A few days ago, Ospraie Management, a large manager of commodity hedge funds announced the closure of its largest funds. It will return capital to shareholders in stages. Ospraie’s funds had been performing well for years, until some wrong-footed trades in natural gas and copper futures led to deep losses in July and August.

Ospraie had a big presence in commodity futures, so its heavy selling has clearly intensified the recent price declines. Rapid price declines have fueled speculation that the commodity bull market is over. I very much doubt that it’s over, because in most cases, commodity supplies are too tight to meet strong, long-term demand from a growing world population — a population governed by politicians who can create both deficits and unlimited amounts of paper money. Governments and central banks will not sit idly by and allow a debt liquidation to destroy the banking system.

On the supply side of the equation, which most headline writers and pundits totally ignore, some commodity producers are shutting down projects that cannot produce at a profit. In a few commodity markets, prices are falling below the cost of production!

The fundamentals of supply and demand will matter again once current fears ebb. They always do. Energy and commodities have solid long-term fundamentals that rest on a foundation of human need. By contrast, financial companies are still facing ugly fundamentals, like plunging collateral values, rising defaults, and capital shortages.

Central banks will prevent the worst-case scenario of uncontrollable, self-reinforcing defaults. But their money-printing efforts will not bring about a re-inflation of the housing and credit bubbles. We probably won’t see another credit bubble for at least a decade. Once the fall in housing and mortgage securities slows down, excess liquidity created by central banks will find its way back into inflation hedges like gold and oil, potentially creating a future bubble in commodity-oriented investments.

As for the rest of 2008, my research leads me to the following most likely outcome: The stock market remains weak until the Federal Reserve totally abandons its “inflation fighting” stance. The Fed may even cut rates further as unemployment rises. At that point, commodity-oriented stocks will probably regain their position of leadership.

The recent decline in commodity prices allows the Fed to conjure up another “deflation” scare. This would provide cover to slash rates and inject reserves more aggressively into the banking system. Then, the U.S. dollar would resume its descent, while gold and commodities would resume their ascent.

The Fed’s current inflation campaign has been very modest thus far. Rather than expand its balance sheet and flood the banking system with liquidity, it has concentrated on swapping U.S. Treasuries for dodgy mortgage securities.

Central bankers on the other side of the Atlantic, though, seem to care more about what’s backing their currency. The European Central Bank just announced that it’s going to limit its role as a dumping ground for impaired mortgage securities. The Financial Times explains:

“[ECB President Jean-Claude] Trichet announced a series of measures to increase the cost of using asset-backed securities to obtain ECB funds and to exclude some such deals when underlying mortgages or other loans are not denominated in euros. The announcement follows comments by ECB council member Yves Mersch last month. He said there were still cases where ‘you see dangers of gaming the system.’

“This year, it emerged Macquarie Bank had constructed a deal backed by Australian car loans that could be used at the ECB and Lehman Brothers had formed a huge collateralized loan obligation of risky buyout debt to use at the central bank.

“Mr. Trichet said the ‘general character’ of its broad-based operations remained unaffected. ‘We’re not changing it, we’re refining it,’ he said.

“Only a ’small fraction’ of collateral would be affected. Banks’ ability to take part in its financing operations would be unimpaired, the ECB president said.

I see the ECB’s decision as a tactic to convince savers and investors that the euro will not be forever backed by securities of dubious quality. But European politics may eventually overwhelm the ECB’s fairly disciplined monetary record. Voters will demand easy money.

In the U.S., fiscal and monetary policy will likely be influenced more and more by big investors and foreign creditors. Bill Gross, manager of a huge bond portfolio, is concerned about the potential for “financial tsunamis” and “debt liquidations.” He thinks that the Treasury Department (i.e., taxpayers) has not done enough to stop the bleeding in mortgage securities. In his latest “Economic Outlook,” Gross describes how institutional mortgage buyers may sit on their hands until the Treasury Dept. initiates a new, huge bailout.

