First of all, some longer quotes
History warns that this is precisely the phase in the globalization cycle when protectionism and geopolitical instability have reared their ugly heads in the past. That was the case in three of the most recent episodes of globalization -- the integration of the Atlantic economy in the second half of the 19th century, the global integration in the first decade of the 1900s, and the globalization in the inter-war era of the 1920s. In each of these instances, the initial rush to global convergence was characterized by a sharp expansion of world trade and global capital flows that seemed unstoppable at the time. Unfortunately, there came a point in all of those periods when that convergence was undermined by mounting instabilities -- namely, ever-widening cross-border income inequalities, unstable trade and capital flows, mounting geopolitical tensions, systemic problems in banking systems, and a reaction against international migration (see Kevin H. O'Rourke and Jeffrey G. Williamson, Globalization and History, The MIT Press, 1999). Unfortunately, many of those destabilizing characteristics of the past are very much in evidence today. For a world that is currently afflicted by record imbalances, those are hardly precedents to take lightly.
The IMF has come to a similar conclusion. In a pre-released chapter of its 2005 World Economic Outlook, the IMF research staff also warns of the double-edged sword of globalization (see Chapter III, "Globalization and External Imbalances" available on www.imf.org). While the world can draw comfort from the cross-border integration of trade and capital flows for reasons noted above, the IMF stresses the increased vulnerability of a system that is so heavily dependent on favorable investor sentiment toward dollar-denominated assets. Should that sentiment be shaken by any reason -- either a loss in confidence by private portfolio investors or a shift in foreign exchange reserve management practices by foreign central banks -- then all bets would be off. In light of protectionist rumblings in Washington, I worry more about the latter possibility -- a retaliatory reduction of overweight dollar positions by Asian authorities.
(As an obvious disclaimer to those that have read my previous diaries, I am fundamentally in agreement with Roach on this one, so take my comments on the rest with the appropriate grain of salt.)
Caution: oil forecasts show signs of burn-out
The [Goldman] forecast has upped the ante in the debate that is dividing stock market strategists - how sustainable is the current surge in oil prices, and the outlook for sector stock valuations. The bulls and the bears are polarising to an unusually high degree over what is a critical call for the market.
as the positive noise over energy stocks has risen, so has the scepticism of the many bears.
They warn that any slowdown in demand - particularly from China - could see the mounting speculative positions in the crude market unwind rapidly.
Tobias Levkovich, Citigroup chief US equity strategist, expresses "growing discomfort" with the energy stock story this week. He says there has been a "tectonic shift in investor sentiment over the past year from one of speculative scoffing about high oil prices to strong conviction that they will never back off".
"Investors have forgotten that this is a highly cyclical sector," says [Merrill Lynch] strategist Richard Bernstein. His colleague David Bowers warns there was a sense of déjà vu in the current bubble. "As Mark Twain once said, history may not repeat itself but it sure does rhyme. In recent weeks we have become increasingly aware of the parallels between investor perceptions of resources [energy plus mining] today and the tech bubble of 1999/2000," he says. "When does the resources bubble burst? Possibly sooner than we all think. The current talk of a commodity Super Cycle may be premature. "
Oil prices may yet continue onwards and upwards given the tight market conditions. But there is a need for caution - one sign of a market approaching the top of a cycle is eye-catching forecasts of super growth to come.
- the oil "bears" are economy "bulls" as they expect that oil price increases are only temporary and that a smallish slowdown will allow them to fall back and allow the economy to keep on humming along nicely. They mostly expect the slowdown to happen in China anyway (where most of the demand growth is), so the whole thing should be pretty painless for hte US - except for those that invest in oil stocks or oil futures. That's why I call them bulls even though they are not necessarily talking drectly about the economy.
- an interesting thing to note, which was pointed out by Stirling Newberry in one of his recent diaries, is that volatility is at record lows, which shows that both sides are camping on their positions and waiting for events to unfold (the trade deficit number due in a small while is one of these events - I'll update the diary as needed...).
All this is happening in a context where commodities are at all-time highs, or at highs not seen in a generation - across the board.
Commodities on the climb
(FT, 10 April, behind subscription wall)
Never has there been a commodities boom like it. Not only oil but also copper and iron ore are fetching record prices, while aluminium and zinc have in the past few weeks hit their highest levels for many years. Copper has more than doubled in value in the past two years and recent long-term iron ore contracts agreed by Japanese steelmakers have been at prices nearly three-quarters higher than last year.
The gains have not been limited to metals and minerals: coffee, at five-year highs, and raw sugar are both at least 50 per cent up on last year. This is the first time that there has been such a strong synchronised rise across so many different commodities.
