Sunday, February 6, 2011

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Everyone Needs Commodities

By Frank Holmes

The essence of natural resources and commodity investing can be boiled down to one key point:

As the earth's population swells to 7 billion, the migration to cities accelerates, incomes rise, and people desire things the things that improve their lives, thus increasing global demand for commodities and natural resources.

A larger, wealthier class of people in the emerging world are demanding more goods as they raise their standard of living and the supply of these goods is impacted by geopolitics, diminishing mature sources and even weather.

The story begins in emerging markets where economies are growing at stable, healthy rates. Current growth rates for countries such as China, India, Malaysia and others are in the 6-10 percent range, manageable levels that are not characteristic of overheating economies. Many forecasters are expecting a slight slowdown in growth for emerging countries but a few (South Africa, Indonesia and Russia) should see GDP growth rates surpass last year's levels.
Many point to China's bank lending, which was roughly $1.2 trillion last year, as a negative because it is such a large amount for a $5 trillion economy, but we don't see it that way. We think what's taking place is more of a normalization of liquidity and interest rates. Growth will still be in the upper single digits, which is very constructive for commodity demand going forward.

Economic growth is just the tip of the iceberg. Many of these emerging markets are just discovering credit. India, China, Brazil and Russia all have consumer debt levels growth below 20 percent. Other burgeoning countries like Saudi Arabia and South Africa have less than 5 percent. As credit expands to this hungry consumer base, the consumption of refrigerators, furniture, air conditioners and other luxuries we consider necessities here in the U.S. should follow suit.

We've already seen the impact rising income levels can have on consumption in Chinese car sales. From 2003 to 2010, China's car sales have increased over 300 percent. In fact, car sales jumped 45 percent last year alone in China. This increase has made China the global leader in car sales. China isn't alone however, estimates show that 72 million cars were produced globally last year and expectations are that it will jump to 79 million in 2011.

This auto boom has shifted the dynamics of energy consumption in the developing world. The transportation sector has historically consumed about 35 percent of all energy used in the developing world. But over the next 15 years or so, it's expected to reach about 60 percent-comparable levels to that of the developed countries of North America and Western Europe.

Emerging market demand is largely the reason global oil demand levels are at record highs despite a sluggish economic recovery in the U.S. and Western Europe. Much of this demand comes from China and India, whose combined share of global oil demand has increased from 9 percent in 2002 to roughly 15 percent last year.

But it's not just oil emerging markets have been gobbling up. It takes a lot of base metals such as copper, tin, nickel and others to expand a nation's power grid, sewer system and transportation lines. China's most recent Five-Year Plan calls for $50 billion to be spent on upgrading the country's power grid and an another $110 billion on building 13,000 kilometers of high-speed railways.

This is a reason why we've seen the price of copper, lead, tin, nickel and zinc jump more than 100 percent during the past two years.

The market isn't expecting prices for these metals to turn around any time soon. Take copper for example. Current prices are north of $4 a pound but the futures market remains bullish with prices set around $5.43 a pound.

Copper's supply/demand fundamentals are very supportive of higher prices. Mine production has been declining since the early 1990s but the metal's versatility has kept copper demand on the rise.

For instance, you may not think that air conditioning demand would have much to do with copper prices but each central air conditioning unit contains roughly 50 pounds of copper. The monthly output of air conditioners in China has increased since the beginning of 2009, coinciding with a 217 percent increase in copper prices.

Copper isn't alone. We're bullish on many industrial commodities for similar reasons. As the rebound in global economic growth continues, we should see increased demand for other commodities like metallurgical coal, which is used to make steel.

The biggest threat to commodity prices is the possibility that the Federal Reserve may begin to raise interest rates, which would weigh on commodity prices. More than likely however, the Federal Reserve will maintain historically low interest rates and the U.S. economic recovery will remain on course through the year.

To listen to the full outlook from the Global Resources Fund team, listen to the Outlook for Natural Resources webcast on demand. [..]

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By Comstock Partners

After an 86 percent gain in 21 months the market looks overbought, overextended and overvalued. Furthermore the economy is unlikely to grow enough to reduce unemployment, lead the Fed to raise the funds rate or cause any significant amount of inflation.

Although the combination of QE2 and the White House/Congressional compromise on the tax extension issue is being touted as the great elixir that will spur economic growth we think that growth will be subdued and temporary. Indeed QE2 is already looking like a failure in its early stages. No matter what the “experts” say now, it was chrystal clear from the get-go that the Fed’s intention was to lower long rates, not raise them. As it stands today the sharp rise in the 10-year Treasury bond is likely to further weaken an already dead housing market by enough to offset any additional growth that QE2 could have provided.

