We are almost half way through the year and the markets are providing us with plenty of trends and issues which we must take into account. From 6 year market highs to the cooling of the housing market, from the energy bonanza to China's effects upon globalization, there is no shortage of topics of interest in the financial press. But as of late, I have been receiving several questions from my subscribers focusing special attention towards the recent commodity boom and the dollar with respect to the future of both.
Morgan Stanley's Chief Economist, Stephen Roach, provides us with some valuable insights on both of our subjects at hand. My long-term readers are familiar with Mr. Roach and the independent perspective that he provides on noteworthy economic conditions. This week's Outside the Box encompasses not one but two of his articles, a global outlook on the "Commodity Bubble" and "Dollar Spin." I entrust that you will enjoy Mr. Roach's commentary and seek to glean some wisdom from this wealth of information.
John Mauldin, editor
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Global: Commodity Bubble
"In the midst of a slightly subpar upturn in global growth, a low-inflation world is experiencing the sharpest run-up in commodity prices in modern history" * What's new
Asset bubbles have dominated financial market experience over the past six years. The world is now in the midst of another bubble -- this one in commodities. It, too, will burst. The only question is when. * Conclusions
In the midst of a slightly subpar upturn in global growth, a low-inflation world is experiencing the sharpest run-up in commodity prices in modern history. (1) World GDP growth is likely to average 4.2% over the 2002-06 period -- fractionally below the average 4.4% pace of the four earlier global expansions. (2) Over the past four years, the Journal of Commerce gauge of industrial commodities has increased by 53% -- a sharper rise than that which occurred in any of the previous four global expansions. (3) In real terms, the JOC is up 42% over the past four years -- nearly double the 23% average gains that occurred in the two commodity booms of the 1970s. (4) All bubbles are based on plausible stories of a "new era." China is widely thought to be the key driver that keeps pushing lofty commodity prices even higher. * Market implications
The super-cycle theory of ever-rising commodity prices is based on the false premise that China stays the same course it has been on for the past 27 years. China is unlikely to do that; a rebalancing toward slower growth will reduce its impact on global commodity prices and demand. * Risks
Contagion is rapidly spreading into the far corners of commodity markets -- including precious metals. Moreover, signs of psychological excess are building -- in an era of globalization, tales of the "new era" are as convincing as ever. Price increases are begetting more price increases -- indicative of a speculative blow-out that can only end badly.
Asset bubbles have dominated financial market experience over the past six years. First equities, then bonds, property, and spread assets. Like clockwork, liquidity-driven investors have migrated from asset to asset, desperately in search of yield. In my opinion, the world is now in the midst of another bubble -- this one in commodities. It, too, will burst. The only question is when.
This is not about thresholds -- $700 gold, $4 copper, $70 oil, and record prices for a broad array of other base metals. I am not making this case based on the parabolic increases in many key commodity prices that have occurred over the past couple of months. I leave that to the market technicians and traders. But suffice it to say that many key materials prices are tracing out patterns that very much resemble the dot-com mania of late 1999 and early 2000. That speaks to an important aspect of any speculative bubble -- that price excesses have now permeated the far reaches of an asset class. To borrow from Yale professor Robert Shiller, who knows something about speculative excesses in markets, the bubble is an outgrowth of amplification mechanisms -- both real and psychological -- which create an unsustainable condition whereby "...price increases beget further price increases" (see Shiller's Irrational Exuberance
, second edition, 2005). Such is the case in commodity markets today.
I make my case, instead, purely from the standpoint of global macro -- emphasizing the extraordinary decoupling that has occurred between a broad aggregation of industrial commodity prices and world GDP growth. This shows up loud and clear in an analysis of world economic growth and commodity prices over the past 35 years (see accompanying chart). Over this time frame, there have been five periods of extended gains in global economic activity -- the current recovery (2002-06) and four earlier recoveries -- two in the 1970s, one in the 1980s, and another in the 1990s. The current rebound, as measured on an annualized world GDP growth basis, has averaged 4.2% -- slightly weaker than the 4.4% average annualized gains in the previous four global upturns. In other words, there's nothing all that exceptional about today's world growth climate when compared with earlier periods global vigor.
