by Puru Saxena
Capital markets powered ahead in 2006. As expected, the big winners were the
emerging stock markets led by Peru, Vietnam, Venezuela, China and Russia.
The laggards, however, were the stock markets of the "developed" world - no
surprises here. Over in the commodities arena, several base metals (zinc,
copper and nickel), precious metals (silver, palladium and
gold) and grains appreciated significantly.
So, how can we explain the simultaneous rise of so many uncorrelated
markets?
During the past 12 months, the ongoing monetary- inflation, credit-growth
and expanding liquidity environment drove up prices in various markets.
Apart from rising interest rates and unrest in the Middle East, we did not
get any major negative developments on the economic front, which also helped
the global markets. Finally, the U.S. housing slowdown did not curb
borrowing and affect consumer spending, thereby preventing a recession. So,
what can we expect in 2007 from the various asset classes?
Going forward, I expect the liquidity environment to remain supportive of
asset prices resulting in another good year for stocks. If my assessment is
correct, emerging market equities and commodities should (once
again) be the biggest beneficiaries in 2007. Even the U.S. stock market may
surprise to the upside.
This is a pre-election year, and history has shown that during pre-election
years, American stocks have done well. Moreover, each mid-term election year
in the United States since 1950 has provided investors with an opportunity
to profit from a significant rally. The current rally began in June 2006
(prior to the mid-term
elections) and if historical patterns remain intact,
the Dow Jones should advance strongly over the
coming year.
The U.S. economy is currently undergoing a mid-cycle slowdown, and the
chances of a full-blown recession are slim. Over the coming months, I expect
U.S. housing to deteriorate further, but a crash is highly unlikely. In
other words, I anticipate a soft-landing in the U.S.
economy. For sure, the world's largest economy has severe problems
(record-high indebtedness and sky-high deficits), however other nations want
to sell their merchandise to the United States and are willing to finance
its deficits. As long as this continues, the U.S. economy should be able to
live on borrowed time.
I am of the opinion that despite a slowing U.S.
economy, growth in other parts of the world may remain unharmed. Asia is
advancing at a blistering pace, Latin America has turned around and Eastern
Europe is developing rapidly. In fact, the "developing" world is expected to
outperform the industrialized nations in the future. Accordingly, our
managed-accounts are invested in the fastest-growing regions of the world.
At present, my preferred stock markets are Brazil, China, Mexico and Russia.
Over the coming year, I expect commodities to resume their bull-market and
make headlines all over the world. Despite all the negative news surrounding
natural resources, the fundamental factors have not changed. In fact, the
recent consolidation has made commodities even more attractive. Global
demand for "things" is rising, supplies are tight and monetary- inflation
continues worldwide.
As China and India continue to urbanize, it is estimated that more than 150
million surplus workers from rural areas will move to cities by 2020. It is
interesting to note that roughly 60% of China's population and 70% of
Indians still live in rural areas. These numbers are shockingly high when
compared to a more developed Asian nation such as Korea, where over 80% of
the population live in cities!
Back in 1980, over 80% of China's population resided in rural areas (versus
60% today) and this number is expected to decline further to 40% by 2030.
India is lagging in this department as its rural population has not fallen
much over the past 30 years, but the downtrend is expected to accelerate in
the years ahead.
I am sure you will agree that people in cities generally earn more money
when compared to those in rural areas. For example, the per-capita income of
rural households in China is US$510 whilst it is US$1,400 in the case of
urban households.
Once the millions of Asians move to urban centres and become wealthier over
the coming years, they will demand a better quality of life and all the
"creature- comforts" you can possibly imagine. These people will want bigger
homes, washing machines, televisions, refrigerators, motorcycles, cars and
so forth. Now, unless you are a central banker and have the ability to
create something out of thin air, it is safe to assume that the demand for
all these goods will require an immense quantity of raw materials such as
cement, steel, copper, rubber, zinc and energy.
Now that we have established the case for a sustainable rise in the demand
for natural resources, let us examine the supply dynamics. Throughout the
1980's and 1990's, prices of commodities were caught in a vicious
bear-market. The devastation was so severe that the majority of the
commodity-producers did not invest in spare capacity. After all, there was
no incentive to spend more money and increase supply when prices were
falling sharply! So, when the demand for commodities suddenly began to rise
4-5 years ago, nobody was prepared for it. Even today, despite the surge in
the prices of raw materials, spare capacity and stockpiles are extremely
low.
