== Part two - Awaiting a final redrafting ==Manic Swings - the Bipolar World
Part 2: Living in a world of price shocks and crashesSUMMARY of Part 1With wild swings in commodity and stock markets, it has NOT been profitable to commit to a single point of view: whether inflationary or deflationary. Unfortunately, huge swings could be an essential part of a global adjustment process in a world where voters and politicians choose to stay in denial. The leaders lack the courage to call for sacrifice and will not lead their countries in making the needed adjustments to their economies. Meantime, the voters prefer to cling to their present ways of living and working, however wasteful they may be. The result is, they delay critical decisions, and leave themselves vulnerable to inevitable price shocks arising from the market adjustment process. Operating this way, politicians would rather waste money and resources trying to "restore the economy to normal", a normal that was never sustainable. Stability cannot be brought back, so long as there is a huge imbalance between the savings-rich East and the debt-incumbered West, and historical exchange rates are maintained. Three Big Drivers of the price swings
In part 1, I identifiedThree big drivers
of prices and the global economy:
+ Reductions in consumption in the west: which are driving consumer prices and western wages lower and savings higher,
+ Government interference like stimulus spending: which attempts to reverse the negative impact of falling consumer spending,
+ Increased prices of essential commodities like food and energy, as savings rich countries bid for "their growing share" of the pie
These influences are war with each other, to some extent, and that is a problem. Money is being wasted on stimulus and restructuring plans that are nothing but temporary "band-aids." And these programs may be adding to the long term pain by increasing indebtedness, and maintaining exchange rate imbalances. Many investors will find themselves leaning in the wrong direction, by betting that the "old normal" can be restored by these measures, and they are leaving themselves vulnerable to the inevitable adjustments in the direction of a "new normal" - a world where the US, UK and other western countries account for a smaller share of the world's consumption. At the same time, we are approaching limits to growth, thanks to peak oil and limited water resources. We will all be fighting for pieces of a pie that has stopped growing. With cost pressures bound to increase, this is not a time to try to maintain a wasteful living arrangement. The savings-rich emerging consumers will not allow it for much longer.The Three Big Drivers, and How they drive the global economy
To get an clearer uderstanding of the three influences identified above, and how they will drive prices and the economy in the future, let's look at how they interacted in the recent past:
The big theme of 2007 and 2008 was one of the three drivers: that is, commodity buying by China, India, and other emerging countries. They bought commodities to build up their own economies, and also to use them as raw materials for goods they were manufacturing for sale to the West. Perhaps "Dr.Copper" is the best indicator of the multi-year surge in commodity prices. Sometimes called the "commodity with a PhD in economics", Copper is often used as a coincident indicator of the industrial economy. So its price rise shows how copper demand, mostly from growing emerging countries is pressing up against limitations in the supply.
Copper prices started to take off in mid-2004, from near $1.20 per pound. Within two years they had increased more that 3-fold to near $4.00 per pound in mid-2006. From there, Copper showed a 2-year oscillating pattern, as Oil prices caught up. The rise in Crude was quick, once it started. Crude also showed a near-tripling in price from just $51 at the beginning of 2007, to $146 just 19 months later in July 2008. Corn shot up too, rising also about 4x from under $1.80 in late 2005 to $7.50 a bushel in mid-2008. By summer 2008, the prices of most key commodities were near record highs.
Although it was rarely cited in the mainstream press, I see the Beijing Olympics as an important influence in the commodities story, since some Chinese companies speeded up their ordering and production prior to the event, so that they would be prepared to slowdown, or even close of their factories, when the Olympics were on. As evidence that this influence mattered, there was a big spike up in Baltic freight rates in Q2 of 2008, no doubt driven partly by aggressive imports into China. The price surge also inspired a stockpiling of commodities on the part of those (in China and elsewhere) who hoped to benefit from, or hedge against continuing price rises, which did not materialise. For example, some corporate energy users, like airlines, bought oil hedges aggressively in spring and summer 2008, to protect from a possible rise to $200, which many people had begun to forecast. Hedging these oil derivatives, put more upwards pressure on oil futures.
The inflationary surge was unsustainable, because it was being driven by temporary factors, like stockpiling and China's brief second quarter growth sprint. It was also being undermined by another one of my three "big drivers", the wobbling Western economies. By mid-2008, the restructuring needs of Western economies was becoming more apparent. Cracks were beginning to appear in the Western banking system, and in some key industries, like automobile manufacturing. Several G8 economies were tipping into recession as credit tightened. Bear Stearns needed rescuing in March, while Fannie Mae, Freddie Mac, and AIG got bailouts in the summer. But the biggest story was tightening credit, being painfully felt by individuals, small businesses, large corporations, and hedge funds as the banks that lend to them found it more difficult to get money themselves, as their credit ratings deteriorated.
Some want to blame the slide in commodities on the Lehman bankruptcy. But that did not happen until mid-September. Commodities had already peaked weeks before that. Gold was the first major commodity to peak at $1,034 in March 2008. Gold fever gave way to a seasonal drop in the late Spring, as it often does. Gold fell 24% over six weeks, before rallying again as all commodities became "hot" heading into the summer. Then Corn topped near $7.50 in June. Copper saw its highs near $3.90 at the beginning of July, and then finally WTI Crude rolled over, peaking at $146 on 14 July 2008. After that, all the commodities began sliding together, including Gold. And they were all well off their highs before the Lehmans bankruptcy.