Yet the current surge in commodity prices has been off the charts when compared with those of the past. This can be seen by an examination of trends in the Journal of Commerce composite gauge of industrial materials prices -- for my money, the best of the so-called macro commodity price measures. JOC industrials include four major components -- textiles (burlap, cotton, and polyester), metals (steel, copper, aluminum, nickel, zinc, lead, and tin), petroleum products (crude oil, benzene, and ethylene), and a miscellaneous grouping (hides, plywood, rubber, red oak flooring, and tallow). Not included are agricultural products and precious metals -- seemingly tangential elements of the commodity complex that can often take on a life of their own.
Over the past four years, the JOC industrial gauge has increased by 53% -- a sharper rise than that which occurred in any of the four previous periods of global recovery. Moreover, as seen in "real" terms -- scaling the JOC by the cumulative increase in the US headline CPI over the same periods -- the current surge in commodity prices stands out as even more extreme. The real JOC is up 42% over the past four years -- nearly double the 23% average gains that occurred in the two commodity booms of the 1970s and in sharp contrast with the relatively stable trends during the global growth cycles of the 1980s and 1990s.
This latter result is a big deal, in my view. It is the functional equivalent of the macro smoking gun of a commodity bubble. It was one thing for commodity prices to surge during the Great Inflation of the 1970s. Such outcomes were very much an outgrowth of a generalized inflation that permeated most aspects of the cost and price structure during that period. It's another thing altogether, however, when commodity prices surge in a low-inflation environment as they are doing today -- and when that spike actually outstrips those of the classic commodity booms of yesteryear. Perspective is key in this instance: In the midst of a slightly subpar upturn in global growth, a low-inflation world is experiencing the sharpest run-up in commodity prices in modern history. If that's not a bubble, I don't know what one is.
Of course, there are a multitude of counter-explanations as to why this is not a commodity bubble. This is a classic response -- borrowing a page right out of the time-honored script of psychological denial that always occurs toward the end of an asset bubble. Shiller stresses that every bubble has its perfectly plausible story -- the "new era" that is always used with great passion to justify fundamental support to sharply rising asset prices. From tulips to dot-com, with plenty in between, the believers are convinced they have a credible and sustainable story. That's very much the case with the current commodity bubble. Globalization is its story -- and China is its poster child.
The basic premise of this new era is that globalization has unleashed a powerful strain of commodity-intensive global growth that caught a supply-constrained world largely by surprise. In other words, it's not global growth per se
that is driving the demand side of this commodity cycle to the upside; that's evident from the cyclical comparison noted above, with world GDP growth in the current recovery slightly below earlier norms. Instead, the argument rests more on an increase in the commodity content per unit of world GDP. China -- the world's greatest development story -- is the most important illustration of this trend. Here's a nation that accounted for only about 4% of world GDP in 2005 but consumed nearly 9% of the world's crude oil, 20% of aluminum, 30-35% of steel, iron ore, and coal, and fully 45% of all the cement in the world. With Chinese economic growth driven by the commodity-intensive activities of urbanization, industrialization, and infrastructure, there is good reason to believe that high and sharply rising commodity prices are here to stay.