Furthermore, the combination of QE2 and the big projected increase in the budget deficit caused by the compromise tax bill has helped spur another jump in commodity prices that will reduce real consumer income and negate much, if not all of the intended boost to consumer spending.

In addition economic growth will be tempered by the temporary nature of the stimulus, continuing high unemployment, a moribund housing sector, the dire condition of state and local finances, a lack of readily available credit and the ongoing fragility of a banking sector that is still loaded with toxic assets that are significantly overvalued on banks’ balance sheets.

Another major headwind to growth is the ongoing need to reduce household debt to normal levels after the credit binge of recent years. Consumer credit excluding student loans continued its year-long slide in October, falling by $32.5 billion, and the unwinding has barely started. Although consumer spending has perked up recently, we note that a national survey indicated that the percentage of people saying that they used their credit cards over the Thanksgiving day weekend was the lowest (17%) in the 27-year history of the survey. According to major credit card companies, the use of personal credit cards dropped 11% in the 3rd quarter from a year earlier. Does all of this sound like a consumer ready to spend freely? We think not.

As if all of the above weren’t enough, the chances of financial and economic crises overseas, particularly in Europe, China and Japan are exceedingly high. The turmoil in the European Union is not a temporary crisis that will be cured with the wave of a wand.
A number of the weaker EU nations are basically insolvent, and their debts, sooner or later will have to be restructured. The New York Times and Wall Street Journal recently highlighted the exposure of German, French, British and Spanish banks to the debts of Greece, Ireland and Portugal. The IMF has warned that if the EU doesn’t come up with a permanent solution the EU economy could go off a cliff. Meanwhile the austerity measures being imposed on the troubled countries will be a drag on the EU economy for some time to come. As for China and Japan, we’ll leave that for future comment.

In light of these problems we believe that investors are overly optimistic. An 81% market rise in 21 months has already discounted a lot of good news—-some of which will not happen. The market looks overbought and overextended, and is showing signs of an imminent top with lagging breadth, a lower number of new highs, overenthusiastic sentiment, higher-volume down days and a more frequent number of late-day selloffs. At this juncture we think that potential upside progress is limited while downside risk is high. [..]

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by Cullen Roche

In June of 2008 Goldman Sachs released a research report titled “Speculators, Index Investors, and Commodity Prices”.  The report was intended to defend the growing role of speculators and “investors” in the commodities markets. If you’ll recall, it was around this time that many were wondering whether there wasn’t an irrational exuberance in the commodity space that was being largely driven by irrational participants.  Goldman, being one of the larger participants, defended their role in the markets and concluded that speculators were not driving prices beyond their fundamentals and that there was no evidence of a bubble in the commodity markets.  A single question and answer from the June 2008 paper succinctly summarized their position at the time:
“Q12: How do we know if fundamentals support prices at these levels, or how do we know this isn’t a speculative bubble?

A: If commodity futures price were too high relative to the underlying supply and demand fundamentals, we would expect to observe large inventory builds, which we do not observe.
The simplest way to address the question of whether the underlying supply and demand fundamentals support prices at these high levels is to ask what would happen if they did not. Suppose commodity prices were too high, then we would expect to see those high commodity prices curbing demand too much, bringing too much supply to the physical market and the resulting excess of supply over demand generating a large build in the physical commodity inventories. Consequently, increasing physical commodity inventories would be the main indicator that current prices are not supported by current fundamentals. The fact that across the commodity markets, we are not observing anything approaching sustained growth in physical inventory indicates that current prices are supported by supply and demand fundamentals.
Therefore, we find the concerns that commodity markets are in the midst of a speculative bubble unwarranted. Physical commodity inventories are not growing, and in fact remain near the bottom of the historical range for many commodities. Net speculative length in the petroleum futures markets has not increased significantly since 2004, even as WTI crude oil prices have risen from $40/bbl to near $140/bbl. In sum, the commodity markets are not behaving in a way that a speculative bubble would suggest. (emphasis added)
In retrospect, it’s clear that there were distortions in the commodity markets and that fundamentals were nowhere near in-line with actual market prices.  Speculators and irrational market participants were clearly helping to drive prices on both the way up and the dramatic way down in 2008.  Goldman later backed down from their 2008 comments admitting that speculators did indeed contribute to the speculative run-up:
“Conversely, speculators bring fundamental views and information to the market, impacting physical supply management and facilitating price discovery. As a result, speculators have a loose relationship with price. In other words, as speculators buy, prices generally tend to rise, and vice versa. Accordingly, speculators also contributed to the extreme price movements over the last two years. For example, new data suggests that speculators increased the price of oil by $9.50/bbl on average during the 2008 run-up. Thus, speculators exacerbated the volatility that was nonetheless rooted in the fundamental imbalance.” (emphasis added)
With a generally weak global economy and surging commodity prices I wonder if we aren’t beginning to experience shades of 2008.  I fear Wall Street is having a far more negative impact on commodity prices than even Goldman is willing to let on.  Since the crash of the Nasdaq bubble investors have found commodities as a reliable alternative to equities despite the asset classes poor historical performance.  This non-correlated asset class has become the perfect sales product for Wall Street.  Over the last 10 years Barclays says the investor class allocation towards commodities has increased from $6 billion to $320 billion and that’s excluding hedge funds.

