Posts Tagged ‘Commodities’

Will there be a commodity price crash?

Thursday, December 3rd, 2009

Remember, back in January 2007, in Analysing recent falls in oil prices?real vs investment demand, we discussed about the difference between investment and real demand for a commodity,

What makes up the demand for oil? There are basically two types of demand for oil: (1) The physical demand where the real side of the economy uses for its everyday needs and (2) The investment demand where the financial side of the economy shifts the money here and there from one asset class to the other.

Lately, we are asking ourselves the same question for the broader range of commodities, particularly base metals. In particular, we draw your attention to this news article,

London Metals Exchange (LME) inventories for most metals have been rising strongly of late. For example, aluminium LME inventories are 75 per cent higher than the prior 20 year high set in May 1994. Nickel inventories are only 6 per cent below the 20 year high set around the same time. Zinc inventories have risen six fold since the start of the subprime crisis in September 2007. Lead inventories are up five-fold over the same period. While not at a record, copper inventories have increased for 20 consecutive weeks and are up 70 per cent since 30 June.

Now, this is a curious phenomenon- as prices for base metals rebounded, so did their inventory stockpile levels. This is a tell-tale sign that much of the price rise are due to the rise in investment demand instead of real demand. This investment demand is based on the same idea in Does rising house prices imply a housing shortage?,

The belief that prices will always go up forever and ever can create its own artificial demand. The insidious thing with this belief is that it is a self-fulfilling prophecy- belief leads to increased ?demand,? which in turn leads to higher prices, which reinforced the belief, which in turn leads to increased ?demand? and so on and so forth. When this happens, higher prices lead to even higher ?demand.? Such artificial demand can act as a sink-hole for whatever quantity of supply.

So, base metal prices are vulnerable to a correction. Current prices are based on the belief on the exaggerated sense of the China (and India) growth story. If this belief is ever molested by some reality check (e.g. see Is the Chinese economy a house of cards?), chances are, base metal prices will fall. There are even reports that China is pretty stocked-up with those commodities as we speak and may be going through a de-stocking phase next year. At the very least, base metal prices may be pretty subdued next year.


P.S. Check out Economy to ride a second wave of China stimulation. The Chinese are preparing to fire a second stimulus that is aimed at boosting consumption. Our interpretation is this: the Chinese government needs to flood the economy with more money, otherwise the bubble will burst. Result: more corruption, speculation and inflation.

Australia is a pawn in the international game of commodities

Thursday, July 2nd, 2009

Since the lows of March 2009, the stock market had a sustained rally. This rally, as we wrote in Are improving consumer sentiments ?good? news?, drove up consumer confidence, which in turn sparked hopes of an economic ‘recovery.’ That hope is rationalised by the belief that Chinese government’s stimulus spending will spark economic growth, which in turn drive up demand for Australian commodities. The excuse to confirm this belief is the tell-tale ‘sign’ of rising commodities prices.

The hope that rising Chinese stimulus demand (which result in rising commodity prices) will prop up the Australian economy is an optimism that is resting on quicksand.

First, how much of the recent rise in commodity prices is due to real demand? There are reports that China is importing so much iron ore that it is stockpiling them far beyond its needs. As this article opined,

Over the weekend, Michael Sainsbury wrote in The Australian that China has stockpiled a remarkable 100 million tonnes of iron ore. It’s one thing to stockpile copper, but iron ore is not easy to store in such huge quantities.

As we wrote last year in April 2008 at What if the US fall into hyperinflation?, the Chinese are probably

Slowly and quietly diversify away their US dollar reserves. Obviously, none of these countries will be doing so while talking about it with their megaphones- the US dollar will crash straight away if they act so foolishly.

Make no mistake about this. The Chinese are slowly getting rid of their US dollars by buying up assets in strategic foreign resource companies (e.g. Australia’s OZ Minerals) and physical commodities. In fact, their stockpile are satisfying far beyond their immediate needs in this current economic climate. As Marc Faber wrote in his latest market commentary,

[Chinese] exports were down (17.5% in January, 25.7% in February, and 17.1% in March), imports were down, consumer prices were down, producer prices were down, electricity consumption was down, sulfur dioxide emissions were down, water pollution was down, FDI was down, SOE profits were down, and government revenue was down.  Unemployment was undoubtedly way up.

You see what games are the Chinese playing?

