The Inflation Cycle of 2002 to 2015 - Uhlmann Price Securities

Industrial Portfolio Strategy
The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -7- Legg Mason Wood Walker, Inc.
Report Conclusion: “History Doesn’t Repeat Itself, But It Does
Rhyme” – Mark Twain
This report began with the question “Do commodity-serving companies, which have generally been
poor investments since the early 1980s, deserve investors’ capital in the coming decade?” Commodityserving
companies generally perform best when commodity supply is tight and/or demand is strong, which
generally has not been the case since 1981. The chart on the cover of this report shows that the U.S. stock
market and the Producer Price Index for commodities have alternated leadership seven times since 1877, in
cycles averaging 18 years, and the hard asset versus financial asset trade-off is clearly driven by inflation.
From 1982 to 2000, commodity prices deflated relative to the S&P 500, and the commodity-serving industries
generally underperformed in that period.
After deliberating on this subject since the growth stock bubble burst in 1Q00, we have come to the
conclusion that the inflation cycle is currently turning up, and we further conclude that this is generally
bullish for the stocks of companies that serve the commodity producers (and, of course, the producers themselves).
We believe signs include surging real estate prices, strong money supply growth, oil and gold
strength, increasing geopolitical instability that may lead to inflationary warfare, and a potential peaking of
the trade-weighted U.S. dollar. While deflation benefits companies with high unit growth and negative pricing
(e.g., computers, software), inflation benefits companies with operating leverage and pricing power.
Throughout this report we use the term deflation in lieu of “disinflation,” but the intent is the same.
We believe a forward-looking approach, if correct, allows investors to position themselves for outsized
investment returns. Positioning is the key word, because analysts are one- or two-trick ponies insofar
as they are generally “wedded” (for richer or poorer) to one or two narrow industry groups, and even
non-specialist investors often require several years to build sector expertise. Foresight is, of course, difficult,
but adversity often has commensurate reward. For example, in 1970, when Middle East troubles were
brewing (after the 1967 war but before the 1973 war) and OPEC (founded in Iraq in 1960) was little known,
a forecast that called for oil to rise tenfold to $30 per barrel within a decade would have been outlandish. In
1980, near the height of inflation, a prediction of double-digit real bond yields in less than a decade would
have seemed absurd. In 1990, when technology stocks were “value” stocks because their earnings were
volatile (sound familiar?), a prediction of a greater-than-tenfold increase to over 5,000 for the NASDAQ
composite within a decade would have seemed ludicrous. But in each of those cases, investors able to anticipate
the environment were well positioned to capitalize on the changes. For the period 2002 to 2015,
we expect a macro-backdrop for our stocks (and the market) with the following features.
Strong nominal GDP growth, with a large real (ex-inflation) GDP component in the first half of
the 2002 to 2015 period, and a larger inflation component in the second half of the period.
Sharply rising GDP leading to Fed rate hikes, but the Fed may have little choice but to return to
an accommodative stance due to the “hangover” of past financial excesses and, potentially, war.
Strong global commodity demand and commodity prices; poor profits have discouraged commodity
producer investment since around 1981, and Persian Gulf instability may constrict supply.
Commodity price pressure that contributes to higher consumer inflation, or, in the case of commodity-consuming
industries with excess capacity, cost pressure may compress profit margins.