This looks to me like one more case of the mass financialization of our economy getting out of control.  In their effort to generate profits Wall Street has created a new financial product that is more readily accessible to the public.  In doing so they have increased the number of players who provide no real service to the industry, but merely shift paper from one pocket to another.  This problem is prevalent across most financial markets these days as more and more college educated people decide that it’s easier to make a living sitting in front of a computer than it is to try to generate real wealth through productive hard work. Flipping shares of Apple Corporation back and forth (though largely unproductive), however, is far different from flipping oil contracts back and forth.  The latter has very real impacts on the global economy and if, as Goldman finds, speculators are substantially exacerbating the price of commodities for their personal gain (at the expense of the rest of us) then we have to begin asking ourselves if this mass financialization isn’t getting out of hand.

I am the first person in the world to defend free market speculation, however, there must remain a real market underneath this speculation.  Speculation, no doubt, has very real benefits, but ultimately, there is a fundamental purpose behind the existence of shares of Apple and contracts of oil.  They represent the real wealth of the economy, the hardwork that men and women put into the economy and the productivity of the global economy.  If the world reaches a point where people are merely shifting pieces of paper amongst eachother as opposed to using commodities and markets to generate real wealth then the global economy has a very serious problem on its hands.  I fear we may already be reaching this critical juncture and the turmoil of the last few years is exhibit A.

Unfortunately, the people who have a vested interest in the perpetual growth of the financialization of the global economy have convinced the world’s leaders that what’s good for markets is good for the world.  The deregulated markets have become too powerful for their own good.  Even worse, we are still influenced by the failed theories of men like Alan Greenspan and Milton Friedman who helped build this behemoth on the ideas that markets are self regulating and always working in the best interests of the global economy.  But as I often say, markets are made up of irrational participants and irrational participants require boundaries that ensure they do not cause systemic problems.  As the bubble in commodities re-emerges and the “Bernanke Put” becomes increasingly impactful it is likely that the imbalances in this financialized USA will once again cause turmoil.

Unfortunately, it is now abundantly clear that it will take a crisis far larger than 2008 to reach through to the people who can actually enact change.   For the sake of us all let’s hope that Milton was more right than I have come to believe and that markets self regulate before they self destruct. [..]
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By John Mauldin

Last week, in the first part of my annual forecast, I suggested that 2011 would be better than Muddle Through, with GDP growth in the US north of 2.5%. World GDP growth should be even better. This week we look at what I see as the real downside risks to that prediction. Oddly enough, the risks are not in the US but on the other side of both our oceans, in Europe and China. Plus, we will visit a few other items, assuming we have space (Bernanke’s recent speech just screams for some comments).

Two housekeeping items. First, I will once again be hosting, along with my partners Altegris Investments, our 8th annual Strategic Investment Conference, in La Jolla April 28-30. Save the date. Each year the conference gets better. We have as strong a lineup of speakers as any conference in the country. I will announce when we will take reservations. It always sells out, so I suggest you do not procrastinate.

Secondly, between finishing my book and the holidays, I have been rather quiet the past few months in regards to my Conversations with John Mauldin, but that is getting ready to change. Over the next few weeks I will be doing conversations with David Rosenberg, Lacy Hunt (his quarterly will be next week’s Outside the Box), George Friedman of Stratfor, and John Burns and Rick Sharga to get the latest on the housing markets; and I am lining up some more very interesting Conversations, so that subscribers will get more than their money’s worth. Now, let’s jump into the letter.


The Fed Adds a Third Mandate

The Fed has two mandates: keeping prices stable and creating an economic climate for low unemployment. I am sure I was not the only one to listen to Steve Liesman’s interview of Ben Bernanke this week and shake my head at the spin he was giving us. First, let’s set the stage.