Obviously, as the Chinese buys, the speculators will come in and bid up the prices further. Since the Chinese would surely want to get as much bang for their buck by not overpaying for commodities in a rising market, we expect the Chinese to play games with their large commodity stockpiles in an attempt to drive prices down and flush out the speculators. As that article continued,

In my second incident, last week the Chinese were stating in the various metal bulletins that they were going to stop strategic stockpiling of copper, aluminium and other minerals.

What about commodities that the Chinese have in abundance? As we wrote in Chinese strategic plans: control of the supply of rare earth metals, they are engaging in predatory pricing to control the supply of rare earths and therefore control the price. Then, as reported,

The United States and the European Union have filed complaints against China at the World Trade Organisation (WTO) on June 23 accusing Beijing of placing export restrictions on raw materials and partially processed raw materials critical to many industries. The nine materials cited by the United States are bauxite, coke, fluorspar, magnesium, manganese, silicon carbide, silicon metal, yellow phosphorus and zinc. The complaint accuses China of restricting exports, thus creating an unfair advantage by contributing to disparities in prices of these precursor materials inside and outside China.

As you can see, this is the game that China is playing against the United States. Australia is just a pawn in this game.

When will the next bull market for commodities arrive?

Tuesday, May 12th, 2009

Following from what we wrote at Does the major Chinese economic slowdown signify the end of the commodities boom?, what is our view on the long-term prices of commodities? To understand our view, you will have to follow our explanations below…

No doubt, the global financial markets have experienced a serious bout of price deflation for financial assets and commodities (except US Treasury bonds), especially in the second half of 2008. So far, government stimulus, bailouts, rescues and money printing are minuscule compared to the overwhelming tide of de-leveraging. It has been said that a value of US$33 trillion was wiped out from the global financial markets. So far, government interventions had only forked out at around a few trillions of dollars at most. These numbers are not meant to be accurate, so please do not quote us on that. The point is, compared to the amount of ‘wealth’ lost in the financial asset markets, government injections of money so far are just a small fraction of what was lost. If you include the coming de-leveraging by consumers in the real-economy, then the outlook for the economy and asset prices is even bleaker. Having said that, if governments continue to inject even more money unceasingly, it’s only a matter of time reflation will occur. Indeed, the current rally in commodities and stock prices shows that reflation is working for now.

So, while asset (and commodity) prices are deflating at such unprecedented speed, what will happen to real physical investments in the real economy? Such volatility in prices will make it very difficult for businesses to engage in long-term real capital investments. Using the mining executive as an example in Real economy suffers while financial markets stuff around with prices,

For example, place yourself in the position of a mining company executive today. Commodity prices are falling precipitously over the past few months as the global economy is staring into a possible depression. At the same time, you know that China and India is still going to demand lots of commodities in the very long run in the coming decades. Besides knowing these two basic facts, there will still be great uncertainty in prices as the forces of deflation and inflation battles each other for supremacy, regardless of which forces will eventually win. Will we even be using US dollars to calibrate prices in the future? Who knows? In such an indeterminate environment, it is clear that many more mining projects will have to be shelved. Some have to be abandoned. You may be scratching your head, wondering whether to push forward your project plans.

As we have already seen in various news reports, mining companies are already losing mining, closing down their mines, laying off staffs, cutting production and so on. These will result in lower productive capacity in the long-term. Since the mining business is very capital intensive, it is not easy to ramp up production at a flick of the switch.

Now, let’s turn our eyes at China. As we explained before in Does the major Chinese economic slowdown signify the end of the commodities boom?, a major economic correction for China does not spell the end of Chinese economic growth. Eventually, they will recover and consume resources hungrily again (see Example of a secular trend- commodities and the upcoming rise of a potential superpower).

The question is, when will China recover? Will it happen within our life-time? Some reckon it’s a matter of waiting a couple of years. Others are more sceptical. But let’s assume that a Chinese recovery will happen in a few years time. At the same time, with the long-term productive capacity of mining companies severely impaired by the effects of the credit crunch, what will happen to commodity prices?

Please note that this does NOT mean that commodity prices will surge soon. Rather, this credit crisis is setting the stage for a new commodity bull market from a very low base. The question is, are the current prices near the low base? Or is there more deflation in prices to come?

What is the role of real assets in preserving your wealth?

Sunday, March 22nd, 2009

In our previous article, we made a case for gold in your portfolio. Today, we will talk about the role of real assets. Before we begin, let’s get our basic definitions right.

