chinese deflation is consequence of CNY appreciation, but it must certainly have some role. If the strength in CNY reflects the policy decision of Chinese authorities, we need to worry about deflation which China will be exporting rather than the inflation.
My take on the inflation trade, especially in Indian context, is as follows:
A large part of the global inflation in past 9 months could be the consequence of (i) supply disruption due to logistic constraints; (ii) inventory building by large consumers like China; and (iii) weakness in USD.
After reading and listening to views of various experts, I have concluded that that China might have built large inventories of all essential commodities (especially metals and energy) to hedge against (i) Trump victory and consequently intensifying trade war; (ii) longer lockdown due to pandemic Both these conditions have failed. Regardless of popular opinion, my view is that CNY strength is a Chinese gesture to US for ending trade dispute. If Biden reciprocates well to this gesture, inflation may not be a concern for next 10yrs at least.
I shall therefore avoid “The inflation trade” for now. However, if I see a sustainable pickup in demand next year, I shall be inclined to buy some domestic commodities like cement and chemicals (primarily import substitute).
Chart for the day