In a paper with Alan Blinder early last decade, Bernanke made the case for the Fed to target a specific inflation number, and the number that came to be accepted as his target was 2%. In his famous helicopter speech in late 2002, he assured us that inflation could not happen “here,” even if the short-term rate was zero, because the Fed would move out the yield curve by buying large amounts of medium-term bonds. This would have the effect of lowering yields all along the upper edge of the curve. This became known as quantitative easing. In Jackson Hole last summer, he made very clear his intention to launch a second round of liquidity-injecting quantitative easing (QE2). In that speech, in later speeches in the fall, and in op-ed pieces he said that such a program would lower rates.

Then a funny thing happened on the way to QE2: long-term rates began to rise all over the developed world. As Yogi Berra noted, “In theory, there is no difference between theory and practice. In practice, there is.” It’s got to be driving Fed types nuts to see the theory of QE, so lovingly advanced and believed in by so many economists, be relegated to the trash heap, along with so many other economic theories (like that of efficient markets). The market has a way of doing that.

So, Liesman asked Bernanke about one minute into the clip (link below) about the little snafu that, following QE2, both interest rates and commodity prices have risen. How can that be a success? Ben’s answer (paraphrased):
“We have seen the stock market go up and the small-cap stock indexes go up even more.”

Really? Is it the third mandate of the Fed now to foster a rising stock market? I wonder what the Fed’s target for the S&P is for the end of the year? That would be an interesting bit of information. Are we going to target other asset classes?

Understand, I am not against a rising stock market. But that is not the purview of the Fed. And certainly not a reason to add $600 billion to the balance sheet of the Fed when we clearly do not understand the consequences. If it looks like they’re making up the rules as they go along, it’s because they are.


A Rational Voice in Dallas

Richard Fisher is the president of the Federal Reserve branch in Dallas and a voting member this year of the FOMC committee. (Also a true gentleman, one of the nicest guys you could want to meet, and my neighbor, just a few blocks down the street.) But being a nice guy doesn’t keep him from espousing some strong and dissenting views about Fed policy. He recently gave a speech to the Manhattan Institute that should be required reading (link below) for all policy makers at all levels of government, and not just Fed types. As an anecdote to the Bernanke spin above, let me quote a few paragraphs:

“The new Congress and the new staff in the White House have their work cut out for them. You cannot overstate the gravity of their duty on the economic front. Over the years, their predecessors — Republicans and Democrats together — have dug a fiscal sinkhole so deep and so wide that, left unrepaired, it will swallow up the economic future of our children, our grandchildren and their children. They must now engineer a way out of that frightful predicament without thwarting the nascent economic recovery.

“I have been outspoken about the limits of monetary policy as a salve for the nation’s fiscal pathology. The Fed has done much, in my words, to provide the bridge financing until the new Congress gets to work restructuring the tax and regulatory incentives American businesses need to confidently expand their payrolls and capital expenditures here at home.

“The Federal Reserve has held rates to nil. We have expanded our balance sheet to unprecedented levels. After much debate — which included strong concern expressed by one member with a formal vote and others, like me, who did not have voting rights in 2010 — the FOMC collectively decided in November to temporarily undertake a program to purchase U.S. Treasuries that, when added to previous policy initiatives, roughly means we are purchasing the equivalent of all newly issued Treasury debt through June.

“By this action, we have run the risk of being viewed as an accomplice to Congress’ fiscal nonfeasance. To avoid that perception, we must vigilantly protect the integrity of our delicate franchise. There are limits to what we can do on the monetary front to provide the bridge financing to fiscal sanity. Last Friday, speaking in Germany, [European Central Bank President] Jean-Claude Trichet said it best: ‘Monetary policy responsibility cannot substitute for government irresponsibility.’

“The entire FOMC knows the history and the ruinous fate that is meted out to countries whose central banks take to regularly monetizing government debt. Barring some unexpected shock to the economy or financial system, I think we have reached our limit. I would be wary of further expanding our balance sheet. But here is the essential fact I want to emphasize today: The Fed could not monetize the debt if the debt were not being created by Congress in the first place.

“Those lawmakers who advocate ‘Ending the Fed’ might better turn their considerable talents toward ending the fiscal debacle that has for too long run amuck within their own house. The Fed does not create government debt; fiscal authorities do. Deficits and the unfunded liabilities of Medicare and Social Security are not created by the Federal Reserve; they are the legacy of those who control the purse strings — the Congress, working with the president. The Fed does not earmark taxpayer money for pet projects in local communities that taxpayers themselves would never countenance; only the Congress does that. The Congress and administration play the dominant role in creating the regulatory environment that incentivizes or discourages job creation.