Whether taxpayers like it or not, Gross’ plea for a new bailout will probably be answered. The leverage in the banking system has grown beyond the point of no return. There’s no way the Fed and Treasury would allow a spiraling liquidation of debts. One way or another, mortgage losses will be partially “socialized.” Most of the burden will fall on savers because over the next decade, more paper money will be created than would otherwise have been created.

Think of paper money as a shock absorber for losses in the financial system. In times of crisis, central banks try to calm fears about bank runs. They spread losses from bad loans around to everyone who holds paper money. This game can keep going until the holders of that paper money lose confidence in its function as a store of value.

But don’t interpret a new bailout plan for mortgage investors as a sign that the financial stock bear market is over. It’s not — at least not for banks holding the worst credit exposures. Over time, these institutions will have to confess losses; take write-downs; and raise new, dilutive capital. Many will be taken over by the FDIC, which wipes out shareholders.

During times like these, investors do well to remember that the commodity sector never requires a “lending facility” from the Fed or a bailout plan for the Treasury.

Regards,
Dan Amoss, CFA
September 17, 2008

Buying Commodities on the Dips was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

In the 80s and 90s, when people were calling you to buy mutual fund and stocks, no one called to say, “Let’s invest in a sugar plantation.” No one called and said, “Let’s invest in a lead mine.” Commodities were in a bear market and in bear markets people do not invest in a productive capacity. They never have. Perhaps they should have, but they’ve never done it throughout history and probably never will. There has been only one lead mine opened in the world the last 25 years. There’s been no major elephant oil fields [of more than a billion barrels] discovered in over 40 years.

Many of you were not even born the last time the world discovered a huge elephant oil field. Think about all the elephant fields in the world that you know about. Alaskan oil fields are in decline; Mexican oil fields are in rapid decline; the North Sea is in decline. The UK has been exporting oil for 27 years now. Within the decade, the UK is going to be a major importer of oil again. Indonesia is a member of OPEC. Indonesia is going to get thrown out because they no longer export oil, they are now net importers of oil.

Malaysia has been one of the great exporting countries in the world for decades. Within the decade, Malaysia is going to be importing oil. 10 years ago, China was one of the major exporters of oil, now they are the second largest importer of oil in the world. Oil fields deplete, mines depletes. This is the way the world’s been working for a few thousand years and it will always work this way. So supply has been going down for 25 years.

Meanwhile, you know what’s happening to demand. Asia’s been booming. There are three billion people in Asia. America’s growing. Most of the world has been growing for the last 25 years. So supply has gone down and demand has gone up for 25 years. That’s called a bull market.

One of the things you’ll find if you go back and do your research is that whenever stocks have done well, such as the 1980s and 90s, commodities have done badly. But conversely, you find that whenever commodities have done well, such as the 1970s, stocks have done poorly. I have a theory as to why this always works, but it doesn’t matter about my theory. The fact is that it always works this way and it’s working this way now.

So before I set off to my second trip around the world, I came to the conclusion that the bear market in commodities was coming to and end. So I started a commodities index fund. This is an index fund. I do not manage it. It’s a basket of commodities we put in the corner. If it goes up we make money; if it goes down we lose money. But since Aug 1st 1998, when the fund started, it is up 471%.

I [mention this index] to show you that the commodity bull market is not something that will happen someday. It’s in process right now, and it’s going to go on for years to come, because supply and demand are out of balance. And by the time we get to the end of the bull market, commodities will go through the roof. There will be setbacks along the way. I don’t know when or why, but I know they are coming, because markets always work that way. Commodities have done 15 times better than stocks in this decade and they’re going to continue that [trend].

My 5-year old daughter knows this. She never owns stocks or bonds; she only owns commodities. She’s very happy owning commodities. She doesn’t care about stocks and bonds, but she knows about gold. I assure you, she knows about gold.

