Commodities during a malaise

Supply and demand

Commodities threaten to enter a decade long run of the Bull, except for the hiccup in 2008 called the financial crisis. As an aside, has everyone noticed that commodity and technology markets are inversely proportional?

Dwight Anderson of Ospraie Management, an old school friend, invests in commodities. He wonders why more investors are not increasing their commodity holdings as a natural store against inflation, especially given negative real interest rates.

Anderson’s postulation is both foundational and simple. Since 9/11 the Fed has been injecting significant liquidity into the market, driving down interest rates and the dollar. Both increase commodities as an attractive asset, partly because most commodities are traded in US dollars. Almost a year ago, Anderson had this to say:

If you combine this monetary and currency backdrop with the stunning rates of Chinese demand growth, you have the six-and-a-half-year bull market that was temporarily interrupted by the financial market crisis of 2008.
When the Fed tried to withdraw liquidity in April, financial and commodity markets fell, so the Fed pumped more money back into the system, allowing rallies in bond markets and storable commodities. The conclusion for this is pretty clear: as long as the Fed is this stimulative, you need to stay in net-long, storable commodities if you want to preserve your purchasing power.
“The Long Look at Commodities | Open Markets”, n.d., written February 10, 2011

Good point. The broader and sympathetic one is that mining stocks, even those of the largest corporations with proven reserves in safe political climates, never attract the PE ratios of oil companies. Is that not a sign of chronic under-value? After all, both industries obtain their treasure by burrowing in the ground.

The trend seems even more mystifying as India and China replicate the Industrial Revolution with more than 10x the population, including the attendant need for commodities that implies. China alone now represents 50% of global demand in iron ore and other commodities.

The question of Chinese demand

Pundits have always been queasy about China. By now each new China expert must step over the bodies of discredited forecasters who went before them, all calling for collapse and retraction.

But what if China is already in recession? If inflation is really say, 12% (and who believes communist numbers?) then the economy is retracting. Chinese leaders recently finally admitted that internal demand could not yet entirely replace declining exports to fuel the economy in the event of another sustained global recession.

And current government action is contractionary; they have raised interest rates and bank capital requirements. The government has even taken to holding precious metals both to strengthen the renminbi and provide an inflation hedge.

The Chinese recession argument is interesting and arguably fits the facts. It may also be at least somewhat irrelevant.

Potash Corp

First, consider that China’s forex reserves dependably increased through the last global recession. Second, the economy itself suffered little, tempering any argument that reliance on cheap exports dwarfs internal demand beyond the pale. That the government helped with its own stimulus package does not obscure the fact that internal demand is no longer an insignificant variable, tossed like a tail by an export tiger.

On the contrary, China probably has little choice in continuing its vast urbanization programs, with plenty of foreign reserves to fund it. Millions of immigrants from the harsh living standards of rural areas are still moving into major cities. There must only be a small chance of successfully turning them back.

Given this scenario, a global recession would need to be quite severe to have a protracted effect on Chinese demand. Hundreds of millions of Chinese are on the cusp of buying cars, housing, washing machines and other consumer goods. The immensity of that demand will not and cannot turn off overnight.

At some point the critical bar will be reached wherein China becomes its own perpetual motion machine. The exposure is that the managed economy becomes too artificially skewed by government management and must undergo a contractionary restructuring before it breaks critical mass.

The giddy naiveté touting the Arab Spring, assuming a world where everyone harbors an irrepressible urge for freedom, may well end very badly if populations prefer the confining culture they know in preference to the liberal culture they have been taught to hate. In China, the issue is reversed; an outsized hubris is required to believe the Chinese government can continue to control the economic development of a billion people who have tasted middle class freedom.

The longer term view must be for continued higher demand for all commodities. Billions of people in India, China and yes, finally in pockets of Africa, are crawling out of the muck of poverty despite the harm of Western and Eastern governments. A reversion to any historical mean is but a remote possibility. The numbers are too large.

China and gold

Currently the Euro and the dollar enjoy undeserved popularity since alternatives are slim and none. While other nations share the brunt of that hereditary advantage, remember that the Chinese currency last collapsed in utter worthlessness in 1948. That is well within the memory of hundreds of millions of Chinese. In fact many people died in the crowds grappling to get to the banks to buy gold before Mao’s troops arrived to dispense their own version of cultural and social justice.

So it is not surprising that today’s Chinese government allows citizens to purchase and trade gold and silver as alternatives to the renminbi. Demand is high and could easily grow higher as inflation, especially food inflation, creeps into the economy and begins making itself a long term lodger. Cultural memory is a powerful motivator. An additional few hundred million buyers of precious metals are enough to redefine markets.