“… A reader of Shakespeare will recall the dialogue between Glendower and Hotspur in Henry IV. Glendower claims, ‘I can call spirits from the vasty deep.’ And Hotspur replies, ‘Why, so can I, or so can any man; But will they come when you do call for them?’

“We shall see if the new Congress will prove worthy of the power the American people have ‘loaned’ them, and, together with the president, actually draw the spirits of fiscal reform and sanity from the ‘vasty deep’ to at long last implement meaningful fiscal and regulatory policy that incentivizes private-sector job creation here at home while arresting the hemorrhaging of our Treasury. If they do, then more Americans will find work and be better off, better paid, and freer to make their own decisions about the economy.

“If they don’t, then woe to our children, their children, and the American Dream.”

Let us hope President Fisher will find support within the FOMC. I commend his speech to you: . And now on to Europe.


Thinking the Unthinkable

My baseline assumption is that Europe kicks the sovereign debt can down the road for the rest of the year. We have seen Portuguese debt sales go well this week, even if at a very steep price. Spain looks like it will also do OK. Trichet is beginning to drum up support for an even bigger fund to stave off the bond vigilantes. It is unthinkable, we are told in many corners of Europe, that a sovereign nation would default on its debt or obligations. But, in my experience, it is the unthinkable things that can rise up to bite you in the derriere. Sometimes rather viciously. It was unthinkable that US subprime mortgages would infect the entire planet. Well actually, not entirely, as some of us did think that very thing in writing, well in advance of the crisis.

It is one of my jobs here in Thoughts from the Frontline to sit around and think about the unthinkable. What is there on page 16, or in some obscure research paper, that is going to make its way to the top of page one?

When asked in interviews what my number one concern is today, I readily answer, “European sovereign debt and European banks.” (In 2006 it was subprime debt. In 2007 it was bank debt and derivatives. Etc.) That heads a long list of present concerns, I will admit, but it is clearly at the top.

Italy, Spain, Belgium, and Portugal will need to raise over $800 billion this year to cover rollover debt and new borrowing. Add in Greece, Ireland, and a few other countries and it quickly gets to a trillion or so. Doable. But is does add a lot of debt.

I posted a piece a few months ago about Belgium. Belgium is not on the “usual suspects” list when we talk about European debt woes. But this page-16 story may be making its way to page one over the next few years.

Belgium’s total debt is pushing 100% of GDP and, given its fiscal deficits, probably will push through that level soon. This is a country of just 10 million people, and a deeply divided one at that, unable to elect a government. They are making progress on getting their fiscal house in order, but are not there. And the market is getting nervous.

My good friend and data maven Greg Weldon gives us some details. Belgian interest rates, while down from the depths of the credit crisis, are once again beginning to rise, along with those of Spain and Italy. (
It is unthinkable that Belgium could have a problem, isn’t it? Except that there is a very serious and growing contingent of citizens who want to divide the country into two parts. I am sure cool heads will prevail, but I do pay attention to Belgium’s politics. I will also be in Brussels in March, so I will get some first-hand stories.

But that is not a 2011 story. No, for this year my concern is the large amount of Irish sovereign debt on the books of European banks.


The Threat of the Irish

In the midst of the credit crisis last year, the Irish government guaranteed not only the deposits of Irish banks but their bonds. Irish banks, like Icelandic banks, were larger than the GDP of the country. As it turns out, those guarantees are going to cost a great deal of money, about 30% of GDP. That would be the equivalent of over $4 trillion for the US, just for some perspective. And many of those guarantees are to German, French, and British banks. Irish taxpayers are in effect bailing out not only their own banks but banks all across Europe.

The “bailout” engineered by the ECB and European authorities will require that that Irish pay around 10% of their national income in a few years just to service the debt, according to Barry Eichengreen, professor at U Cal Berkeley. How can you take 30-50% of your government taxes and pay down such high debt loads at 6% interest? That doesn’t leave much for actual government services. The short answer is, only with a lot of local pain and none for the bank bondholders, which again are German, French, and British banks. As Eichengreen writes:

“This is not politically sustainable, as anyone who remembers Germany’s own experience with World War I reparations should know. A populist backlash is inevitable. The Commission, the ECB, and the German Government have set the stage for a situation where Ireland’s new government, once formed early next year, rejects the budget negotiated by its predecessor.