Some of you probably diversify, or believe in diversification. I do not diversify; I am not a fan of diversification. This is something that stockbrokers came up with to protect themselves. But you’re never going to get rich diversifying. I assure you. But if you DO diversify, commodities are the best anchor because they are not going to do what the rest of your assets are going to do.

I will give you one brief case study about oil, because it’s one of the most important commodities. Some of you know that a company called ARAMCO owns oil in Saudi Arabia. It was nationalized in the 70s. They threw out BP and Shell and Exxon. But the last Western company to leave did an audit [of Saudi oil reserves] and came to the conclusion that Saudi Arabia had 245 billion barrels of oil. Then in 1980, after 10 years, Saudi Arabia suddenly announced that it had 260 billion barrels of oil. Every year since 1988 – 20 years in a row – Saudi Arabia has announced, “We have 260 billion barrels of oil.”

It is the damndest thing. 20 years; it never goes up, it never goes down, and they have produced 67 billion barrels of oil in this period of time. When nuts like me go to Saudi, we ask, “How can this be? How can it be that they always have 260 billion barrels of oil?” (By the way, last year they said they have 261 billion barrel of oil). And the Saudis say, “You either believe us or you don’t,” and that’s the end of the conversation.

I have never been to the Saudi oil fields, and even if I had, I wouldn’t know what I was looking at. But I do know something is wrong. I know that every oil country in the world has a reserve problem, except Saudi Arabia of course. I know that every oil company in the world has declining reserves. So I know that unless someone discovers a lot of oil quickly, the surprise to most people is going to be how high the price of oil stays and how high it goes eventually. That is the supply side. Let’s look at the demand side.

The Indians use 1/20th as much oil as their neighbors in Japan and Korea use. The Chinese use 1/10th as much per capita. There are 2.3 billion people in India and China alone. Well, the Indians are going to get more electricity. The Indians are going to get motor scooters. They are going to start using more energy, so are the Chinese. But if the Indians just doubled the amount of oil used per capita, they would still use only 1/10th of what the Koreans use. If the Chinese doubled their oil use, they would still be using only 1/5th what the Japanese and the Koreans are using. So you can see what kind of pressures there are on the demand side for oil and energy, at a time of terrible stress on the supply side. These are simple things.

So I would urge you to take a lesson from my little girls. My little girls are learning Chinese. My little girls are getting out of the US dollar. My little girls own a lot of commodities. I would urge you to do the same.

Regards,
Jim Rogers
August 22, 2008

Commodity Bull Market was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

I also understand that airline passengers with excess luggage will have to pay extra. However, what I don’t understand is why passengers who are themselves overweight don’t have to pay more than passengers of normal weight. To be fair, airlines should weigh both passengers and their luggage at the same time. Then, if the total weight exceeds the limit per person, they should charge for the excess weight irrespective of whether it comes from the passenger or from their luggage.

Just as corporate profits cannot grow at a higher rate than nominal GDP for the very long term, debt growth cannot exceed nominal GDP growth forever. At some point, either debt growth will slow down to the rate of nominal GDP growth or nominal GDP growth will accelerate to the rate of growth in credit. The latter can be achieved by real GDP growth or by inflation accelerating sharply.

Since it is unlikely that the US economy can grow in real terms by far more than 3% per annum, at some point debt growth will have to slow down or inflation will pick up considerably. If debt growth were to slow down sharply and join nominal GDP growth rates, I suppose that some kind of a deflationary recession would follow
– an outcome Mr. Bernanke wants to avoid with the money printing press he controls.

Therefore, it would seem to me that the more likely scenario will be for inflation to accelerate in future. If one uses common sense — and not the statistics published by the Bureau of Labor Statistics — it is surely apparent that our cost of living increases are far higher than the published CPI figures.

