Are surging earnings the inflation canary in the coal mine?
Another day on the London Stock Exchange, and another couple of gangbuster updates from the big mining firms that make up such a big chunk of the FTSE 100.
Record volumes, higher prices
Vedanta Resources (LSE: VED) saw total revenues increase by 54% in the six months to 30 September. The Indian-centred mining company, which reports in US dollars, said revenues hit $4.6 billion, with operating profit doubling to $985m.
After adjusting for its $1.6 billion of net debts, tax, and the substantial share of its earnings that go to partners, Vedanta shareholders were left with $337 million for the half, or 122 cents in earnings per share. That's double last year.
Chairman Anil Agarwal is pretty explicit about the fundamentals driving Vedanta's good fortune:
"The combination of record volumes and higher metals prices led to a rise in revenues and profitability during the first half of this year."
Huge demand is seeing Vedanta's zinc-lead and aluminium smelters running at record levels.
It's a similar story with the third-quarter results from the Kazakhstan-based giant Eurasian Natural Resources (LSE: ENRC), where CEO Felix Vulis says:
"During the period we continued to operate at full capacity and expect to do so for the remainder of the year, reflecting strong underlying demand for our products."
The company doesn't break down its financials on a quarterly basis, but it is clear shareholders have a lot to look forward to; the company says it has seen a "significant increase" in revenues over the nine months of the year to date.
In ferroalloys, where the group is top dog globally, production is running 39% ahead of last year. Iron ore production is running at full capacity, and the prices the company is achieving are 59% ahead of the same period last year. Aluminium revenues saw an "exceptional increase" over last year, again due to higher prices and demand.
The super-duper cycle
Ongoing Chinese GDP growth of 7-9% and strong expansion in other emerging markets underpins Eurasian's longer-term optimism, and that of the other big mining companies.
In other words, the commodity super-cycle is back on.
Investors have short memories. Only a couple years ago, the super-cycle turned into a rollercoaster. The share prices of giants like Xstrata (LSE: XTA) fell 90% in less than a year from their highs, as the markets priced in a second Great Depression.
The gains since those lows have been stunning. Even fairly stable diversified mining giant BHP Biliton (LSE: BLT) is up 150% on late 2008, with its shares this month busting through the £24 level for the first time.
But while it would be nice to think that companies like Vedanta and BHP could continue to pour extraordinary profits into the coffers of FTSE 100 investors for years to come without consequences, there is a good reason for believing growth in revenues will at least moderate.
And that reason has a name: Inflation.
How rising prices can curb profits
There are two ways in which inflation will impact the earnings of resource companies.
Firstly, mining is itself commodity dependent. Crucially, it's an energy-intensive business. It takes masses of energy to dig big lumps of ore out of the ground in ever more remote locales, to refine it, and to ship it across the world to the final market.
Higher demand for energy, such as oil, will increase the price of such commodities, which in turn will increase miners' expenses and so at least moderate their profit growth. Inflation also shows up in equipment costs. For instance, the price of rubber is on a tear, which will increase the cost of vehicle tracks and conveyor belts.
Secondly, ever-increasing commodity prices will also, one way or another, curb demand. Either directly because industrial customers buy less of the commodity, because of slowing growth in the urbanization of China, for instance. Or higher commodity prices could fuel inflation across a broad range of end products, which causes inflation to rise, and so prompts central banks to increase interest rates to force down growth and inflation expectations.
We're seeing this happen to an extent already in the emerging markets. On Thursday, inflation in China hit a two-year high, with the official October inflation rate up to 4.4%, from 3.6% in the prior month. No wonder the Chinese authorities recently raised interest rates.
Copper prices have just reached all-time highs, to $8,495 per metric ton, surpassing their previous July 2008 peak. Rising copper prices prompted Chinese producers cut production in October and reduce imports to a 12-month low, though these figures are extremely volatile month-to-month.
Higher inputs, uncertain outputs
Record prices for commodities and inflation rising across the emerging markets show how bearish Western investors who concentrate on the US and UK's troubles are missing the big picture.
Ben Bernanke at the US Federal Reserve might kill right now for an inflation problem (or at least do the economist's equivalent, which is his $600 billion second round of quantitative easing) but much of Asia and the developing world is racing away.
Indeed, Jim O'Neill, the influential chairman of Goldman Sachs Asset Management, says some Asian authorities refer to the 2007 to 2009 credit crisis and subsequent recession "the North Atlantic crisis".
Investors who've ridden the recovery in metal prices and miners might agree. But we'll have to wait to see whether rising commodity prices and inflation in far-off lands is the first leg of the sustained global recovery that personally I expect, a bubble fuelled by excessively easy money from our own central banks, or the harbinger of some hideous stagflation in the West.
More from Owain Bennallack:
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