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Economic Slowdown to Hit Commodities in 08?
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Since 2002, gold and commodities have risen dramatically due to things like the housing bubbles and huge growth in China, India and such. Much of the commodity investing community sees that trend continuing, even in the face of a significant world recession. Their primary argument for that scenario is that China and India, for example, will decouple from a Western recession, if one appears in 08. Their continued growth will carry commodities upward they say, even amidst a recession in the West.
The Asia Ace?
Economist Nouriel Roubini has stated that the decoupling argument is faulty. According to data he presents, there is clear evidence that the major trading economies with the West are actually more linked, not less linked than in 2000. The reason is that the significant inter Asian trade growth in that period is actually for components that are manufactured in Asia, then assembled in China for goods exported to Western consumers. Therefore, if Western consumers pull back significantly, all that growth in Asian interregional trade will also shrink.
Their other argument, that Asian consumers will pick up demand if Western consumers pull back, is also flawed. China consumers account for about $1Trillion worth of world consumer demand, while the US alone accounts for $9 trillion worth. India has much less of the pie than China. Considering that the EU is now arguably China’s largest export market, and that the EU is also highly coupled to the US consumers, the idea that the EU, China, India etc can decouple from the US consumers at this point is frankly wrong. If the EU and US consumers pull back, then roughly half of world consumer demand drops. China and India cannot make that up yet. Not even close.
So, should the US, EU, and the Western economies contract in 08, the question arises, what is the fate of the recently hot commodity complex? Well, recent weakness in industrial metals, particularly copper, does not bode well for the ‘ever rising commodity complex’ investment mantra.
Gold is in a separate category, as it is a central bank reserve asset, and is cash. In severe recessions cash is king, and gold will likely escape the worst effects of a significant world recession on the commodity complex.
I don’t know why it is that, in every investment boom, the people who would seem to be the most able to foresee a top in their markets are often the last to see it.
I think this is particularly true now, when, in the midst of a very serious world credit/banking crisis, big investment funds are hanging onto the ever rising commodity song. This, while they can easily see the effects of the credit crisis on their other investments, such as bonds and various mortgage derivatives like ABS (asset backed securities) SIVs and CDOs (bundles of mortgages sold off as securities and so on).
The ever increasing revelations of new tens of $billions worth of these losses in the world’s biggest banks, and the fact that they are all scrambling like mad to bolster their severely deteriorated balance sheets, should make any investor pause. They should seriously reconsider the commodity growth paradigm in a severe recession. We will get to that part of the discussion in a minute.
But what are all these investors, institutions, analysts doing now? They seem to ignore all the present financial chaos, and see the commodity sectors as the only remaining sector that will protect their gains of recent years. Also, the stock markets have thus far mostly ignored the rather critical credit/banking crisis. Well, as profits start to drop in the quarters after August when the credit crisis detonated, stock markets will have to relent, and drop probably over 20% next year…
Are they going to tell me that, if I am right, and world stocks drop 20% or more next year, that the commodity complex is going to escape wrath?
I would even surmise, that all the oil hoopla (for good reasons, but for reasons that are about to go away in part due to economic contraction) is also overblown. I would not be surprised in the least to see oil in the $60 range or lower in 08 and stay there. But oil is not what this article is about…
I don’t know how they do it. We at PrudentSquirrel have closely tracked the emerging credit/banking crisis since the end of July. It has become obvious to us that there is a Western credit emergency, that economic growth will be stifled. That, and a collapsing world housing bubble will guarantee a serious world recession. And the fact that the world growth kings, China, India and so on, are not less linked to Western economies, but rather more linked since 2000, will guarantee a contraction in commodity prices to more historical norms. The ‘decoupling’ mantra is wrong, at least at this point, and is merely a nice sounding phrase for investment managers who want to save their skins. It’s wishful thinking.