It is probably too obvious to point out that precious metal holdings provide implicit support for the renminbi. But could not western governments employ the same tactics in reverse? The US could easily leverage its gold holdings by guaranteeing a long term bond issue with the price of gold. Such a move would transfer some of the wind out of gold and into American bonds, popping pressure on their long term debt.

Politics as supply shock

Fertilizer, pesticides and agronomy in general greatly reduce the negative effects of weather and other natural effects on crop production while vastly increasing yield. Unfortunately, politics is impervious to both science and common sense.

One of my brothers is a farmer. Needless to say he has access to a great deal of feed corn. His Amish made corn stove heats his 5 bedroom, hundred year old farm house for about $180 a month in an Ontario winter, even at historic corn prices. The stove looks like its old wood predecessor although it is technologically superior, burns much cleaner (the daily residue is a small hand sized char) and requires only a dryer vent as opposed to a chimney. It is a natural use for corn, and competes well against current energy without subsidy.

As for ethanol, even environmentalists now concede it is an unworthy substitute for energy and oil in particular. Some argue that if water were subjected to market forces, this truth would have been apparent from the outset.

That the last defenders of ethanol have now admitted their folly does not mean that the USA will end ethanol subsidy any time soon. Almost 40% of a growing corn crop is now captured in ethanol production that requires at least 7 liters of oil to produce 8 liters of ethanol, devours water, drives up the cost of all grains, and eventually all food supplies. It also wreaks havoc on motors even as it provides questionable reductions in CO². What are the benefits again?

China index

Regardless of the facts and the terrible pressure rising food prices exert on undeveloped nations, the FDA continues to slaver at the idea of raising gasoline requirements to 15% ethanol. Given the administration’s proclivities on the XL pipeline, their oil hatred may well over-ride any common sense on this issue as well.

We can demonstrably produce enough food to feed the world. But energy markets are close to 100 times larger. Clearly politicians pose a real and enduring danger to food supplies and prices relatively impervious to any market forces or human suffering.

India top 30 index

Meanwhile the fallen bamboo curtain strives to enter the middle class, including moving up the protein chain. It turns out no one chooses to live on noodles, rice and beans unless living standards force them. And we surmise that Chinese consumers will return to that diet only midst severe conditions.

Having said that, food inflation, driven by manic politicians, erroneous IMF and World Bank planting programs which neutered hundreds of thousands of acres of food production, and northern crop failures due to harsh weather, are having an outsized effect from Egypt to India and China. Some of those economies have a 30% exposure to food prices.

In the end, all upstream inputs such as pesticides and fertilizers will enjoy outsized demand that remains largely recession proof. It matters little if the demand is driven by a richer world or politically correct malfeasance.

As mentioned earlier, it seems irrational that those companies do not obtain higher PEs now; some of them are exceptionally well run. Given the eastern macro landscape and the continued unattractiveness of western equities, there is no reason to believe these companies will trade at a discount forever.

Euro or dollar devaluation

Precious metals and commodities in general deserve outsized allocation in portfolios regardless of short term supply and demand forecasts. The reason is simple; historical times demand safe havens, which are by definition commodities.

The proof is already in the pudding; most commodity volatility in the past half year is due to Fed tinkering and the reaction it inspired. And despite popular and pervading monetary discussions, history teaches us that all successful economies grew in stable currency environments; no country ever grew to prosperity by debasing its currency over time. It cannot be a coincidence that US wage stagnation and currency decline both began in the 1970s.

It is also largely inarguable that the long term future of both the dollar and the Euro is structurally dismal. In other words, and in line with Anderson’s argument, Fed monetary policy in the next decade will look more like Japan than Canada, who in the 1990s tamed similar structural issues with relatively little monetary injection.

Unfortunately, Western Europe and USA remain enamored with a feeble version of Keynes that is ensuring eventual crisis but adding no stimulus. There again the model is in Canada, where a determined Bob Rae ran the Ontario budget from a $1B surplus to a $10B deficit in one year, using programs that make Obama look like a copycat. If he had a printing press, perhaps Mr. Rae would still be at it, citing Japan as his Keynesian guide to prosperity.

Both the American and Eurozone reluctance to deal with their actual problems demands an increasing exposure to commodities and the safe companies that produce them. And as either currency devalues, the established trend to commodities which has been driving gold for years could at any time turn into a flood.

Goldcorp

Smart money is already buying up land across the world. Given there is a good chance that USA and Eurozone growth will be stagnant or negative over the next decade at least, we suggest land input investments will be next, with precious metals an ongoing and enduring attraction. And with or without western civilization’s economic growth, China and India will crawl out of poverty.

To cap off the worst case scenario discussion, if Spain and/or Italy falls, the Eurozone will quickly enter recession, triggering negative global GDP numbers. Those slides will hasten Europe’s long term unfunded liability issues and force even more contraction as they restructure. In any of those scenarios, currency havens are the only savior.