The second unusual feature of the current expansion is that China and, increasingly, India are for the first time in modern history a factor in the global economy. No one paid any attention to these two economies in the 1975, 1982, and 1991 economic recoveries. But today, the Chinese economy has great significance, both as a supplier of goods and in terms of its demand for natural resources.

In fact, the incremental demand from China for natural resources has shifted the demand curve for commodities to the right, resulting in a higher equilibrium price.

In last month’s report, I argued that of all the emerging economies India had by far the highest economic potential, both because of its size and because, in terms of economic development, it had lagged so far behind the other emerging economies until very recently. Matt Fernley, an analyst at UBS, has just published a highly interesting study entitled, “What if India Grows Like China?”

In this report, Matt makes the case that, from a macroeconomic perspective, India has numerous similarities with the China of the 1980s and 1990s, and that if India realizes its potential, its demand for key materials may treble by 2015. So, if in recent years the incremental demand for commodities from China has shifted the demand curve to the right, then under the scenario outlined by Matt Fernley it is almost a certainty that India, with its billion people and still growing population, would do the same going forward. (Note that India has a far younger population than China.)

This should cheer the commodity bulls, as the demand-driven commodity bull market would extend far beyond 2015 (though, naturally, interrupted by intermediate correction phases).

Related to China, and now also India, driving the demand for commodities higher is also the emergence — for the first time in modern history — of commodities as a distinctive asset class. I am aware that some distinguished economists might dispute the fact that commodities are an “asset class”, but common sense would suggest that assets, for which shortages exist and, I may add, may persist for a long time, are likely to be more rewarding investments than assets for which the supply is limitless (such as US dollars).

Also, while we had a commodities boom in the 1970s, financial institutions at that time didn’t consider commodities to be a separate asset class, and certainly didn’t invest in a basket of commodities or in physical natural resources. (I suppose that commodities, and especially precious metals, become an asset class in an environment where paper money is continuously diluted in value through a rapid increase in its quantity.)

The third unusual feature of the current economic expansion is that it is accompanied by significant imbalances. Rapid debt growth in the US has led to rising asset prices (notably, homes) and sustained strong consumption growth in excess of income gains. In turn, high consumption in the US has led to an expanding trade and current account deficit whose growth in the long term, as a percentage of GDP, isn’t sustainable either.

It may be that the current account deficit, which has soared from 2% of GDP in 1998 to over 7% of GDP, will rise to 10% — or even 20% — of GDP, but it should be obvious that it cannot expand forever. My common sense, however, isn’t convinced that those academics, with their sophisticated mathematical and econometrical models, who claim that “the current account deficit doesn’t matter”, realize that the current account deficit cannot reach 100% or 200% of GDP!

So, in order to stabilize the trade deficit, either US exports will have to rise very rapidly at some point (at twice the rate of imports in order to stabilize the trade deficit at the current level), or consumption in the US will have to slow down sharply (in order to reduce import growth).

Moreover, while, as just indicated, the learned economists will tell you that these external deficits don’t matter, common sense suggests that we are in the midst of a huge shift of wealth from the US to Asia, a theme I have expounded upon on numerous occasions. Simply put, if the US consumes, and Asia invests and produces, it will lead for a large segment of the Asian population to higher per capita income increases than in the US.

Attracting this incremental capital requires an increasingly favorable relative expected return. And the fastest way to raise the expected return is by lowering the price. Sometimes it happens through a higher interest rate, sometimes through a lower stock price, sometimes through a falling currency.

Some observers have been puzzled by the outperformance of emerging markets, and of the stock markets of Japan and Europe compared to the US, but it makes perfect sense that where the liquidity accumulates as a result of current account surpluses, asset prices rise more than in those countries that are over-consuming and are plagued by a current account deficit.

According to Bridgewater Associates, “U.S. assets have consistently fallen in value relative to those abroad by a cumulative value of over 35% in four years [see Figure 1]. This will continue until the dollar falls sufficiently to shift the pricing of U.S. goods and services enough to reduce the need for capital. Until then, the price of U.S. capital will fall in relation to abroad.”

