Commodities and the global economy after QE2 – Simon Hunt
By Simon Hunt,
Simon Hunt says, 2012 will see a new round of money printing by the Fed resulting in another bout of commodity and equity buying after the pullback seen in the summer of 2011
n one of our chats with a senior economist in Beijing, he remarked that forecasting China’s economy was becoming more difficult by “the complicated global economy”. He went onto to say that the world order had become very complicated by Bernanke’s monetary policy, by developments in the Middle East and now by the tragedy in Japan.
This seemed to us to be a very sensible view of the world, in fact, one in which he asked for our views. Our answer only gave him more problems so we thought we would explain our thinking. For those who believe that all is well with the global economy, that sustainable growth is the New Order without risk, then stop here. It cannot be because all that authorities have done is to increase the pile of debt without remedying the underlying structure. A wake-up call is needed. It is coming.
Business recessions are caused by the accumulation of excessive inventories. They need to be worked off, which is why they are generally short in length with limited damage. Credit crises, however, are characterised by the accumulation of excess liabilities; they don‟t end in recessions, but in depressions.
Chart1: A Stair-Step Decline
Depressions last several years, interspersed with periods of growth, but the down years exceed the up ones. There is no better illustration of this phenomenon than our favourite chart, A Stair-Step Decline, which shows the movement of the DJIA weekly from April 1930 to July 1932, a period when the DJIA fell by 86%, but interspersed by seven rallies averaging 24%.
We are in one those euphoric periods in which stock markets rise not just on good news, but any news, when the US economy seems to be expanding, employment rising and businesses both large and small starting to invest for the future.
Optimism is rampant. The crisis of two years ago is forgotten. Now it is the world of imagination. As our colleague Bert Dohmen wrote recently, “Look at the new bubble mentality. It’s reminiscent of 1999, just a few months before the monumental internet bubble burst. Now we have Facebook valued at $60 billion (it’s just a website). CLSA point out that Groupon is valued at $15 billion (it sells discount coupons online), ZYNGA is valued at $9 billion and sells “imaginary products for games on Facebook, which allow people to build imaginary worlds”.
This burst of economic and market euphoria is based on Bernanke’s monetary policy, which is so criticised throughout Asia, including our friend in Beijing. Again, as Bert Dohmen writes, Adjusted Reserves in the two months ended 23 March 2011, grew by a 388% annualised rate, the Adjusted Monetary Base by 161% annual rate and even Commercial & Industrial loans are starting to recover.
Another way of looking at the US economy is to see how stated Federal debt has grown as a percentage of GDP. Since 2000, GDP has risen by 47%, but federal debt by 147%. More alarming is the relative increases since 2006, debt by 62% but GDP by only 5%.
Graph 2: USA: Stated Federal Debt as % of US GDP
From 1980 to 1996, debt as a percentage of GDP virtually doubled to 67% and then for the next five years it fell by 16% to 56%. By 1996, it was back close to the 1996 level of 67%. Since then debt has exploded, accounting for 97% of GDP last year. This is an extraordinary development for an economy whose currency is the reserve currency of the world. Whilst money supply is increasing faster than the economy, funds are being leaked into equity and commodity markets. Some is being directed towards Asian markets. All commodity markets have risen sharply over the past year. Bernanke may dispute the fact that his policies are the cause of commodity price inflation, but markets don’t believe him.
It beggars belief that the Federal Reserve, as guardian of the world’s reserve currency and with its hordes of economists, did not think through the global ramifications of its monetary policy: currency debasement, rising oil and commodity markets including food etc. For whatever reason, laying the foundations for inflating equity and commodity markets into probable bubbles must be a deliberate policy. But to what end?
To our cynical brain, two thoughts come to mind. First, the modern variation of geopolitics is being played out through the financial system. America’s omnipotent power is under threat. Asia, led by China, is in the process of regaining the global status that it enjoyed until the mid-1800s. For instance until the 1820s, Asia accounted for 60-75% of world GDP. Colonialism, combined with the Industrial Revolution, sank Asia’s dominant role so that by the start of WW11, Asia only accounted for about 20% of global GDP.
Post the first oil shock in the early 1970s, Japan started to relocate capacity out of the country into SE Asian economies, a process which is still ongoing and has been expanded into China and other parts of the world. In fact, if we took account of this massive relocation of capacity and continued new investment outside of the country, Japan‟s economic performance would be seen in a very different light.