This is a great story -- in fact, one that I have been telling for quite some time myself. The problem with the story -- like most tales of new eras -- is that it, too, has its limits. The key here is to realize that China is not going to keep increasing the commodity-intensity of its GDP growth. In fact, in the just-enacted 11th Five-Year Plan, the Chinese leadership announced explicit targets to reduce its energy content per unit of GDP by 20% over the next five years. China's concerns go well beyond oil. Potential bottlenecks of industrial materials, together with sharp increases in input prices such bottlenecks trigger, are viewed as a serious threat to sustainable economic growth. It is not that difficult for China -- or any country in the developing world -- to improve the commodity efficiency of its economic growth. After all, China currently consumes twice as much oil per unit of GDP as the developed world, on average. Technological change has long focused on reducing the energy and commodity content of manufactured products. In its rush to develop, China has lagged in deploying oil and other commodity-conserving production technologies. The Chinese do not have to develop new technologies to enhance commodity efficiency -- they merely need to copy those already in existence elsewhere in the world. Great at copying and courtesy of higher input prices, China's appetite for industrial materials seems likely to diminish in the years ahead.
This is a key reason why China has now embraced a very different macro strategy over the next five years -- moving away from a commodity-intensive export and investment growth dynamic toward more of a commodity-saving strain of consumer-led growth (see my 24 April Special Economic Study
, "China's Rebalancing Challenge"). Yet the super-cycle theory of ever-rising commodity prices is based on the false premise that China stays the same course it has been on for the past 27 years -- suggesting that China is expected to grab an ever-greater share of world commodity consumption. Similarly, the New Paradigm crowd of the late 1990s presumed the US was on a path of ever-accelerating productivity growth. Just as that presumption ultimately turned out to be unfounded, I suspect the coming rebalancing of the Chinese economy will succeed in reducing its commodity-intensity -- thereby lowering its global demand for industrial materials. Like Nasdaq, irrationally exuberant commodity markets will also be taken by surprise.
My conclusions are macro. They are not aimed at the event-driven stories that can impact commodity price fluctuations from time to time. Nor am I expressing a view on gold or other precious metals that seem to have some very special characteristics of their own. My focus, instead, is on industrial materials -- and their relationship to real economic activity in the global economy. On a global growth-adjusted basis, the current surge in industrial commodity prices far outstrips anything we have seen in modern experience. Parabolic price increases have become the norm, spreading across an increasingly broad spectrum of the asset class with a powerful contagion. To the extent this contagion takes on a life of its own -- not uncommon for full-blown asset bubbles -- it could also infect precious metals and agricultural products. The psychological signs of excess are equally classic. From China to the "end of oil," perfectly plausible stories of the new era abound. Price increases are begetting more price increases. Yes, it can go on for longer than we think -- speculative blow-outs usually do. But history tells us how it will end. Play the commodity bubble of 2006 at your own peril.
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Global: Dollar Spin
Dollar depreciation is back on track again, and my guess is there is a good deal more to come. The good news is that the decline now appears likely to be measured and orderly -- a welcome departure from the dollar-crisis scenario I had previously feared. The bad news is that a weaker dollar will accomplish surprisingly little in fixing all that ails an unbalanced world.
The US dollar appears to be entering the second major phase of its multi-year structural decline. The first, which lasted from early 2002 through late 2004, saw the broad trade-weighted dollar index decline 16% in real terms. The bulk of this decline was concentrated against the euro, which rose nearly 60% versus the dollar, from 0.86 on 31 January 2002 to 1.36 on 31 December 2004. By contrast, the dollar adjusted considerably less against Asian currencies; the yen/dollar cross rate appreciated by 32% from early 2002 through early 2005, whereas the Chinese currency peg remained unchanged over that period.
The mistake we all made -- and I am certainly as guilty as anyone -- was in believing the dollar's downtrend would continue in a straight line. With the consensus tightly clustered around that presumption in late 2004, the currency markets did what they always seem to do best -- go the other way. The dollar rose instead of fell for most of 2005 -- appreciating 5% in real terms on a broad-trade-weighted basis, or unwinding about one-third of the decline that had occurred over the preceding 34 months. The case for global rebalancing, which had done an excellent job in explaining the first leg of the currency realignment, was suddenly in tatters. New paradigmers came out in force, arguing that the world had reorganized itself around a "Bretton Woods II" framework -- in effect, an expanded dollar bloc that required a cheap currency for the producers/savers (Asia) and a strong currency for the recipient of surplus saving (the United States).