There are broadly two types of assets:

  1. Financial asset – This is basically a piece of paper (e.g. document or certificate of title) that represents a physical asset. A financial asset has no intrinsic value because it is an intangible representation of a real asset. In the ancient past, most assets are real, physical and tangible (e.g. land, gold, silver, etc). The rise of the modern economy allows people to hold assets in conveniently intangible forms. Examples of financial assets include: money in the bank (bank liabilities), government bonds (government debt), real estate mortgages (household debt), shares (company shareholders’ funds).
  2. Real asset – This is basically tangible and physical things that provide economic value. Real assets include real monetary assets (e.g. gold, silver and other precious metals), commodities (e.g. copper, iron, oil, grain, wheat, corn, etc), real estates (e.g. properties), farms, mines, factories and (for the paranoid), guns, food, water and so on.

Interestingly, the word “credit” comes from the Latin word “cr?dere,” which has the meaning of trust (“to believe”). Therefore, the credit crisis implies a crisis in trust in the global financial system. Without trust in the financial system, the value of financial assets becomes suspect. Thus, as we said before in Fading glory of the financial services and ?wealth? management industry, the reality of this new world is that,

Thus, the global credit crisis is a return back to reality as the masses wake up their idea that all these ?wealth? are illusionary.

As far as we can see, the bull market (in real terms) on financial assets is over.

This generation is so used to the idea that the financial system can be trusted. Unfortunately, this trust had been abused and exploited. It takes a Global Financial Crisis (GFC) to expose the fact that this trust is unfounded.

Hence, the extent of your diversification towards real assets will depend on the extent of your distrust in the financial system. It will also depend on your expectation of the state’s legal and administrative infrastructure to enforce and define your rights. Obviously, weak states cannot provide such infrastructure. Therefore, if you really distrust the financial system and is very pessimistic about the global economy and geo-political situation in the days ahead, you will be switching some of your wealth into real assets.

Within real assets, you will have to allocate between (1) real monetary assets (e.g. gold and to a certain extent, silver) and (2) real non-monetary assets (e.g. commodities, land, farms, etc). How should the allocation be made?

We cannot advise you on that. But here are some pointers to take note of:

  1. Both types of real assets serve different functions. The former functions as money. The whole purpose of money is to exchange for things that you want. The latter are things that are (I) directly wanted  (e.g. commodities, food) or (II) means of production for things that are directly wanted (e.g. mines, farms, factories, timber land).
  2. Without money, the only way to get things that you want is by (a) force or by (b) bartering. Since we do not advocate violence, we will rule out (a). For (b), it is highly inefficient. That’s why human society evolved away from direct bartering to using money.
  3. The only way for you to completely do away with money is for you to be (i) completely self-sufficient or (ii) have the energy and will to engage in bartering. Otherwise, there will be a need for exchange using money.

Real non-monetary assets have their risks too. In particular, ownership of farms, lands and properties requires a functioning legal and administrative infrastructure to enforce and define your property rights. In states like Zimbabwe, the government abandoned the rule of law and enforcement of property rights by allowing war ‘veterans’ to take away the land of the white farmers. In Russia, the government nationalises the real assets of foreign businesses- no wonder investors detests Russia.

For the ultra-pessimists, a shot-gun is an asset too. But let’s hope the world wouldn’t degenerate into that.

Can China save Australia?

Tuesday, October 21st, 2008

Today, we watched SBS’s Insight program, Greed. It is basically a small forum where audiences and experts mingle together and talk about the global financial crisis. Near the end, Peter Schiff said that Australia will be fine because China’s insatiable demand for commodities will intensify as the Chinese revert to consuming their own produce. This will intensify China’s demand for Australia’s commodities, which means that Australia will be in a very safe position.

Here, we disagree with Peter Schiff. Our reasoning goes like this:

  1. Yes, in the very long run, as we said before in Example of a secular trend- commodities and the upcoming rise of a potential superpower, China’s demand for commodities will continue to grow. But the question is what happens in the interim (i.e. the short to medium term). The worst case is a epic bust for the Chinese economy (see Can China really ?de-couple? from a US recession?). The best case is a slow-down. In between these two scenarios is a major Chinese economic correction. Furthermore, we believe that this slowdown could be within the designs of the Chinese government in order to achieve their long-term plans. We will talk more about it in the coming articles.
  2. Australia has a very highly leveraged economy (see Aussie household debt not as bad as it seems?). It is this high leverage that can be the undoing of Australia’s economy in the interim.