Back in 2007, I used to hear in Hong Kong (where I live) that the bull market in Chinese stocks would go on until the Olympics began on 8 August 2008. This was clearly wrong since Chinese stocks peaked well before that in October 2007. But as a date for the end of the great bull market in commodities, it was not a bad call. Much of the Chinese economy was virtually shutdown, especially around Beijing, where many factories were actually closed a few weeks before in July to allow the air of China's capital city to clear. Perhaps that sudden slowing of Chinese production, and the resulting lower demand for commodity inputs, was the mainstraw that broke the camel's back. I watched the opening of the Olympics, wonder if price detruction in commodities like Gold was going to end. By late-August, most of the commodities were in freefall. On Friday Sept.12th, leading into the weekend before Lehman declared bankruptcy, crude oil was trading at $100, which was already 32% off its July high. Gold was down to $750 per ounce. It would make more sense to blame the price slide on the Chinese slowdown that came just before the Olympics, than on an event which did not happen until the commodities meltdown was already well underway.
No doubt, the primary reason for the commodities liquidation was the credit crunch, when banks stopped lending to each other. Interbank loans become scarce. Banks did not want to lend to their customers either, particularly to highly-geared hedge funds, whose assets were losing value day-by-day. Rarely mentioned, but important nonetheless, was a policy decision in China. In September, Chinese regulators told domestic banks to "stop interbank lending to U.S. financial institutions to prevent possible losses during the financial crisis." This story was first picked up in Hong Kong's South China Morning Post, and later reported in Reuters on September 25th. The ban on handing Chinese money to the US banks may have been imposed before it was discovered, but it coincided neatly with the upwards spike in Libor, and may have been one of its principal causes.
The chart on the left shows the 3 Month Eurodollar contract, which is structured to trade on an inverse basis, where Libor is equal to 100 minus the contract price. So a lower Eurodollar contract, means a higher interest rate. I have shown the contract all the way back to 2000. since I think rates are an important part of the big picture, of how government interference has distorted the economy, and worsened the global imbalance.
A quick look at the shorter term, three-year chart at right above should worry any thinking person. Only the massive dumping of credit into the banking system, which have driven down Libor rates to 50 b.p. or less, have succeeded in stimulating the signs of "green shoots" and stock market rallies that we are seeing. That may seem good news to some who are watching their stock accounts and home values creep higher. But it should be obvious to others, that the stimulus countries like the US and the UK have painted themselves into a tremendously vulnerable corner. It will not be easy to walk out of it, without an enormous painful adjustment. If the quick jump in Libor from 2.38% to 4.59% last year crashed the economy, then what is going to happen when rates begin to rise from the articificial and temporary 0.50% Libor of today? And what excesses of speculation, and wrongful investment are being inspired by the low rates of today. More on this later. Roots of the Crisis: Low Rates and Speculative Malinvestment
It is important to look back even further than last year's crisis, to understand the roots of the credit crisis. It was not just that subprime debt valuations began crumble on their own in 2007 0r 2008. It needs to be remembered that the assets backing those debts were losing value too. If the money had been well-invested, then there would have been cash flows to support the debts, and the debt securities would not have become impaired. The real problem was the malinvestment that happened in the first place - in things like suburban homes, overpriced condos, SUV's, and depreciating LCD TV's, and all manner of junk imported from factories in places like China. Cheap rates, easy credit, and a pattern of malinvestment - all three of these occurred together. If any of these had not happened, then the fictitious existence of 2004-7 that we created through these influences would not have happened, and there would have been no bubble to burst.
My Third Big Driver is government interference in the economy. It has been a huge factor within 2009, with the aggressive efforts of a new president. But misguided government initiatives started years earlier.
I have shown a longer period in the Eurodollar chart, going all the way back to 2000, because I want to use the same chart to trace the build-up to the 2008 crisis, and make the connection between interest rate levels and the imprudent lending in the property sector that created the bubble. The changes in Libor resulted from decisions by the Federal Reserve, and particularly its chairmen, Greenspan and Bernanke. The Fed's rate decisions illustrate how governmental interference to "fix problems" can actually make them a great deal worse. (I acknowledge that the Fed is a privately owned bank, but its actions are driven by the same clique of Washington politicians and Wall Street elites that are driving the bailout and stimulus efforts, so I think it is not wrong to identify the Fed as a principle source of governmental interference.)