In fact, I wouldn’t rule out that within the next ten years bond yields in Brazil or Russia could decline below US bond yields as they have already done in many newly industrialized economies. Moreover, whereas US financial assets have, over the last four years, declined by a cumulative 35% relative to assets overseas, the underperformance of US financial assets compared to gold and silver is even more striking.

Against gold, US bonds and stocks have lost more than half their value since 2001. As explained in the past, I expect this underperformance to persist for many years to come. US home prices have also begun to decline sharply against gold. Courtesy of Ned Schmidt, publisher of the Value View Gold Report ( valueviewgoldreport@earthlink.net), we can see from Figure 2 that, since July 2005, the prices of single-family homes in the US, as measured by the gold price, have declined by 25%. (A year ago, 440 ounces of gold would buy the typical house, whereas today only 380 ounces of gold are required.)

The massive shift in wealth to Asia – most notably to China – has also meant that, for many countries, China has displaced the US as the engine of growth. From Figure 3, courtesy of the Bank Credit Analyst, we can see that whereas China has a huge trade surplus with the US, it has a large trade deficit with the rest of Asia.

In fact, some Asian countries now have larger exports to China, which are still growing rapidly, than to the US. Moreover, in countries where exports to China are still smaller than to the US (such as Latin American and African countries), they are growing far more rapidly than to the US and, therefore, have a highly stimulative impact on their economies.

That this shift of wealth from the US to Asia will also have important geopolitical consequences ought to be clear. (Angola has become China’s largest supplier of oil.)

This shift of wealth from the US to the emerging economies has led to a bizarre situation in the history of capitalism. In modern economic development it was always the rich countries that financed economic development in the emerging economies. European capital financed the construction of canals and railroads in the emerging American economy of the 19th century.

Then, in the 20th century, European and American capital financed economic development in Latin America, Australia, Asia and Russia (until the Russian Revolution). But now, it is not the rich US that is financing the emerging economies, but the poor countries, mostly from Asia (notably China), that are financing US consumption through the purchase of US dollar fixed-interest securities with their bulging foreign exchange reserves.

This situation is truly unique in economic history and one has to wonder how sustainable the condition will be. (A symptom of this shift in wealth to emerging economies is the disappearance of Brady bonds. Governments that issued them in the early 1990s, in order to help resolve defaulted commercial bank loans, are now buying them back.)

The final unusual feature of the present global economic expansion is that, so far, the Fed’s busy money printing press has lifted in value all asset classes, including stocks and bonds in developed and emerging economies, industrial commodities and precious metals, real estate, art, collectibles, and even bonds (until very recently).

Common sense would argue that it is impossible for all asset classes to move up forever in concert. In particular, rising property and commodity prices are a symptom of some inflation in the system and can themselves cause, in time, consumer prices to increase at an accelerating rate. Therefore, it should be clear to anyone that sooner or later commodity prices or bond prices will tumble.

If monetary policies become really tight, commodities, including precious metals, will fall hard. Conversely, if monetary policies remain expansionary, interest rates are likely to rise for far longer and bonds to decline much further.

We can see that since the early 1980s gold and interest rates moved down in concert until 2001. But since then, gold has more than doubled in price, while interest rates fell further into 2003. Since then, interest rates have hardened modestly.

Some economists will argue that rising gold prices and low, or even declining, interest rates are entirely compatible amid the ongoing globalization. But I don’t buy such reasoning. Something will undoubtedly give in a very big way and lead to far higher volatility in the asset markets.

In my opinion, the precious metal markets are signaling high rates of inflation in the future, while the bond market is saying that inflation won’t be a problem. Someone will pay dearly for being on the wrong side of the trade and I suspect it will be the bondholders.

Until next time,
Marc Faber
April 27, 2006

A Simpleton’s Guide to Economics and Investment Markets, Part I was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.