These days there is a lot of noise about the copper "bubble." It is my
observation that asset-bubbles are usually accompanied by an oversupply of
the item in question and buildup of its inventories. Yet, if you take note
of the copper inventories on the London Metals Exchange, you will quickly
realize that the "bubble-talk" is totally absurd! On the contrary,
supply-shocks in the near future may cause inventories to diminish further
as Bolivia plans to "industrialize"
a river that supplies water to Chile's Atacama Desert,
thereby threatening the world's largest
copper-mining district.
I suspect copper (like many other commodities) is simply consolidating
within its ongoing bull-market and its price in real (inflation-adjusted)
terms is still way below its all-time high recorded in the 1970's.
Over the coming days, copper may decline somewhat more but once the
correction is over, I anticipate copper to resume its uptrend. Utilize any
weakness in the near future as an opportunity and consider investing in
copper-mining companies that have huge reserves and cash flows.
Furthermore, it seems to me that the multi-month consolidation in precious
metals is now almost complete and we are likely to see upward moves over the
coming weeks. Both gold and silver have built a huge base and they have
recently shown strength in the face of a strong U.S. dollar - impressive
action. It is my belief that this maybe the final opportunity for investors
to buy precious metals and quality mining stocks at these depressed levels -
it always pays to buy when the sentiment is negative.
Regards,
Puru Saxena
for The Daily Reckoning
How do you say 'bubble' in Mandarin? The Shanghai exchange has gained 200%
in the last 18 months. In Singapore, the stock market nearly doubled last
year.
And yesterday, the Dow hit a new record too.
And in Bozeman, Montana, it is a dash for trash.
On Blixseth!
Mr. Tim Blixseth, whom we mentioned yesterday, is building what is easily
the gaudiest cabin in the Montana woods...and perhaps the most expensive
house in the whole world.
But, for making headlines, he has plenty of competition. Everything is
soaring...
Oil rose to over $58. Gold shot up to $657. And Mr. Jim Wilson of Missouri
won a Powerball pot of $254 million.
We were thinking of all this money this morning; it is the Age of Mammon,
for sure, which is why we have our Crash Alert flag still flying. Things
don't go up this sharply without then going down sharply too - in a crash
for example.
But, don't worry, say the experts, all this new sophistication in the
financial markets - they have computers now! - makes crashes a thing of the
past.
And yet, the Financial Times report from earlier this week troubled our
sleep:
"There is now such creativity of new and very sophisticated financial
instruments . . . that we don't know fully where the risks are located,"
said Jean- Claude Trichet, head of the European Central Bank. "We are trying
to understand what is going on - but it is a big, big challenge."
If the head of the second most powerful banking cartel in the world can't
make sense of it, what hope is there for us? We don't know. But we have an
obligation to our dear readers to try. So, for the last three days we have
done nothing else...pausing only to pray and burn incense to the credit
gods.
Do all these new financial instruments really reduce risk? Or do they
increase it? First, we had to master the peculiar dialect in which this
subject is discussed. Swaps, securitized debt, alphas - you have to
understand the language of the high priests before you can enter the temple.
Then, when you get inside, you discover that the whole religion is nothing
more than hocus-pocus...
After about 20 seconds of reflection, we realized that the answer, for once,
lay not in the details, but in the generalities. The particular formula by
which a specific derivative contract is constructed only affects the
particular participants. But the phenomenon as a whole affects the entire
world financial system.
$450 trillion is a lot of money. In fact, it's nearly
15 times world GDP. What it represents is more leverage and higher asset
prices. Both make the financial world riskier.
Let's look again at how it works. The feds make money and credit available.
This reduces the cost of borrowing...and boosts up asset prices. Thereby, a
man's suburban castle rises in price, and he is able to 'take out' a little
cash, by increasing his mortgage.
This money gives him the wherewithal to buy a new car, made in Japan. The
man himself is now immediately placed in a riskier position; he owes more
money than he did before. And then comes Goldman Sachs, which borrows the
same money from the Japanese - at very low interest rates - and uses it to,
say, finance the leveraged buyout of Equity Office Properties by the
Blackstone Group. However much Equity Office Properties owed on its real
estate holdings, the new owners are sure to owe more. That's how leveraged
buyouts work; the purchase is made on credit. The effect, once again, is to
increase the risk in the system. If you own a commercial building in full,
you can sit out a downturn in the business cycle. All that happens is that
your income goes down. But if the building is leveraged, you have to pay
interest on the debt. And if the interest is high enough...and your income
falls low enough...you go broke.
