The Rise of the Chinese Consumer

By Frank E. Holmes         July 12, 2006 www.usfunds.com

Letter from the CEO

It's not news that the world's commodities markets have seen a dramatic upswing in recent months, with gold climbing past $700 an ounce, and oil and copper hitting all-time price highs.

But what may be news to many is the story behind this energized market.

To understand what's driving commodities, we have to go back to just before the end of the last millennium and examine an event whose significance was not fully appreciated at the time.

Earth's population reached 6 billion people in October 1999, more than double what it was in 1960. Here's another way of looking at the rapid pace of human population growth - it took from the dawn of time until 1927 to get to 2 billion people, and less than 75 years for that number to triple. And in the past six years or so, we've grown halfway to the 7 billion mark. Six billion is more than just another round number. It also represents a "tipping point" for commodities demand accelerated by advances in technology and economic globalization.

Where do all of these people live? China and India together have 2.4 billion residents, nearly 40 percent of the globe's total. Another 800 million live in Russia , Mexico , Brazil , Indonesia and Pakistan .

What do these seven countries have in common? They are all emerging nations whose economies have been growing faster than those of the developed world. Collectively we call these countries the Emerging 7, or E-7.

China 's government recently reported that its GDP grew at a 10-percent clip in the first quarter of 2006, and India 's economy is expected to expand almost 9 percent this year. Nearly all of the E-7 countries - and many more in the emerging world - have projected 2006 growth rates surpassing that of the United States and the rest of the G-7.

That growth can be seen in ambitious construction projects in these nations.

China plans to build 14 express highways, six railways and a dozen new seaport facilities before 2010. India invests 3.5 percent of its GDP on power plants, roads and other infrastructure and the government there is financing "industrial townships" to promote more manufacturing. Even Bangladesh , one of the world's poorest countries, is building hundreds of miles of highways, as well as schools, water systems and the like.

China 's energy consumption is expected to be 69 percent higher in 2010 than in 2002, according to the Federal Energy Information Administration. That growth rate is five times higher than the estimate for the United States and more than 15 times higher than Europe .

China , in the midst of a massive infrastructure build-out, used half of the world's cement and 40 percent of the world's steel last year, according to government statistics.

But because of years of low commodity prices and other factors, exploration and development of these now-coveted resources have not kept pace with global population and GDP growth. That has created an Economics 101 scenario - demand is greater than supply, so prices climb.

Not only are populations growing quickly in many developing and emerging nations, so are their incomes and their desires for the types of consumer goods that Westerners have long taken for granted. In the past two decades, China 's per-capita GDP has gone up more than tenfold.

According to the Boston Consulting Group (BCG), more than 40 percent of the world's economic GDP growth over the next decade is expected to come in China , India , Central and Eastern Europe, and Latin America .

By 2010, these "rapidly developing economies" are also expected to account for a third of sales for multinational corporations, according to BCG.

And as those economies expand, there will be greater demand for oil, gold, minerals and other natural resources.

The benchmark CRB Commodity Index has consistently been in record territory in recent months. It is up roughly double in less than five years. Gold, silver and platinum prices have risen 100+ percent since early 2001, while zinc, lead and copper are each up more than 200 percent. For crude oil and natural gas, the price hike is greater than 300 percent. Despite these impressive run-ups, we believe that we are still early in the secular bull market for these and other commodities.

To get some perspective on this enduring rally, you can look at the "Kuznets Cycle," a cycle of economic activity that drives commodities demand.

Economist Simon Kuznets, who came up with the concept of GDP, won the 1971 Nobel Prize for his work to explain infrastructure investment. That work is relevant to what we're seeing today in emerging nations. Kuznets noticed that roads and highways, seaports, airports and other infrastructure are built over a 15- to 20-year period. It is a period of strong jobs creation, and once these pieces are built, the economy is growing and robust.

A good example of this is when the U.S. built interstate highways in the 1950s. This construction work absorbed more than half of the world's commodities. This is very significant as we look at those emerging economies that have policies for infrastructure construction and growing demand for commodities.