The FT has a hard time choosing between the optimists and the pessimists, and simply presents both cases:
Is this just a normal commodities cycle of boom followed by bust - or are there structural reasons for believing it will continue for longer than normal? The International Monetary Fund warned last week of a "permanent oil shock" that will result in sustained high oil prices over the next two decades. Citigroup has talked of a "super-cycle", characterised by an extended period of high demand for raw materials, and Goldman Sachs suggests oil prices, currently about $57 a barrel, may exceed $100 in what it terms a "super-spike".
The effects stretch well beyond the resources sector. Shipping companies are receiving record freight rates, with shipyards in South Korea, Taiwan, Japan and China fully booked for the next three years as ship owners look to expand their fleets to carry increasing volumes of oil, natural gas, iron ore, coal and grains. Port operators are expanding loading bays to keep pace with a surge in shipping traffic. Makers of heavy machinery for the mining and farming sectors are recording their best sales in years.
The popular explanation for the boom is China. With its economy growing at 9.5 per cent a year, the country has become the biggest importer of a number of commodities, such as iron ore, copper and alumina. Mr Lewis describes China's economic expansion as on a par with the industrial revolution in Britain in the 1850s, the development of the western US in the late 19th century and the industrialisation of Japan after the second world war.
"Events on this scale happen about once every 50 years, and that is what we are seeing in China," he says. Demand has also been strong from the economically resurgent US, which remains overall the world's biggest consumer of commodities. At the same time, the weak dollar has helped drive up commodity prices, nearly all of which are quoted in the US currency.
There are also huge supply constraints. At the height of the dotcom boom five years ago, miners and oil producers were deemed "old economy" and were neglected by investors who were shovelling funds into technology stocks. This meant producers failed to invest sufficiently in new mine or oil well capacity. That was compounded by underinvestment in railways, ports, pipelines and shipping fleets, leaving bottlenecks all along the supply chain. The result: supply has been unable to respond to the recent surge in demand and prices have therefore been forced sharply higher. Richard Elman, chief executive of the Hong Kong-based Noble Group, one of Asia's largest commodities traders, predicted recently that the global shortage of raw materials might not be resolved for years, because of the infrastructure bottlenecks and the long lead-time needed for new natural resources projects.
So that actually adds one more item to our long list of global unbalances: infrastructure investment has been insufficient while the dotcom party was going on. Actually, this is quite directly linked to the usual suspect - the excessive consumption of the US consumer, fuelled by debt. You either consume or invest. Using debt to consume crowds out investment even more.
This is really bad, in the sense that the under-investment is located in one area where the consequences are really bad because both demand and supply are so unelastic and a small demand/supply imbalance will lead to really higher prices, until some consumption is abandoned (which requires real economic pain) or new supply comes on line (which takes investment and time).
But, wait, back to the rosy case:
Yet physical supply and demand cannot by themselves explain the gains. Speculative money has also poured into commodities markets. Indeed, comparisons are increasingly being made between the current commodities price boom and the dotcom bubble. In a research note this month entitled "Are resources the new tech?", David Bowers, global equity strategist at Merrill Lynch, reminded clients that in 1999-2000 "everybody thought that the business cycle as a concept was dead" - adding that "in 2005 many investors have begun to behave as though the business cycle is dead". He asked rhetorically: "After all, Chinese GDP can grow at 8 per cent per annum all the way out to 2050 can't it? If the US economy slows, who cares . . . China will consume anything that the US does not consume and more, won't it?"
Kevin Norrish, head of commodities research at Barclays Capital, says the comparison with the technology boom is unfair: "The internet bubble represented a misallocation of capital where too much capital was spent on too few assets, whereas prices in the commodities market are signals that more needs to be spent on supply infrastructure."
Strong commodity prices have attracted investors, including banks, which in recent years have become owners of utilities and other energy production facilities and are hedging their exposure in derivative markets. Hedge funds have shifted vast sums of capital into commodities in the search for above average investment returns. Longer-term investors such as pension funds and mutual funds have also been allocating more to commodities as part of diversification strategies.
Stock and bond markets, which usually fall when commodities are rising, have remained relatively resilient so far. But the equity market rally has stalled in recent weeks - partly because of record oil prices - and long-term bond yields have risen on increased inflation concerns. One reason that market sentiment has in general been relaxed, however, is that many analysts continue to expect the commodity price rises to be temporary. Another is that developed-world economies are less dependent on oil than they were 25 years ago.