Copper/Gold Ratio
According to MineWeb, the Bank Credit Analyst states that the Copper/Gold ratio indicates problems with the commodity complex which I have just outlined:
“The ratio of gold:crude oil prices - in dollar terms - has long been used as a tool by various specialist investors, but the copper:gold ratio (CGR) can also be very useful. At this juncture, the Bank Credit Analyst is asking just what it is that the CGR is telling investors, with the most compelling factor by far being the "rare divergence between the price of base metals and precious metals over the past few months".
The event is seen as containing both a message, and as providing an investment opportunity. The price of copper, the leading base metal, has long been seen as a barometer of economic strength, while the price of gold can be most handily described as "a bellwether for liquidity creation".
As such, the corollary is that the CGR reflects the interplay between global economic trends and policy responses. History shows that the CGR plunged when central banks fell behind the deflation curve (that is, 1992-1993 and 2001-2002), and surged when rates were normalized or policymakers were struggling to cool economic growth (1994, 1999-2000 and 2003). During the 2003-2006 period, the CGR moved potently from roughly 0.2 to over 0.6 times, as calculated by BCA Research.
BCA Research argues that the current breakdown in the CGR ratio suggests that more liquidity is needed to reflate the global financial system and keep the economic expansion on track.
This could be a tough ask, given that measures of banking sector risk have exploded, starting early August, triggering an ongoing deterioration of liquidity in interbank money markets. Interbank lending has long been the main channel through which central banks affect financial markets and the economy. As interbank lending markets become increasingly moribund, so interest rate cuts become increasingly impotent.
In the physical markets, all metals are affected by idiosyncratic and specific supply and demand factors. The price of gold bullion is also impacted by its perceived monetary role, not only as a safe haven asset, but also as the most direct substitute for the dollar, which entered a protracted bear market early in 2002.
As for copper, prices remain on something of a knife edge. Copper - currently trading just below $3/lb, has fallen 25% in the past two months. Price trends for other base metals reflect similar trends. As a rule of thumb, the professional analyst community anticipates that a 1% reduction in global demand for copper could lead to a surplus of about 35,000 tons of copper in 2007. This would push inventory levels beyond historic metrics, and could trigger a further serious retrenchment of copper prices.
Investment demand, not by any means least from hedge funds and speculators, has played a significant role in pushing prices higher more quickly than would otherwise have been the case. Thus the professional analyst community anticipates long term copper prices of around $1.25/lb, significantly lower than current prices, and far closer to the $1/lb prices seen in 2002, before the CGR ratio started going into orbit.”
Barry Saregeant, Mineweb
Bold emphasis is mine.
Remember, copper is called Dr. Copper, as a leading economic indicator, since it is used in so many products.
The second part of this paper looks more in detail to our other thesis, that the world credit/banking crisis will cause major economic problems in 08.
On verge of Western bank crisis
I have started to focus more and more research into the deteriorating banking situation in the West since August. It became clear then, and is more clear now, that we are witnessing what seems to be an irreversible and growing Western bank liquidity crisis.
The implications of this, to every market, are no less than staggering. Banking is so essential to every aspect of every economy that, if it breaks down, commerce can literally stop. The key interbank lending markets, which funnel bank credit to economies, are having big trouble since August. This is one reason Central bank efforts to loosen interest rates is failing to loosen credit markets such as the CP (commercial short term paper used for operations and money market funds etc) and LIBOR (London interbank rates) is rising the most since about 2000.
Stock markets yet to react
Somehow, the world stock markets have yet to react to the magnitude of this situation. One would have thought we would have seen stock drops on the order of 20% to 30% already in the EU, and US. By way of economic and financial market linkages, the same magnitude of stock declines would follow for the world stock markets, even if they don’t have a banking crisis of their own.
There are many aspects of this crisis, so all I can do in this article is to try and give a general sense of the severity of this situation.
While most of the headlines about this bank crisis relate to the losses that can be traced to subprime US mortgages and their derivatives, there is a huge and growing story about interbank lending that is collapsing. We now progress from losses at the biggest banks in the world to the verge of world financial paralysis. The problems are so widespread that the US Fed, and ECB (European Central Bank) have been unable to stop the continued contraction of bank liquidity in the US and EU. Other regions are also being affected.