Consider the aforementioned Mr. Blixseth, who is bringing more of the
world's good things to Bozeman, Montana. He is building a luxury ski chalet
that he plans to sell for $155 million. What kind of a man would be able to
buy it? Maybe someone who just got a wad of cash that didn't exist
before...someone who owned Equity Office Properties and just stuck it to a
group of investors for $38 billion! But even buying bricks, mortar, and
Italian granite countertops can be a risky proposition. The price of the
house could go down. There's a lot more risk inherent in a $155 million
house than there is in one at $155,000.
But that's not the end of it. The $155 million house can be a financial
asset too - it can be used to secure a position in stocks, bonds, or private
equity. And the debt used to acquire Equity Office Properties can also be
traded, repackaged, sliced, diced and baked in a pie. Then, it too can be
counted as an asset and placed in leveraged portfolios, passing around more
risk. And as liquidity rises, people not only make more and bigger bets, but
riskier ones. It is a classic bubble, where too much money chases too few
decent investments. As Martin Fridson points out, the lowest- rated credits
- Triple -C or below - which made up just 2% of the junk debt market in
1990, are now closer to 20%.
Still, here are the experts telling us that the financial system is actually
less risky - because these fancy new products 'disperse' risk. Besides, they
say, nothing bad has happened thus far; so, probably nothing ever will.
What do they take us for? The only reason nothing has gone wrong is.. that
nothing has gone wrong. We are living through the biggest credit expansion
in history.
When it ends, plenty will go wrong.
But will it ever come to an end? Yes, dear reader, everything does...which
is why we keep our Crash Alert fluttering on the mast...
Remind you of anything?
Runaway inflation could be next in today's unfunny re-run of the 1970s
economic catastrophe. But there are simple steps you can take to protect
yourself and your money...
And more thoughts...
*** "Personal debt levels reach a record 140% of income," says the Daily
Telegraph, speaking of the English. In 1980, the paper explained, the level
was only half as high. The Telegraph might have been speaking of almost any
country in the English-speaking world. The leading financial regulator in
the U.K., the FSA, warned yesterday that debt levels were becoming
dangerously high. Mortgage repossessions rose 65% last year. "There is a
risk that consumers could be unprepared for a weaker economic
environment...," said the FSA.
What has happened in the Anglo-Saxon economies? Several
things: first, the financial industry in these countries has been
extraordinarily innovative and aggressive - always finding new ways to lure
people into debt. Second, these economies are more closely allied with the
U.S. and the U.S dollar. The steady loss of purchasing power in the dollar
and the threat of consumer price inflation lead people to spend rather than
save. Finally, the Anglo-Saxon culture, along with the English language, has
become the imperial standard... But it is a late-stage imperial culture,
dominated by a 'get it now' emphasis on money, status and material
well-being.
*** Next week, we will have another opportunity to laugh at the rich.
Christie's and Sotheby's will auction off some incredibly trivial paintings
at incredibly high prices. A self portrait of Andy Warhol hamming it up for
a photographer is expected to bring
$3 million. Another hideous portrait by Francis Bacon should sell for a
similar amount. And there are also works by Gerhard Richter, Picasso,
Twombly, and many others.
*** The frogs have succumbed to the spirit of the age.
We're having lunch with two hard-boiled smokers later today - will they
light up despite the new ban? We'll see. The French usually have the good
sense to ignore the law; public smoking may still survive in the land of
Liberte.
"C'est la merde..." said a taxi driver. "Everything is forbidden.
Everything. I'm sick of it."
Soon, we fear, people will not be allowed to smoke in private either.
But how do the health police know the world will be a better place without
the smell of cigarette smoke? In the old days, a man sentenced to death
would get a chance to smoke a cigarette before the firing squad shot him
dead. Or, a man wheezing with a critical chest wound on the battlefield
would ask his buddies for one last smoke. The U.S. army gave out cigarettes;
it settled nerves... Our own father reported that he couldn't have waged war
in the Pacific islands without the help of the Philip Morris company.
And how could you discuss Sartre or Foucault, without cigarette smoke to
blot out the imbecilities of it? How could Marlene Dietrich have appeared so
seductive, without a cigarette dangling in her hand? Or, Humphrey
Bogart...what would he have been without smokes? Bacall might have paid no
attention to him.
Thousands of people die because of tobacco, say the meddlers. True. But how
many survive without it? It is never a question of whether...but only when.
Cigarettes have surely hastened millions to an early grave...but who
measures the good they might have done?
Who can tell, except the smokers themselves? We have never smoked a
cigarette, but we are thinking of taking it up just to find out.
The Daily Reckoning PRESENTS: Puru Saxena looks ahead in 2007 and reckons
its emerging Asia again and they'll be sucking in commodities...
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