Resources remain a good bet against inflation

The strong Canadian dollar has largely shielded investors from inflation, but the long term trend on prices is pointing higher, according to strategists at Guardian Group of Funds.

“We believe this move to higher prices is a long term phenomenon, not merely a statistical spike, and investors need to position their portfolio to preserve their capital against the effect of inflation,” says Gavin Graham, vice president and director of investments at GGOF.

China and India are the world’s two largest labour markets and the rapid industrialization of these economies has driven up global energy and mineral costs, even as they crank out cheaper consumer goods and outsourced services.

While much has been made of “the Wal-Mart effect” in maintaining low consumer prices, the construction of the infrastructure required for that production has required massive imports of raw materials. Nickel producers, for example, have benefited from the demand for stainless steel.

“I think there are many reasons to think the growth environment will remain reasonably robust,” says Andrew Foster, director of research for Matthews International Capital Management, the lead managers of GGOF Asian Growth and Income Fund. He points out that the widely-prophesized slowdown in China has yet to materialize and that India is growing even more rapidly than before.

“The Indian economy shows many signs of even accelerating the pace of growth that it has experienced in recent years,” Foster says. “Its trend growth has been in the five to six per cent range, but the most recent economic statistics are reading in the seven to eight per cent growth range.”

Not only is India’s economy growing faster, but it is growing in a more diversified manner, with rural spending increasing along with urban growth. This differs from the trend in China, where mass migration from the countryside to the cities has been more common.

“The broadening of consumption across the geography is quite important,” says Foster. “The emergence of a middle class is a trend we expect to see continue.”

Meanwhile, Asia’s central banks have remained very accommodative toward the high growth rate. Interest rates may have risen recently, but for the most part rate hikes have fallen short of the pace in U.S., despite consumer inflation of about 4% in India. China, with its government still exerting control over much of the economy, has posted a relatively tame inflation rate of around 2%.

Foster sounds a cautionary note, however, pointing out that economic shocks in the western world would have knock-on effects into Asia. He adds that Asian consumerism remains “nascent” and could be choked off by such a slowdown.

“In any event, we think the synchronous growth that is occurring across the region paints a very robust outlook for the year ahead,” he says.

While Asia is driving strong global demand, the supply side has been lagging, according to Wally Kusters, Barrantagh Investment Management, co-manager of GGOF Resource Fund.

“We think what we’re going through is more like a capital cycle, as opposed to an economic cycle,” Kusters says. “In a capital cycle, you see far greater demand than people expected and supply takes a long time to respond to the unexpected demand.”

Over the past 20 years, the rate of inflation has been trending lower, but Kusters says that trend has now reversed. While increasing inflation may panic the consumer, investors in the commodities markets tend to do quite well.

“Will there still be cyclicality? Oh yes…there’s no question. But people will be surprised at how well these resource companies can do,” he says.

He compares this to the rapid growth of demand during the Industrial Revolution and the reconstruction efforts after the Second World War. Such a build-out of capital infrastructure lasts longer than a simple economic cycle, giving investors a wider window of opportunity.

“We think this is different than what we’ve seen over the last 20 years, where commodity prices have incessantly gone down,” he says. “The best value we can add today is from the resource supply side.”

Some mineral deposits discovered 15 years ago have yet to come on line, for various reasons — either over environmental concerns or the commodity price simply couldn’t support production. The nickel mine Voisey’s Bay, for example, is not expected to begin production until 2007 or 2008.

“That capacity has to come on in the nickel market for supply and demand to be in equilibrium,” he says. “If those mines stumble for some reason, we think nickel prices will be far higher than today, even though today’s prices are very strong and very good for the producers themselves.”

In the energy sector, demand for oil and natural gas has sent prices soaring over the past two years, yet new production has been slow to catch up. In North America, most energy reserves that are being tapped were once considered “non-conventional” such as heavy crude and coal-bed methane. Because demand is so high, these reserves have not only become commercially viable, but vital.

The higher cost of extracting these reserves drives the price of all energy products higher, resulting in fatter profit margins for conventional producers, who benefit from the higher prices but do not face the same high production costs.

“Ten or 15 years from now, when India and China become consumer nations, you’ll see commodities like aluminum doing better, because the number one demand for aluminum is cans,” he says. “That’s the sort of cycle that we’re watching on the commodity side.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(12/14/05)