Then along came Deng and the opening up of China to the outside world, in the process unleashing decades of pent-up entrepreneurship. What Japan started a decade earlier, US and European management followed by moving capacity to Asia and mostly to China. In effect, China and the rest of Asia became the manufacturing hub of the world, a development that has cost the USA and Europe jobs and revenue.
Times change and models need to be adjusted. Logistical and operating costs in China are rising, in many cases sharply. Some countries, such as China, no longer are so welcome to foreign investment except under tough conditions, such as technology transfers. Moreover, major manufacturers now want their supply chains to be close to the market, not located on the other side of the world. But, there is a reluctance for many in the supply chain to make this move under a repressive tax and regulatory system in the USA.
Stepping back for a moment, Asian and MENA countries, including China, spend far more of their disposable income on food than the USA or Europe. Rising food prices are especially sensitive to lower income families in these two regions. Hunger always creates conflict which the MENA countries now have in plenty. Internal conflict in these countries will persist for many years. Autocratic governments are being ousted one by one and dynastic rulers will go the same way. Markets perceive that conflict will extend to Gulf countries, that Iran and its Shiite neighbours see the present as an opportunity to become the dominant power in the region.
Even though there are massive oil stocks owned by the financial sector and others, oil prices are rising. They will continue to do so well into 2012. The perception of oil supplies being significantly disrupted will be a powerful incentive for further purchases.
An integral part of the Federal Reserve’s policy has been to slam the US dollar, despite, once again denying this objective. A falling dollar is another reason for investors/speculators to acquire commodities, equities, art, stamps, wine etc. – in fact almost anything but holding the US currency.
As we began this section by saying, the Fed must have been fully aware of the ramifications of their policy. Asian countries, including China, are being forced to appreciate their currencies. Funds flow into the region (though some have recently flowed out) together with the increase in basic foods caused a rise in the cost of living and inflating assets such as real estate. At an appropriate time, many of these funds will flow back into the USA.
2012 is an important election year in the USA. The Fed’s QE2 will run its course into June. QE3 will probably not follow immediately. Just how sustainable the US economy is will then be tested in the following months. We suspect that it will fail the test. The US dollar will begin an intermediate term rally of some strength starting around May/June lasting until around the end of the year, so causing commodity prices to fall pro-tem. The Fed will become nervous that the US economy is failing its test. Funds which have been poured into the Asian region will be encouraged to return to the USA with QE3 following would be our best guess. 2012 will be an important year for markets and the global economy. A new round of money printing by the Fed will unleash another bout of commodity and equity buying after the pullback seen in the summer of 2011. Rises could be pretty parabolic. Our sense is that there is a determination in some quarters to see oil prices in the $150-200 range. Copper and other base metals will resemble even more the precious metals status they currently enjoy with the former rising to around the $13,000 level. Of course the US dollar will tumble.
Bond vigilantes won‟t like this inflation outlook combined with a fast falling US currency. Market yields across the world will rise. We may well see the US 10-year Treasury yielding 6-8% by mid-2012. A combination of new highs in oil prices and other commodities together with such a sharp rise in bond yields will set the stage for a serious recession starting in 2013.
It will also lay the foundations for a renewed global credit crisis. This time policy makers will not have the luxury of „kicking the can down the street‟ by using the printing press and just adding to a country‟s debt burden. It will be a hard slog of deflation and recession – or should we call it depression – that will engulf the world until about 2016-18. Our second thought centres on this emerging crisis in 2012/13. The USA has a budget crisis of epic proportions. It will need a grave crisis to bring the two parties together or for a leader to emerge from the pack prepared to shake the trees. Only by so doing will the USA return to a path of solvency. That crisis will erupt in this period, whether before the November election we do not know. Once the US government does what is necessary many things will slot into place. The economy will be weak, but businesses will return to the US shores so laying the foundations for the USA‟s great revival from around 2016.
It was this outlook which left our friend in Beijing pondering on how to manage China’s economy during its own transition from one model to another whilst the world outside its borders is forced to adjust to a generation of debt accumulation that only produced illusory growth.
Categories: Africa / Middle East, Asia, Commodities, Food for Thought, North America, The Big Picture