In retrospect, the dollar's detour of 2005 may have had nothing to do with the esoteric battle of the paradigms. It may have been as simple as an outgrowth of asynchronous moves by the world's major central banks. Fixated on normalizing an overly-accommodative policy stance, the Federal Reserve tightened in each of its eight policy meetings of 2005; by contrast, the Bank of Japan did nothing, and it wasn't until December of 2005 that the European Central Bank finally awoke from its slumber. With Fed normalization sticking out like a sore thumb in a world where other central banks were sitting on their collective hands, the interest rate differential -- a proxy for asset-based returns -- tilted away from dollar weakness toward strength.
The saga of the interest rate differential is now, of course, going the other way. Notwithstanding unfortunate cocktail party chatter, Fed Chairman Ben Bernanke sent a clear signal in his recent testimony in front of the Joint Economic Committee that the US central bank is nearing the end of its long march toward normalization. At the same time, the BOJ has turned increasingly aggressive in upgrading its assessment of the outlook for the Japanese economy; this has prompted our Japan team to place a 90% probability on a rate hike in either June or July, which would bring an end to over seven years of ZIRP (zero interest rate policy). And Jean-Claude Trichet has just upped the ante on the ECB's assessment of policy risks -- making a June rate hike a foregone conclusion and prompting debate over whether 25 basis points will be enough.
Just like that, interest rate differentials are now tilting away from the dollar. Moreover, the G-7 communiqué of 21 April -- a major flashpoint on my own road to conversion -- provides financial markets with a framework to extrapolate these trends into the future. By voicing explicit concerns over global imbalances in the form of a rare annex to the main statement and by underscoring the need for "greater exchange rate flexibility" as the means toward this end, global authorities have drawn a new and important line in the sand. The IMF's companion announcement of a new multilateral process of surveillance and consultation adds teeth to the rebalancing commitment. That has added more fuel to the second downleg of the dollar's decline. The surprise to date is that it has not been more concentrated against Asia. The G-7 singled out China and other emerging markets -- code words for developing Asia -- as being the most likely candidates for adjustment. But China has not taken the bait -- at least not yet -- and the euro and yen have both appreciated by roughly the same 3 percentage points against the dollar since 21 April.
The problem for me is that this all sounds too neat. Theory tells us that relative price changes are the cure for global imbalances -- specifically, that a weaker dollar will be the means by which America finally tames its gaping trade deficit. Not only should a cheaper greenback make US exports more competitive, but it should also make imports more expensive -- forcing a shift in the sourcing of domestic demand away from goods made overseas toward those produced at home. Sure, there are lags and other complications, but the standard conclusion from academia is that the broad trade-weighted dollar index needs to decline by a minimum of 20-30% in real terms in order to fix America's current account problem. While the academics concede the fix may not completely eliminate the US current account deficit, they argue that it will at least take it down to a more sustainable range of 2% as a share of GDP.
I don't buy this logic for several reasons: First, as Stephen Li Jen has pointed out, the arithmetic of a large dollar decline has very ominous -- and politically unpalatable -- implications for other currencies (see his 12 April dispatch, "The Math of the Coming Decline in the Dollar"). By his calculation, a drop in the real effective exchange rate of 20% -- the minimum the academic consensus is looking for -- would require dollar cross rates of 1.50 versus the euro, 94 against the yen, and 6.4 against the Chinese renminbi. Similarly, a 30 % dollar depreciation would imply 1.70 against the euro, 83 versus the yen, and 5.6 against the RMB. In my view, these thresholds would evoke howls of protest and massive intervention. As such, they can hardly be considered as a realistic option for resolving the US current account deficit -- the central source of disequilibrium for an unbalanced world.