Back in 2000, the US was headed towards a serious recession which might have cleaned out many of the excesses of the dotcom bubble. But it was not allowed to happen. The Eurodollar contract bottomed at 93.00 (100-93 = Libor of 7.00%) in the first half of 2000, as the SPX was peaking above SPX-1500. As stock markets fell, Fed chairman Greenspan gave into pressures from Wall Street and cut rates aggressively. By summer 2001, SPX had fallen to below 1,200 and the Eurodollar contract had responded to Greenspan's rate cuts and risen to 96.50 (ie. a Libor of 3.50%, half the rate of 15 months earlier.) A normal cyclical correction might have ensued. But 9/11 changed everything. Stocks plunged to below SPX-1000, and fears ran high in America. There was a widespread worry that the US economy would slide into a more serious recession. Greenspan responded in his customary way and cut rates even further. By mid-2002, the Eurodollar contract was at above 98.00 (with Libor of less than 2.00%) and Greenspan was well on his way to engineering the greatest housing bubble in history.
The period of falling interest rate added fuel to a budding rally in housing, which kicked off as rates fell from 7.00%. The Case-Schiller CSXR index of 10 cities rose from its base of 100 in January 2000, to 114.58, a year later, to 135.04 in mid-2002 when rates were brought down to under 2.00%. Prices kept rising at an average of 14.1% per year up to the peak of 226.26 four years later in August 2006.
The 14% per annum rise in real estate went far beyond the 2% interest rates, and was also far more than the inflation rate. It should have been obvious that a dangerous bubble was being formed, but Greenspan believed that house price could not fall, simply because he had never seen that happen in his lifetime. So he was slow in raising rates back up, and other regulators (and Congress too!) turned a blind eye to the excesses that were happening in the mortgage market.
With mortgage lending rapidly becoming a major boomtime industry, real estate maintained its upward momentum even as the Fed started pushing rates higher in 2004. By the time US house prices peaked in mid-2006, 3 month Libor was back up to 5.50%. Property prices had risen much faster than rents (which were rising at lower levels, similar to inflation) and the ability to repay the mortgages. But that didn't matter and falling rental yields did not slow the market, even though rates were rising by then. The boom gained its fuel from speculative urges, particularly from those who had not previously been able to play in the property market, because of their substandard credit standing. New borrowers could lie about their incomes, and still get money. Investors bought packaged mortgages, not because the borrowers were sound, but because they mortgaged-backed securities they were buying had been awarded fictional triple-A ratings, and so could be sold. The financial system was corrupted by greed and incompetence at every layer, and so it was able to keep a boom going purely on the speculative greed for would-be capital gains, even when the cash flows to support those investments had deteriorated. This glorious malinvestment was fueled by low rates, creative lending packages, and unbridled greed. Greenspan's Fed should have known better, but few cared when they were all making money. The smart ones got out early, and then we found that our economy was collectively holding the bag.
== ==possible sidebar
Where I pick up an explanation from an article written in October 2005 called "Lessons of the Grandparents",
China wanted this boom too...
== == Aggressive Deleveraging hit stocks and commodities
Stocks fell sharply by almost half, from SPX-1440 in May to SPX-741 in November, as Lehman Brothers collapsed, and banks panicked and stopped lending money to each other and their customers. To quote Warren Buffett, "The economy experienced cardiac arrest."
But what was that stock drop really about? A sudden mass realisation that the economy has become too reliant on debt. If the economy can grind to a halt when a single investment bank fails, doesn't that mean that we have all become too reliant on financial system and its credit? The lesson has finally been learned, and American consumers are making a sea-change in their behavior. They are beginning to save again. In only a few months, the savings rate has moved from near zero in the first half of 2008 to 6.9% of their incomes by May 2009. If Americans spent 8 years worth of income in 7 years, they will now need to spend 7 years worth of income in 8 years to get back to where they were. That will mean a big drop in consumer spending in the West, and for many years to come. The businesses that were most heavily reliant on those consumers will suffering the most, and laying off employees. Those jobs will not return, since the level of spending will be permanently reduced. If the people are to be employed again, it will have to be in new and healthy sectors of the economy which are growing. The problem is that those new areas are not so easy to identify, and may provide lower incomes. Either way, a large number of people in the West will need to downsize their living arrangements, and live on less income.
When the banks stopped lending, there was massive deleveraging, and almost everything sold off in price. That includes the commodities that have been fueling China's amazing growth. Oil fell by 76%, and copper by 69%. These commodities were at bargain prices as the year began - now here comes the one of the big drivers once again. China did what any rich person would do with a large wallet, when confronted by mouth watering bargains; they started buying. Even beyond their immediate needs. From the lows, crude oil has risen by 110%, and copper by 119%. And these commodities have been stockpiled. However, this sort of aggressive buying cannot go on forever. It is a temporary swing, fueled by the opportunity presented from last year's downswing in prices.
As Nouriel Roubini put it, in a recent mining conference in Australia, "China may have overstocked" these commodities. He now sees the risk of a slowdown, and a correction in commodity prices in the second half. He holds brighter hopes for a resumption of price increases for next year - and that is what was most commonly reported in the press. But he did warn about a price drop in the second half. So maybe the optimists are behaving with a bit too much mania now, as they push commodities back up towards their highs for the year.
This historical summary highlights the bipolar swings from the optimism of rising commodity prices to the depression of falling stock prices. It neatly encapsulates the ups and downs that I am expecting over the next year or two, and possibly longer. = Continues, on part three, where I talk about : how to invest in a world of bipolar markets
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