Bearish outlook for commodities
May 6, 2005

The gold price is holding up rather well. Except for a brief drop to $410 an ounce in late January the gold price has held itself above $420 this year with a slight upward trend in place. For the past six weeks the gold price has hovered around $430 an ounce.

The US dollar is still on thin ice, and when it falls through the ice the dollar-gold price will resume a more aggressive upward trend. My bet is still that we will see $700 to $800 an ounce within the next few years. But I am much less optimistic about commodities such as copper, zinc, or nickel.

Keep in mind that gold is not a commodity: it is money. The price of gold and the prices of other metals do not have to follow the same path and, in fact, I don’t think they will follow the same path going forward.

Being the largest economy in the world, the health of the US economy is of paramount importance. I, and many other analysts, have long belabored the huge amount of debt in the US economy and how that debt will one day come home to roost. Let’s take a look at some recent news headlines from the Wall Street Journal.

“Slowdown at U.S. Factories May Herald Further Chill.”
According to a survey quoted by the Journal, the US manufacturing sector turned in its slowest pace of growth in nearly two years. The manufacturing sector has been slowing for five straight months.

I’m not going to rant about why the US economy is in trouble. There are enough articles in the Commentary section on my website at www.paulvaneeden.com on that topic. What I want to point out is that we might be approaching the tipping point. It is quite possible that the wobbles we are seeing now are the wheels coming off. More headlines:

“Delta Puts Figures to Its Pension Bill”
It’s no secret that the airline industry is in trouble. Ever since 9/11 they have been having a tough time and now, with the rising cost of fuel, they are in serious trouble. But slow revenue growth and rising fuel costs are not the only problems. One of the really big issues facing the US economy, and not just the airlines, is under-funded pension plans. Delta reckons that it has to pay $3.15 billion into its employee retirement plans over the next three years. That is in addition to the $450 million it will pay this year. Let’s put that number in perspective. Delta had revenues of $15 billion in 2004 but made a $3.3 billion operating loss. The total loss for the year was $5.2 billion. Shareholders’ equity in the company is a negative $5.8 billion. If you just add the money that they have to pay into their employment retirement plans the loss becomes almost $10 billion, and that’s assuming we don’t have any more operating losses, which is a bad assumption to make.

It is not just the airline industry that’s in trouble. Watch the auto manufacturers; they’re next. In fact, most of America’s “Big Business” is in trouble. But investors don’t care. The average price to earnings for S&P 500 Index is 19.2 and the price to book is 2.8.

“S&P Downgrades GM Debt to Junk Status”
Talking about Standard and Poor’s, on Thursday they cut the corporate credit ratings of General Motors Corp., General Motors Acceptance Corp., and all related entities to junk status. S&P also stated a negative outlook, indicating that a further downgrade is possible.

This is serious business. It affects about $300 billion in outstanding debt and increases GM’s cost of doing business across the board. You might not have known this, but GM is the largest issuer of corporate bonds in the US. A harbinger? Possibly.

It’s not just Corporate America that’s in trouble.

“Treasury is Considering Bringing Back Long Bond”
In August the US Treasury will announce whether it is going to start issuing 30-year bonds again. During the dot com bubble and the stock mania of the late Nineties the US Treasury was raking in tax receipts from investors who making a killing on the stock market. The oracles in Washington were so impressed by the addition tax revenues that they decided to stop issuing 30-year Treasury Bonds. America’s Government was going to start paying off its debt.

Of course, making future projections based on abnormal circumstances is not prudent, and they should have known that the financial environment during the late Nineties was unsustainable; Alan Greenspan said as much in 1996 with his famous quote of “irrational exuberance” in the US equities markets.

Instead of reducing its debt, the US Government is going ever deeper into debt. Just this week the House of Representatives, without voting, increased the US Government’s debt ceiling by $781 billion to almost $9 trillion.

US interest rates have remained low to a large extent because China, Japan, South Korea, and others, have been buying US Treasuries with their trade dollars. But long term US interest rates have also been kept in check because the Government was redeeming 30-year bonds and issuing shorter term bonds. If the Treasury decides to reintroduce the 30-year bond in August, don’t be surprised if 30-year interest rates start rising. I have long cautioned that the US Budget Deficit is a virtual guarantee that US interest rates will go up. The Government’s deficit has to be met by issuing bonds. As the supply of bonds increases the price of the bonds will decline, and interest rates are inversely related to bond prices. So if bond prices fall, interest rates rise. By the end of this year I expect we will see higher US interest rates across the spectrum, not just on the short end, as we’ve seen in the recent past.

Of course, higher US interest rates are not going to help Corporate America, or the consumers who are consuming more than they’re earning. So none of this bodes well for the US economy.

If the US economy slows down the rest of the world slows down as well. The European Central Bank has said that growth prospects in Europe have only worsened since the Bank downgraded its forecast for the year in March. And who do you think is going fuel China’s growth if both the US and Europe are having economic troubles. Japan?

On this backdrop you can see why I am not bullish about the near term future for commodities. I suspect the cyclical bull market in commodities is over. China is not yet in a position to sustain its economic development with internal demand. If export revenues stop rising at the pace of the past decade then China is more likely to slow down than to increase it’s rate of expansion.

Now, we should not forget that there is almost universal pressure on China to revalue its currency upwards against the dollar. As I explained in my commentary of February 10 (available at www.paulvaneeden.com in the Commentary section), a revaluation of the renminbi will cause interest rates to rise and the dollar to fall. The falling dollar will make the gold price in US dollars go up and it will mitigate any decline in worldwide commodity prices in terms of US dollars. So even though the price of copper and other metals might be declining in many currencies, the price of copper in US dollars could appear to be holding ground. Don’t let this fool you. The bull market in base metals is not very likely to continue.

There are only two metals that I think have good upside potential with acceptable risk: gold and uranium. I am, however, becoming less optimistic about uranium. But that’s a story for another day.

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Paul van Eeden

Paul van Eeden works primarily to find investments for his own portfolio and shares his investment ideas with subscribers to his weekly investment publication. For more information please visit his website (www.paulvaneeden.com) or contact his publisher at (800) 528-0559 or (602) 252-4477.

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