“Do Mr. Trichet and Mrs. Merkel have a contingency plan for this?

“Nor is the situation economically sustainable. Ireland is told to reduce wages and costs. It must engage in ‘internal devaluation’ because the traditional option of external devaluation is not available to a country that lacks its own national currency.

“But the more successful it is at reducing wages and costs, the heavier will be its inherited debt load. Public spending then has to be cut even more deeply. Taxes have to rise even higher to service the debt of the government and its wards such as the banks.

“This in turn implies the need for yet more internal devaluation, which further heightens the burden of the debt in a vicious spiral. This is the phenomenon of ‘debt deflation’ about which the Yale economist Irving Fisher wrote in a famous article at the nadir of the Great Depression.”

This is precisely the same phenomenon that I was describing last year when I was writing about Greece. I deal with it at length in my new book, Endgame, out in early March (I hope). This debt deflation/devaluation spiral will end in tears. The question is, will those tears be from Irish eyes?

Let’s think what is unthinkable by most Europhiles, but not to Eichengreen or your humble analyst.

All the polls indicate that the governing party, which cut the deal to increase the debt load by some 30% of GDP, will lose the elections, most likely to parties that are campaigning on repudiating that debt. Irish bank bondholders could face a haircut of some 80% or more, which is more like a leg amputation than a haircut.

The party (or parties if there is a coalition) will have a mandate to simply not guarantee Irish bank debt, which would get their total debt-to-GDP down to a still-high but manageable 100%. Not good, but something they can grow out of over time. There are a lot of good things still happening in Ireland, and you don’t have to look too hard to find some positives.

I read a very good blog about Ireland written by Ronan Lyons, whom I hope to share a pint or two with some day, when I make my first pilgrimage to the Fair Isle. He gives us eleven reasons to be optimistic about Ireland. Maybe it’s just the nature of the Irish to find that silver lining, but this comes under the heading of optimistic realism. Here’s Ronan:

“So, while Ireland faces very significant challenges, we should not write ourselves off just yet. Yes, our problems are largely our own fault in not preparing for life in the eurozone. Yes, the next five Budgets are going to be tough ones for everyone. And yes, Ireland in 2016 will not be what we might have thought it would in 2006…

“But Ireland in 2016 will probably be a far better place to live than any of us thought possible in 1996, 1986 or indeed any previous decade. The Celtic Tiger was not a mirage. And we have a very real economy that, with a good bit of hard work and with a fundamental reorganization of how government raises and spends money, can deliver for us again. That starts in 2011.”

But part of that reorganization may involve some very tough negotiations. The incoming parties should stick to their mandate. Why should they back Irish bank debt to the Germans and the French at the expense of being mired in a depression for a decade or more? At least I think that is what the political discussion will be.

If the ECB, IMF, and the rest of the EU says, “If you don’t take on that debt we will not buy any more of your debt. You will be shut off from the subsidized debt markets,” then what? Ireland could answer back, “You want us to pay the rest of this debt? Go pound sand.” Or whatever the Irish equivalent is. It will be a very intense and interesting set of negotiations.

But while that is happening there is a lot of uncertainty, and markets hate, hate, hate uncertainty. Will the EU or ECB buy that bad bank debt off the books of the private banks? (Refer to the graph below to see where the debt is.) Who picks up the tab? German taxpayers? The Bank of England? Note that nearly $100 billion is owed to US banks. That is NOT chump change.
Britain is particularly exposed. What would it do to the pound if the Bank of England had to bail out British banks to the tune of almost $200 billion? Note that Royal Bank of Scotland and Lloyds are almost wards of the state, as it is. And the euro could come under intense pressure.

If eurozone leaders do not act, such a confrontation could spiral out of control rather quickly. Think November 2007. Think Bear Stearns and Lehman. Interbank lending could dry up almost overnight.

Will it happen? No one knows. But it should be on our radar screen. Here’s a side issue. If Ireland walks away, what does that say to Greek voters? Or to the Portuguese? Is it a one-off —Ireland just not wanting to back their bank debt — or could it be the first domino of a general debt restructuring? This we will need to watch. There. We thought about it.


Has China Found a Miracle Business Cycle?

Quickly, let’s look over the Pacific Ocean to China. They seem to have repealed the laws of business-cycle gravity, going from one fabulous growth year to the next. Most analysts are predicting another solid year of high single-digit growth. And that is the base-case scenario. But what if the unthinkable happens?