This is a subtle point that eludes many people, including the experts. Sure, the end point may be a paradise in the mountain peak. But it is a mistake to assume that the path to the mountain peak is an upward slopping straight line. The current high leverage of the Australian economy can pull us down to a deep valley of hell in the interim. The problem is, many will not survive through the valley and for those who survive, they will be transformed (and even scarred) by the experience.

What is the meaning of ?oversold?? Part 2: Value perspective

Tuesday, September 16th, 2008

Continuing from our previous article, What is the meaning of ?oversold?? Part 1: Technical analysis perspective, we will explain the meaning of “oversold” from the value-investing perspective.

In Are some Aussie resource stocks oversold?, Pete, our regular reader commented that,

So on one hand, if demand is the same, then they are oversold, but on the other hand, if demand is decreasing, then even though they are currently oversold, the current oversold price may become a nominal price in the near future?
Eg: BHP shares may be worth $40 now, but trade at $35 or so. But due to lack of demand, by December, they may only be ‘worth’ $35. Although by then my guess is that they would be oversold even more to $30, etc.

On that note, when we say the resource stocks might be oversold, is it perhaps a bit like real-estate, where they are in fact not oversold at their current prices, but were in fact ‘over-bought’ in the first place, and are now returning to more normal levels? Perhaps they are still overbought now, just less so?

Before you read on further, please make sure that you understand the concept of value investing in our guide, Value investing for dummies. Particularly, pay attention to the first 4 articles. What follows will assume the pre-requisite understanding of these articles in the guide.

The important things to understand about the mining business is this:

  1. It’s revenue is very much dependent on the price of the commodities it sells (this is a very obvious point).
  2. It’s a price taker in general. In other words, most mining businesses do not have the market power to affect prices. The exception will be BHP and Rio Tinto as they have enough market power to affect the price of iron.
  3. It’s products (e.g. copper, zinc) is relatively very much un-differentiable from those of their competitors unlike the more traditional businesses.
  4. A mining business do not have an theoretical infinite life as some other traditional businesses. That is because ALL mines have a finite amount of the commodity that can be economically extracted. In other words, there is a finite life to every mine/oil/gas field at a specific rate of extraction.

The problem is, the future earnings of a mining company is notoriously difficult to predict. For example, these factors will affect the future earnings:

  1. Commodity prices (that’s obvious point).
  2. Cost of its input (energy is one of the major inputs and that in itself is a commodity whose prices are at the mercy of the markets).
  3. Exchange rate. Since commodity prices are denominated in US dollars, an Australian mining business’s earnings will be dependent on the exchange rate.
  4. The future quantity of the commodities it will produce. Obviously, profits rise when the sale price increases or the quantity of the produce increases. That will depend on the outcome of the development and exploration projects of the mining business.

Within point (1) i.e. the commodity price, there are many factors that will have impact on it:

  1. Underlying demand- this is the real physical demand of the commodity needed by people and nations.
  2. Investment demand or hoarding- This is the second type of demand in which the buyers and sellers do not have interests in the physical commodity. Instead, they trade the commodity in the context of money shuffling.
  3. Physical supply of the commodity- for example, as commodity prices collapses, some mines become uneconomical and close down as a result. This will reduce the supply of commodity produced. Other supply disruptions include strikes, natural disasters and so on. Or there may be new mining projects that start to produce and increase the supply to the market.

Now, let us look at point (1) and (2) that affects the price of commodities. As we explained before in Analysing recent falls in oil prices?real vs investment demand,

Now, let?s go back to oil. What makes up the demand for oil? There are basically two types of demand for oil: (1) The physical demand where the real side of the economy uses for its everyday needs and (2) The investment demand where the financial side of the economy shifts the money here and there from one asset class to the other. We need to ask ourselves the following question: Has the physical demand for oil changed? Will it change in the long run?

In today’s globalised financial system, the investment demand (we like to call it “hoarding” instead) has increasingly significant impact on prices. To complicate the issue, it is very difficult (or impossible, depending on your theoretical inclination) to sift between investment demand and physical demand as the commodity trades are made through complex web of intermediaries and relationships. As we questioned in Price fluctuations and hoarding

In today?s context, does a sudden fall in the price of a commodity (e.g. oil, iron, grain, wheat) mean that its underlying demand has suddenly fallen or its supply has suddenly increased? Obviously, the answer is no.

Let’s say that prices were originally too high because of the artificial demand from investment (or rather, hoarding). Now that the de-leveraging process (see Is the credit crisis the end of the beginning?) is under way, forced liquidation and flight from commodities from these investors/hoarders will send prices down very rapidly. As the change in physical demand/supply of commodities tend to move very much slower (relatively) than the change in investment demand/supply, we believe that this forced selling will tend to cause prices to undershoot (i.e. drop to too low) in the short term.