Second, currency depreciation is no substitute for the tough medicine America needs in order to fix its trade deficit. In my view, it's all about resolving a massive excess consumption problem. In the first quarter of 2006, tradable goods imports into the US were fully 83% larger than America's exports of such goods (in real terms). This huge mismatch is largely an outgrowth of record import penetration in conjunction with an unprecedented consumption binge. By our calculation, goods imports hit a record 34% of domestic demand for goods in 1Q06 at the same time that increasingly wealth-dependent US consumption has been holding at an unheard-of 71% of US GDP since early 2002. Given the hollowing out of US manufacturing, it is hard to envision a currency correction that would enable America to export its way back to a trade balance and/or miraculously replace foreign sourcing by a rebirth of domestic production. The only realistic cure for this mismatch, in my opinion, is a post-housing bubble shakeout of the excesses of wealth-dependent consumption -- aided and abetted by a meaningful back-up in real long-term US interest rates. Those adjustments may just be getting under way.
Third, globalization has fundamentally altered the transmission mechanism between currencies, trade adjustments, and broader macro impacts. This shows up loud and clear in research undertaken by the BIS over the past year as well as in more recent findings by Fed economists (see, for example, Chapter 2 of the 75th annual report of the Bank for International Settlements, June 2005, and Jane Ihrig et al., "Exchange-Rate Pass-through in the G7 Countries," Federal Reserve International Finance Discussion Paper 851, January 2006). In an increasingly open global economy, with world trade now closing in on 30% of world GDP, the battle for market share has apparently become so intense that currency movements are now reflected more in the form of fluctuations in profit margins than by major shifts in global trading patterns. Clearly, massive currency realignments might change that result, but, as argued above, the odds of such extreme swings are quite low. Unless the forces of globalization are arrested -- something Washington-led protectionists certainly wouldn't mind -- US trade deficits may well be here to stay.
Nor do I buy the idea that the inflationary impacts of a weaker dollar may prompt a policy response from the Fed that would push up real interest rates, hit the housing market, unwind the wealth-dependent excesses of USconsumption, and fix the trade deficit. Reduced inflationary impacts are an important corollary of globalization's impact on the macro transmission of currency fluctuations (see my 10 April dispatch, "The Global Price Rule"). I do not share *** Berner's view that a modest cyclical tightening in US labor and product markets outweighs the powerful structural headwinds of globalization -- transforming what has so far been an orderly decline of the dollar into a more serious threat to US inflation (see ***'s 5 May dispatch, "The Dollar and Inflation"). Take a look at what happened -- or actually, what didn't happen -- to US inflation when the dollar sagged to record lows in the spring of 1995.
The US dollar is headed lower. In a rebalancing framework, this move should be seen as a necessary, but by no means sufficient condition for fixing America's trade deficit. The recent actions of the G-7 and the IMF, in conjunction with signals from the world's major central banks, are consistent with a resumption of the dollar's structural depreciation that began in early 2002. Over time, I believe this downtrend in the dollar will be reinforced by an important evolution in the reserve management practices of developing economies -- moving a significant portion of what Larry Summers estimates to be some $2 trillion of "excess" reserves out of a massive overweight in low-yielding, dollar-denominated assets into higher-yielding investments that are more compatible with urgent development needs (see my 5 May dispatch, "Imbalances Matter More than Ever"). This could well be one of the most important developments -- as well as one of the biggest risks -- currency markets will need to face in the years ahead.
The major thing that has changed for me is that I no longer see a dollar crisis as a high-probability outcome for an unbalanced world. Courtesy of encouraging actions by the stewards of globalization, the fat tail has just gotten thinner. That hardly puts me in the strong dollar camp. It means, instead, that I now embrace a managed dollar-decline scenario that could take the broad dollar index down on a "measured" basis by about 10-15% over the next couple of years. What that also means, of course, is that in the end there must be far more to global rebalancing than currency realignment. The heavy lifting on the policy front has only just begun.
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John F. Mauldinjohnmauldin@investorsinsight.com
John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.
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05-15-2006 9:47 PM