Official inflation is in the high single digits. Unofficial inflation may be running closer to 20%. Simon Hunt wrote last year:

“Our friends in Beijing talk about the daily cost of living rising at an annual rate of around 20%. In Shanghai gas prices to the home have risen by some 600% in two years and electricity by over 300%.”

More recently he wrote:

“The large increase in minimum wages announced after Christmas have two powerful implications. First, de facto, they suggest that actual inflation is higher than is being shown in the official CPI data; and, second, that China’s pool of surplus labor is drying up. The latter has important implications for wage inflation and the structure of manufacturing.

“Beijing announced an increase in minimum wages of 21%, after raising them by 20% in June this year. Across China every municipal authority has already raised its minimum wage with most only six months ago. Further hikes are possible early this year. Wage increases of this size are more than can be warranted by normal living adjustments. They reflect an abnormal rise in inflation and a tightening labor market.”

The Chinese central bank keeps raising reserve requirements for banks, and is slowly allowing interest rates to rise. Can the Chinese central bank engineer a soft landing with inflation so high?

I am not sure about this year, but I do know this: no country has ever figured out how to repeal the business cycle. Eventually there is a recession. And when China has a recession, the rest of the world will feel it, just as the world responds to a US recession. Recessions are just nature’s way of wringing out excesses. They are not permanent. In fact some research suggests that the longer a recession is delayed, the worse the excesses get. This is yet another situation we will need to give close attention.

As an aside, I think the inflation predicament China finds itself in will give the Chinese some reason and room to gradually allow the renminbi to rise against the dollar. And the country is to be applauded for recently allowing more free trading of their currency in the US. Eventually they will float their currency, as it cannot become a real candidate for a reserve currency until they do. But that is clearly what they would like to see. It is just a matter of time. [..]


by Cullen Roche
“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”  -   Benjamin Graham
Commodities have become an increasingly popular asset class in recent years as faith in fiat currencies has declined, economic growth has stagnated and traditional investments such as equities and bonds have become increasingly unreliable.  As demand for hard assets has increased Wall Street has been right there to satisfy this demand with various new products that are sold as “investments”, “hedges” or whatever can help these banks meet their ever increasing need to drive bottom line growth (and take money from greater fools).

Yesterday, Dylan Grice of Societe Generale published what I believe is an incredibly important piece of research showing that commodities are NOT investments.  In fact, when you buy a commodity for non-commercial purposes you are speculating.  Grice elaborated:
“The fluctuations of commodity prices have fascinated speculators for hundreds of years, but why should investors be interested? Commodities aren’t productive assets, so how can they create wealth over time? And why should they provide investors with a collectable risk-premium?  Commodity returns can be decomposed into the  “spot”  return and the  “roll” return. It’s not obvious to me that either are dependable sources of compoundable profit.”
He goes on to show that commodities have actually been terrible investments over the last 140 years  *(see more images below):
This makes sense as commodities have no cash flow and the purchase of such assets ultimately involves playing a zero sum game with the hope of one day selling to someone else at a higher price.  Seth Klarman, the founder of hedge fund Baupost and of value investing fame, recently described this phenomenon:
“Buying anything that is a collectible, has no cash flow, and is based only on a future sale to a greater fool, if you will—even if that purchaser is not a fool—is speculating. The “investment” might work—owing to a limited supply of Monets, for example—but a commodity doesn’t have the same characteristics as a security, characteristics that allow for analysis. Other than a recent sale or appreciation due to inflation, analyzing the current or future worth of a commodity is nearly impossible.
The line I draw in the sand is that if an asset has cash flow or the likelihood of cash flow in the near term and is not purely dependent on what a future buyer might pay, then it’s an investment. If an asset’s value is totally dependent on the amount a future buyer might pay, then its purchase is speculation. The hardest commodity-like asset to categorize is land, an asset that is valuable to a future buyer because it will deliver cash flow, not because it will be sold to a future speculator.”
Grice added that the purchase of commodities is actually the sale of human ingenuity.  You are essentially betting that humans won’t one day replace their oil based energy needs with some alternative energy.  Or you are betting that humans won’t find a way to more efficiently produce wheat:
“Why  should  commodities provide investors with a real risk premium? Shouldn’t  prices actually decline  in real terms over time? A bushel of wheat, a lump of  iron-ore or an ingot of silver today is identical to a bushel of wheat, lump of iron-ore or ingot of silver produced one thousand years ago. The only difference is that they’re generally cheaper to produce because over time, human innovation has  lowered the cost of production.  When you buy commodities, you’re selling human ingenuity.
Past performance is no guarantee of future results, obviously, but human ingenuity has a good track record of overcoming nature’s constraints so far. A commodity bull market is really just a bottleneck  and as a  species we’ve succeeded in bottleneck  removal. Historically, most bull markets have ended up where they started.
Why bet against human ingenuity by buying physical commodities when you can bet on it by investing in  the enterprises whose  task  is to remove the bottlenecks and lower commodity prices?”
Of course, there is a complexity in the equation here that Grice also tackles.  Commodities futures contracts have a built-in risk premium because you don’t transact in the spot price.  But Grice finds no evidence that this risk premium necessarily exists.  In fact, he finds that commodities markets tend to be in a consistent state of contango therefore creating a negative roll effect:
“If investors  had been  picking up  a  risk premium by systematically rolling futures indices their  total  return would be higher than the spot market return. So the ratio of the total return index to the spot index should steadily rise over time. In fact, the ratio has been zero for the last twenty years.”
“What the chart doesn’t show is that over the past 20 years the GSCI’s annualised total return has been 4.3% despite the spot return being 5.2%. In other words, the ‘roll yield’ has  been -0.9%. Since the year 2000 it has been even worse. The GSCI spot return has annualised an impressive 9.9%, but the total return has been only 3.9%. The “roll yield” has been -6%!”
Of course, this doesn’t mean you can’t make money in commodities.  As we’ve seen in recent years there are fantastic swings in commodity prices over time and savvy speculators can benefit from such swings.  For instance, CTA’s (trend followers) have had fantastic success trading commodities over the last 30 years according to the Barclay’s CTA Hedge Fund Index (the index doesn’t include survivorship bias, however):
The more important takeaway is to avoid believing that you are making an investment when you buy commodities.  Rather, you are making a specific speculative bet.  The fact that Wall Street has begun selling the idea of “investing” in commodities should play no role in your decision to buy a commodity.  In fact, I believe this is just one more case of Wall Street attempting to monetize the ignorance of the general public.  If you’re interested in generating sustainable income from commodities you are better off investing in the commodities related companies themselves.