Now, consider this: as price falls by a lot all of a sudden (due to the sell-off by investors/hoarders), guess what will happen to the physical demand? Obviously, physical demand will increase. To a certain extent, this sell-off will result in a change in the composition of demand (between physical and investment demands). If the miners can increase production in response to increased demand, this will counteract the negative effects of falling prices on profits.

Next, as we mentioned before in Are some Aussie resource stocks oversold?, although commodity prices are falling in US dollars, it has not fallen as much in Aussie dollars.

Another consideration: as investors/hoarders sell commodities indiscriminately, the prices get undershoot. The stock market tends to overreact and price the business as if the prices of commodities will fall even further as rapidly as before. That is, it extrapolates the direction and speed of further commodity price falls too far out. It also tends to ignore the positive counteracting effects on profits as well (e.g. increased physical demand and falling Aussie exchange rate). Now, we will have a second ‘layer’ of price undershooting.

Finally, we will provide a qualifier: it is still possible for commodity prices to fall further in say, 2009 and 2010. But assuming that:

  1. Central bankers will eventually resort to money printing (see Understanding the big picture in the inflation-deflation debate) in the context of…
  2. long-run growth in Chinese and Indian demand (see Are we in a long-term inflationary environment?) and
  3. Physical demand will not collapse as much and as suddenly in the longer term as the short-term prices seem to suggests, …

… we believe that the long-run earnings of some mining businesses may not be as devastating as what their stock prices suggests. If these resource stock prices continue to plunge further, it will come to a point that it will be priced as if there will be a devastating world-wide Greater Deflationary Depression along with perpetual Chinese/Indian anarchy/revolution/chaos.

But having said that, remember that as we said before, all mines/oil/gas fields have a finite life. In the absence of potential new production from future exploration and mining development projects, a mining business will cease after an estimated number of years, after the supply of commodities are being exhausted. The implication is that if the downturn is severe and long enough, some mining businesses may not last long enough to be able to realise the value of the long-term inflationary trend of commodities. On the other hand, a mining business may choose to ‘extend’ the life of its mines by hibernating (e.g. laying off workers, entering maintenance mode and doing nothing) and waking up when commodity prices are more favourable for production.

A warning though: we are not suggesting that you go out and throw all your entire life-savings into any resource stocks now. Not all resource stocks are undervalued right now. And there is still scope for further commodity price deflation in 2009 and 2010. You have to do your homework and look at each company on a case-by-case basis. Even then, after you have decided which stock to buy, you still have to decide at what price you think it is a bargain. Even then, you still have to decide when to buy. And yet even then, this does not mean that stock prices will not fall further.

We will finish this article with an interesting quote on Jimmy Rogers (see Jim Rogers Talks About Latest Investment Activity) for you to think about:

The bull market [in oil] will not end until somebody finds a lot of oil, or unless we have worldwide economic collapse, perpetual economic collapse…

I will tell you I’ve not sold any oil. Even if it goes to $75, I don’t plan to sell any oil.

Do NOT see it as a recommendation for oil or oil stocks (note that Jimmy Rogers has an interest in oil). Rather, see it as window to his line of thinking.

Are some Aussie resource stocks oversold?

Thursday, September 11th, 2008

Over the past couple of months, we are witnessing price deflation almost all asset class, including commodities. This huge falls in commodity prices is hardly surprising. As we explained back in March 2007 in Warning: gold price can still fall significantly,

When the inevitable liquidity contraction occurs, gold price will fall as well.

18 months had gone past since that article was written. Today, we are witnessing the deflation that we had been waiting for. In this deflation, commodity prices in general are falling. It is in this context of falling commodity prices that many Australian resource stocks are falling, especially the smaller cap ones. Many of them are even falling below their 12 month lows. The market’s logic is that falling commodity prices imply falling revenue and therefore profit will fall.

Is this logic correct?

First, commodities are priced in US dollars and they are falling in terms of US dollars. Next, the Australian dollar is perceived to be a commodity currency and tend to have some correlation with commodity prices. In that context, as commodity price falls, the Australian dollar tends to follow along to a certain degree.  At this time of writing, the Australian dollar is worth of US$0.795. In just 1 ½ months, the Aussie dollar has fallen almost 20%!