Major US banks are asking companies and institutions to hold of drawing down short term credit facilities to December. Their balance sheets just don’t have the money because interbank lending is paralyzed. CP market paralysis is also forcing companies to use their short term credit facilities because they cannot access the CP markets. This puts all the pressure on the big bank’s balance sheets. Basically, big banks have not only taken huge losses due to mortgage derivatives such as CDOs, but they are also having to be lender of last resort to all the businesses who normally access the paralyzed CP markets. A double capital/balance sheet whammy.
The Problem
Collapsing credit in the West is severe.
- The US GSE (Government Sponsored lending Entities) Fannie and Freddie are madly scrambling for new capital. They are losing lots of money on mortgages, and at the same time, are being promoted as the best last source of new mortgage lending to save the housing bubble. Good luck.
- Citi needs to raise $30 billion in new capital as of a month ago, and with new 4th quarter losses, that number will only increase. The other big 5 US banks are in similar trouble and need to raise capital immediately. The $7 billion Abu Dhabi capital infusion to Citi recently is said to be too little too late. Citi is paying an incredible 11% interest rate on that! Talk about having to go begging!
- The EU and ECB are very – VERY – alarmed about their frozen interbank lending markets. Like the US Fed, they are trying to be lenders of last resort to banks who need short term money. Remember, banks typically loan ten times or more of their capital. If the interbank lending markets freeze, they have to use their precious capital to honor their lending commitments. This is one reason banks are asking their customers to try and not use their short term credit facilities right now.
- The proposed US rate freeze on US adjustable mortgages will be celebrated by the stock markets. But, I estimate the rate freeze will affect not more than 10% of the 2 million adjustable mortgages coming up in the next year or two. That, unless they just do a mass freeze, and I’m sure the lenders will balk at that. If they did a mass freeze, the future of US mortgage markets will be super bleak, as investors worldwide will flee any future US mortgages. Sure, an ARM rate freeze would alleviate US home owners, but then such action will give a coup de grace on the future of the US mortgage markets into 09, and beyond. This plan has to be implemented with the utmost wisdom to avoid that fate.
- Moody’s places US bond insurers on ratings watch. If they cannot raise capital, they may lose their AAA ratings and jeopardize the AAA ratings on the huge amount of bonds of all types they insure. If that happens, funds who must have AAA rated bonds will be forced into fire sales of the down rated bonds, further damaging the bond markets and their own balance sheets. Such a scenario is quite possible, and would lead to mass exoduses from the gigantic money market fund universe… and likely more forced selling.
- Gregory Peters of Morgan Stanley said there is a better than 50% chance of a systemic banking crisis that will hammer credit markets at this time.
So, we wanted to do a brief overview of what our research has uncovered on the credit/banking crisis. One of the conclusions is that collapsing credit worldwide will severely dampen world economic GDP. That will put a big damper on the resurgent commodity complex into 08 and beyond. The mantra that the commodity complex will grow forever, that Asia is decoupled and will survive a Western recession is wishful thinking. Gold will likely escape the worst effects of this commodity leveling. Stock markets have not yet recognized the severity of the credit crisis, and in coming quarters, as economic statistics reflect that and earnings drop, stocks will drop significantly.
The PrudentSquirrel newsletter is a gold and economic commentary, 44 issues a year. Subscribers have closely tracked many aspects of the credit/banking crisis. We also have mid week market alerts, which have anticipated the 5 major stock and gold drops this year by up to a week in advance. Subscribers have told me that the alerts alone are worth the subscription.
Stop by and have a look.
Christopher Laird
Editor-in-Chief
www.PrudentSquirrel.com
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Chris Laird is not an investment advisor/professional. This article, and the PrudentSquirrel newsletter and alerts, are general market commentary only. They are not intended as specific advice. You should talk to your own investment professionals for specific advice.
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