There’s an interesting counterargument that can be made for a commodity such as gold, however.  Doesn’t its currency like characteristics make it unique?  Seth Klarman says no:
“Gold is unique because it has the age-old aspect of being viewed as a store of value. Nevertheless, it’s still a commodity and has no tangible value, and so I would say that gold is a speculation. But because of my fear about the potential debasing of paper money and about paper money not being a store of value, I want some exposure to gold.”
I would add that Grice’s comments regarding innovation are applicable here as well.  Ultimately, a bet on gold is a bet that we will revert back to some form of commodity based currency system which proves the modern fiat monetary system is flawed.  But as I have previously explained, I believe this is faulty thinking in the long-run.  In fact, the move from the gold standard was a form of financial innovation due to the fact that the gold standard imposed inherent restrictions on the modern complex and dynamic global economy.

What we are seeing in single currency Europe is in many ways equivalent to the flaws generated in a world which was once a single currency world (see here for more).  Obviously, that system is highly flawed. And it was these inherent flaws that ultimately led to the demise of the gold standard.  A move back to the gold standard would quite literally be like moving back into the stone age.

In the near-term, however, (remembering that all commodities are speculative bets) we can’t ignore the voracious demand for gold as a currency, the problems in Europe, the false belief that the Fed is “printing money” and the misguided belief that fiat currencies are not the wave of the future.  As I have repeatedly stated in recent years, it’s likely that gold prices continue to surge higher as investors seek a safehaven from a world of economic uncertainty, political strife and what is viewed as a failing fiat currency in Europe.  Ultimately, I still believe gold’s endgame in the current cycle is an irrational bubble, but that is a purely speculative short-term bet and not a long-term investment.

In conclusion, mathematician John Allen Paulos famously said:
“people generally worry only about what happens one or two steps ahead and anticipate being able to get out before a collapse… In countless situations people prepare exclusively for near-term outcomes and don’t look very far ahead. They myopically discount the future at an absurdly steep rate.”
Investors are caught in a wave of euphoria in the commodity markets today.  And that’s not to say that it is wrong to own commodities or that their prices won’t be substantially higher in the coming years.  But just remember that the product your Wall Street broker so nicely wrapped up for you is NOT an investment.  It is a product that is guaranteed to line the pockets of bankers while you make nothing more than a speculative bet that a greater fool will one day buy from you at a higher price. [..]
*Additional images provided below:
(Real Commodity Prices)
(Copper, aluminum & zinc prices)
(Real gold and silver prices)
(Real oil prices)
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