Therefore, in terms of Aussie dollar, the fall in commodity prices is not as bad as it looks. However, some costs may rise may rise due to rising price of oil in terms of Aussie dollars. Everything else being equal, a falling Australian dollar is actually good for the bottom line of resource producers.

Thus, if you look at some of the massive falls in some of the smaller resource stocks, it looks that they are being oversold.

Are commodity prices at a longer-term or short-term peak?

Sunday, September 7th, 2008

In just a couple of weeks ago, we mentioned in Will deflation win? that deflation is gaining the upper hand. For those who are following us for a very long time, this development is hardly surprising. You may want to read that article to gain an understanding of what is happening.

Today, we will provide additional commentary from Marc Faber about the current situation. Recently, he was interviewed (you can see that a partial transcript of that interview here). Regarding commodities, he has this to say:

The second half of 2008 of this year would not be favourable for commodity prices… As far as I?m concerned, we peaked out in commodity prices, and later on we will have to see whether it?s a longer-term peak or a short-term peak. But we don?t know yet.

Now, let us put this comment in context. Around a couple of months ago, Marc Faber told his subscribers that commodity prices have peaked and it’s a time to sell commodities. The question is, whether this is a longer-term peak or just a short-term peak. As you can read from our earlier article, Will deflation win?, it is in this context that commodity prices are falling.

At this point in time, you may wonder why there is a feel of uncertainty in Marc Faber as he said, “whether it?s a longer-term peak or a short-term peak. To understand his doubt, let’s turn to our earlier article, China?s slowdown & its implication for Australia,

At this point, we have to ask these crucial questions: (1) Is this Chinese slowdown merely a temporary blip for the sake of the Olympics (i.e. after the Olympics, the break-neck growth will resume again)? (2) Or is it, as we explained in Will China slow down from 2009?, a chance to catch a breather for a while? (3) Or worse still, a pre-cursor to a major economic correction, as we explained in Can China really ?de-couple? from a US recession??

At one extreme, if point (1) is true, we may see a resumption of the up trend in commodity prices in the short-term. If point (2) is true, commodity price may stagnate or drift lower in the short to medium term. If point (3) is true, which is the worst case scenario, we will see a depression in commodity prices at least in the medium term. This worst case scenario can play out as a Greater Depression (that rivals the Great Depression of the 1930s).

But having said that, if point (3) (severe deflation) is to occur, the wild card will be how the governments and people choose to handle it. If they react by repealing the credit-system mechanism (see Understanding the big picture in the inflation-deflation debate for what this means), then the end game will be hyper-inflationary type of Depression (see What if the US fall into hyperinflation?).

Thus, it is in this backdrop of uncertainty that Marc Faber is advising investors to hold their fire and wait and see. Of course, all these has to be viewed in the context of the long term as we describe in Are we in a long-term inflationary environment?.

Will deflation win?

Thursday, August 21st, 2008

In just a few months ago, the talk in town was price inflation. Oil, food and commodity prices were rising, as we wrote Who is to blame for surging food and oil prices?. Today, the talk is different. US house prices have never stop falling. Gold, oil and base metals are falling. There is even talk about the end of the commodity boom, the end of the commodity “super-cycle.” Economic slowdown and recessions are the expectations of the market.

Long time readers of this publication should never be surprised to see this is happening. As we said back in March last year in Inflation or deflation first?,

If you have been with us long enough, you may have heard us mulling over both the threats of inflation and deflation on the global economy (see Spectre of deflation and Have we escaped from the dangers of inflation?). You may be wondering whether we are contradicting ourselves. How can both threats exist simultaneously? Since one is a general rising of prices and the other is the opposite, are they not mutually exclusive?

At this current phase of the financial crisis, we are experiencing deflation. It is reported that the US M3 money supply is currently “collapsing.” A falling money supply is the definition of deflation, for which the symptoms will be falling asset prices, which if prolonged enough, will lead to falling consumer prices. But before we go off to celebrate falling prices, remember that this is an evil type of deflation because it is the type that is associated with bad debts, bankruptcies, unemployment, falling income, bank runs and so on. The angelic type of deflation is caused by rising output and production, which is clearly not the case in the debt-addicted Western economies but more true for China with its government-forced savings.

When the US money supply shrinks, it increases in value relative to the other currencies as the US dollar gets repatriated back to make up for the dwindling supply of cash back in the US. That’s why we are witnessing a rally in the US dollar and a fall in commodity prices as there is a mad scramble to liquidate whatever assets to raise cash.