Asia's rapid growth is driving this secular bull market. Asia 's 3 billion people now consume about 20 million barrels of oil daily, while 300 million Americans consume 22 million barrels per day. The difference is that Asia has been growing at 6 percent per year, twice the U.S. rate. Since 2000, there have not been enough new discoveries of oil, gas and precious metals to meet Asia 's demand as they have built infrastructure. This is the most important reason why we are living with ever-higher energy prices.

Emerging economies are also heavy consumers of copper, whose price has been at record levels this spring. Copper inventories hit a 30-year low this past summer, and there have been a host of issues - refining bottlenecks, various labor issues and rising capital costs - that have kept the market tight.

Toyota 's Prius hybrid automobile uses five times more copper than a standard gasoline-powered car. With the strong demand growth for hybrids, we will continue to see strong copper demand for products such as the Prius.

In the short term, the biggest domestic risk we see for copper prices is the housing market. The average house contains some 400 pounds of copper in the form of wiring, water pipes and appliances, so if home construction were to slow down dramatically, that could hurt copper prices in the short term. Long-term, there is still much demand around the world without much increase in supply. China has been negotiating energy and minerals deals with South American and African countries as a way to ensure supplies to feed its economy.

When it comes to China , our investment team has a simple philosophy: whatever China needs, get long, and whatever they have as surplus, get it out of the way, because China will just dump it. That happened with both steel and aluminum.

It's very important to be able to track those supply and demand factors. Copper prices took off when China stopped selling copper. Zinc prices were 45 cents a pound last year when China was a net seller, and they're nearly four times higher since the country became a net buyer. China is also no longer exporting silver, whose price is at a 25-year high.

While some quarters have been volatile, we believe the gold and natural resource markets will continue to offer exceptional opportunities to investors. We always remind investors, however, that it's important to diversify between various asset classes.

In his best-selling book "Asset Allocation: Balancing Financial Risk," Roger Gibson recommends an equal allocation between domestic equities, international equities, fixed-income instruments and hard assets (commodities, precious metals, real estate, etc.). In his simple model, investors should limit their hard-assets exposure to 25 percent of their portfolio in the form of natural resources stocks and mutual funds, and they should rebalance every year.

U.S. Global Investors funds have turned in exceptional performance over the short term, as well as over longer periods. Our Global Resources Fund (PSPFX) won the Lipper Fund Award USA in 2006 for consistent performance over the preceding three years in the natural resources category as of 12/31/05. The fund ranked #1 out of 74 funds in its category.

While the wind is at our back now, it's important to keep in mind that there's always a risk of severe short-term market corrections. The 1982-2000 bull market for equities included the spectacular "Black Monday" correction of 1987, when the Dow Jones Industrial Average fell nearly 23 percent in a single day. But by mid-1988, stocks had recouped that loss and the bull market continued for another dozen years, hitting record highs along the way.

Managing risk and expectations is important for every investor. Please read the article "Anticipate Before You Participate," beginning on page 14, for more on how to use common measurements to benefit your portfolio.

U.S. Global Investors prides itself on being a reliable source of information for its shareholders on market cycles, global trends and the benefits of diversification, mean reversion and rebalancing. We are always trying to educate our investors about the critical drivers that influence the various asset classes. We believe performance sells itself, and that it's more important for investors to have a balanced, timely and insightful view of what's behind that performance.

Sincerely,

CEO and Chief Investment Officer of U.S. Global Investors

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All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor. Gold funds may be susceptible to adverse economic, political or regulatory developments due to concentrating in a single theme. The price of gold is subject to substantial price fluctuations over short periods of time and may be affected by unpredicted international monetary and political policies. We suggest investing no more than 3% to 5% of your portfolio in gold or gold stocks. The AMEX Gold Bugs Index (HUI) is a modified equal-dollar weighted index of companies involved in major gold mining. The S&P 500 Stock Index is a widely recognized capitalization-weighted index of 500 common stock prices in U.S. companies.