With the current legal powers, the US Federal Reserve is quite powerless to stop deflation (see Are we heading for a deflationary type of recession?). It can cut interest rates, but it cannot force people to borrow. Even at 2% Fed fund rate, the shrinking M3 money supply is proof that monetary policy is still tight (see What makes monetary policy ?loose? or ?tight??). Will the Fed continue to cut interest rates? It had already tried but failed a few months, which resulted in skyrocketing oil and gold prices. We doubt Ben Bernanke is going to try it again.

Meanwhile, the US Treasury is preparing open up the bottomless coffers of the US government to nationalise Freedie Mac and Fannie Mae, who are essentially insolvent. The question is, with the US budget deficit already in the red (plus the massive current account deficits), where is the money going to come from to do that? If a savings-less individual spend more than he/she earns, that individual is basically bankrupt. But for governments, it is a completely different story. They can make up for the shortfall by borrowing from the public by selling newly issued government bonds. As a last resort, it can sell the bonds to the Federal Reserve, which is called “monetising debt” or printing money.

Will it get that bad? It can if the deflation threatens to shock and awe the entire nation into a Greater Depression. By then, as we said before in A painful cleansing or pain avoidance at all cost?,

Even if Ben Bernanke is an Austrian economist, political pressure alone will do the job of forcing him to act otherwise. This is the Achilles? heel of democracy. The mob will scream at the Fed to bail them out by ?printing? money (i.e. pump liquidity into the economy in the form of cutting interest rates). Should the Fed refuse to comply, we can imagine the mob storming the Federal Reserve to demand the head of Ben Bernanke. Therefore, the Fed will have no choice but to acquiesce to the desire of the mob, whose aim is to avoid immediate pain as much as possible.

Therefore, as we advised before in Recipe for hyperinflation,

Therefore, watch what the US government is doing with the monetary ?rules? in its attempt to fight deflation.

Refuting Michael Pascoe’s optimism about continued growth

Thursday, August 7th, 2008

As we all know, there are a lot of chatters about recessions in the Australian media recently. As always the case, there are two opposing camps of perennial optimists and committed doomsayers on this recession debate. The question is, will there be a recession in Australia?

Our answer is, a recession is not a matter of if but a matter of when. In other words, we still believe that the economy moves in cycles. We do not believe there is such a thing as ever-lasting growth forever and ever till infinity. In fact, we made the first recession call back in February 2007 in Where are we in the business cycle?:

Thus, we believe that Australia (and the US as well) is at the top of the business cycle. For investors, we have to bear in mind that we are now probably at the cyclical top. If we assume that the current trend of companies? profit growth will extend indefinitely into the future, we will be in for a nasty surprise.

Due to some quirk in human nature, it is very easy to fall into turkey thinking as we explained in Failure to understand Black Swan leads to fallacious thinking. Therefore, it is in this context that we wish to refute Michael Pascoe’s punditry on recession, Doomsayers to the fore. We have been hearing his commentary for a couple of years already and know that he had made many wrong calls in the past, including the comments he made last year about the sub-prime crisis being just a “storm in a tea-cup.” Below are our refutations on his “10 reasons for why we won’t suffer a national recession any time soon”:

The Reserve Bank has lots and lots of dry powder if it needs it. As a result of bumping up interest rates, the RBA can easily cut and cut quite dramatically if it thinks the economy is slowing too fast.

This was the same argument made by Shane Oliver, the chief economist of AMP. As we refuted Oliver’s factual error in Aussie household debt not as bad as it seems?,

[Reflation] did not work in Japan! Remember Japan?s infamous zero-interest rate monetary policy as well as massive government spending fiscal policy? Yet, deflation dogged the nation for more than 16 years. There is only one way to fight deflation and that way leads to hyperinflation (see Recipe for hyperinflation).

Central to Michael Pascoe’s idea is the belief that the pushing of the short-term overnight cash-rates levers by the RBA is a kind of do-it-all snake oil that can solve every economic malaise. But as we sarcastically put forth this question in Why does the central bank (RBA) need to punish the Australian economy with rising interest rates?,

Think about this: if raising interest rates is ?bad? and cutting interest rates is ?good,? then why don?t the RBA set interest rates to zero, thereby putting the economy into a path of eternal boom (plus runaway inflation)? For those who think this is a good idea, then this article will set to let you understand why this is a bad idea.

Also, as we quoted Ludwig von Mises in How will asset-driven ?growth? eventually harm the economy?,

The economists were and are still today confronted with the superstitious belief that the scarcity of factors of production could be brushed away, either entirely or at least to some extent, by increasing the amount of money in circulation and by credit expansion.

To make a final debunking of this idea, consider this present fact: the US Federal Reserve raising interest rates in baby steps from 1% to 5.25% under Alan Greenspan. Then, in reaction to the credit crisis, it began slashing interest rates quickly to 2% today. Did that solve the core of the rot in the US economy? As we explained yesterday in Would the RBA?s rate cut do any good?, a too hasty and massive cuts in interest rates will have a very negative effect on the Australian dollar, which will not be good news for the Australian economy.

Next, Michael Pascoe said,

The RBA is ready to push money at the banks if necessary. Cutting interest rates isn’t the Governor’s only option. He also is set up to lend the banks money in exchange for mortgages if liquidity gets too tight.

Well, take a look at how the US is faring right now. This step may save the banks, but it may not be good for the Australian people. Furthermore, when debt deflation takes hold, shoving money to banks will not be enough to persuade the economy to take on more debt. As we said before in What makes monetary policy ?loose? or ?tight??,

… we have to remember that the central bank cannot control the demand for money and credit. It can supply whatever amount of them that it wants, but it cannot force business and people to desire them. Put it simply, you can lead a horse to the water, but you cannot force it to drink.

Michael Pascoe said,

We’re not the US or the UK. While a couple of our banks have ‘fessed up to big write offs and provisions, they all remain fabulously profitable and their loan book is in much better shape.

We have this to say at How safe are Australian banks?.

Next, he said,

If the unemployment starts to rise uncomfortably, the government has the option of turning off or at least turning down the big immigration inflow it’s presently encouraging. Australia’s gross immigration is running at more than 300,000 people a year.

The problem is not one of over or under employment. Rather, it is the structure (or configuration) of employment. Take a read at Overproduction or mis-configuration of production?. Also, if Australia falls into serious unemployment problems, do you think migrants will still want to come here?

Next, he said,

The Federal Government has surpluses it can turn into spending if it looks like we’re heading for the recession door. Kevin Rudd wants to be Prime Minister for a lot more than one term.

If the government spends too much money too early (by turning the budget surplus into deficit), it will not solve the problems of mal-investments and mis-configuration of production in the economy. Instead, price inflation will be the main effect. Remember, at this point in time, Australia is close to full employment.

Next, he said,

The oil price could well continue to fall, providing some needed psychological relief for consumers feeling battered by prices prices and, what’s worse, the media screaming doom and gloom about oil.

Mere short-term psychological factors will not solve the basic economic problem of scarcity of factors of production and mal-investments. Take a read at our guide, What causes economic booms and busts?.

Next, he said,

The big picture hasn’t changed – Beijing still wants to see about 200 million peasants move into the cities from subsistence existences down on the farm over about 10 years. Think about the infrastructure demands for housing and moving that many people every year and you won’t be panicked into worrying too much about the United States not buying as many Chinese-made shirts and sandshoes.

And therefore demand for our resources remains strong. The surging iron ore and coal prices are yet to fully emerge from the statistical noise and be shown as the great stimulus that the terms of trade are providing.

He got this half-right. Our views on China is summarised in Crisis and the China growth story. Let’s say China’s economic growth slowed down from around 12% to say, 5%. Relative to the ailing US economy, it is still a fantastic growth rate. But relative to itself, it is a major recession. What will this do to commodity prices in the short to medium term?

Next, he said,

Remember where our economy has come from. Yes, there has been a sharp slowdown in retail sales and credit growth – but they’re coming off very high bases. And the economy overall was running at near capacity – the RBA had to make room for the resources boom impetus.

Michael Pascoe forgot that Australia’s debt level had gone too far from the mean by a far margin. The “base” that he mentioned should be the mean, which is somewhere very much lower that where it is today.

Finally, he said,

And, finally, we do learn from our mistakes. The doomsayers tend to be so busy screaming about any potential disaster that they overlook moves buy the government and RBA to counteract them. We have to give the mandarins just a little credit – the RBA certainly doesn’t want a repeat of the last recession when it was arguably a little slow to put up rates and then far to slow in cutting them.

He forgot that Australia is not an isolated economy. It is a relatively small economy that is very much inter-linked to the global financial system and is at the mercy of global macroeconomic forces. There are some factors that is totally beyond the control of the Australian government and the RBA- for example, oil prices, credit crisis, etc.