Despite rising oil prices, world economic growth is estimated to have hit 5 per cent last year, according to the IMF - the fastest rate since 1976, while oil prices were at their highest levels in real terms since the mid-1980s. "Nobody knows where oil prices start to hurt economic growth," says one executive with a large US hedge fund. "Last year, people thought it was over $40, then they started to think it was $50. We have passed those two levels and we are still seeing strong demand for oil, so right now the question is, 'How high does the price go before it starts destroying demand?'."
Even though oil demand has risen by more than 50 per cent over the past 30 years, its share of global gross domestic product has fallen. That reflects advances in technology, the increased dependence of western countries on services rather than manufacturing, and efficiency and productivity gains. This is one reason why economists believe the global economy is not heading towards imminent recession.
- we don't need oil as much as we used to;
- the price increases are caused by speculation (Wall street blaming Wall Street - that should make you suspicious...);
- it's just a localised bubble (strange how they are willing to call a bubble in this case but not in the case of real estate or bonds...).
"When does the resources bubble burst?" asks Merrill's Mr Bowers. "Possibly sooner than we all think. The current talk of a commodity super- cycle may be premature." He adds: "The key issue for us is what combination of Fed tightening [of US monetary policy] and higher oil prices will dampen US domestic demand growth to such an extent that it start to adversely impact the US supply-chain in Asia."
If US consumers sharply reined back their spending, Chinese manufacturing and economic growth would almost certainly suffer. In that scenario, there is little doubt that commodity prices would fall sharply.The most dramatic and diverse resources boom to date would be over. How "super" the cycle turned out to be would depend largely on how long it had lasted.
So we get to an actually more interesting distinction: the bulls are those that believe in a soft landing, whereas the bears (including myself) fear a full crash.
In the rosy scenario, interest rates will be raised just enough to slow US demand slightly; this will reduce the trade deficit and strengthen the dollar, and it will reduce slightly demand for commodities, and bring prices to lower, more reasonable levels. Growth can then continue unabated.
In the crisis scenario, interest rate increases are indeed raised (THAT point everybody agrees upon, which means that everybody agrees that the current growth is not sustainable and/or that inflation threatens); that triggers a collapse of the various asset bubbles that have been created by cheap dollars: US real estate, a lot of financial assets; US consumers stop spending brutally as the debt burden increases, available income drops, and house equity becomes unavailable; the economy crashes in a vicous circle of reduced demand and higher unemployment, as the dollar crashes amongst calls for protectionism.
So I'll give the last word to Stephen Roach again (same link)
today's increasingly integrated global economy is beset by record imbalances. The disparity between current-account deficits (mainly the United States) and surpluses (mainly Asia and, to a lesser extent, Europe) is now approaching a record 4% of world GDP. The global economy is increasingly supported by a unipolar consumption dynamic -- riding on the back of saving-short, wage-constrained, and overly-indebted American consumer. Meanwhile, job growth and unemployment remain under extraordinary pressure in the rich, developed world.
And contrary to the hopes and dreams of the ideal world of globalization, there is little sign of the long-awaited spark to domestic demand in the developing world that was supposed to provide new markets for exporters in the developed world. China -- the dynamo of the developing world -- is a case in point: Household consumption fell to a record low of 42% of Chinese GDP in 2004. Moreover, a recent study of the Asian Development Bank finds that there has been no meaningful shift to domestic-demand-led growth models in the region as a whole over the past decade (see pp 40-62 of Part I of the Asian Development Outlook 2005). Alas, a real-time status-check on globalization speaks more of imbalances and tensions than of the proverbial rising tide that lifts all boats.
And so the politicians have entered the equation. The theory of globalization counsels patience -- that it takes time for the flowers of the virtuous circle to bloom. Yet politicians have no such patience -- or at least they run out of it very quickly. Forever focused on the next election, political leaders have a very different time horizon than that provided by the evolutionary forces that may be reshaping the world, in general, and conditions in their home countries, in particular. Politicians need short-term results to withstand the howls of protest from equally myopic voters. And so they intervene in an effort to temper the impacts of global imbalances on their constituents. This then sows the seeds for trade frictions and protectionism -- always the weakest link in the ideal world of globalization.
As the political pendulum swings from trade liberalization toward trade frictions and protectionism, the possibility of a threat to sentiment needs to be taken seriously.
Two extreme scenarios bracket the wide range of global rebalancing alternatives -- the benign outcome, where the adjustments are gently spread over a long period of time, and the disruptive outcome, where the adjustments are concentrated in a relatively short period of time. Everyone favors the benign outcome. Financial markets are priced for that possibility and, not surprisingly, global policy makers express confidence in the painless fix. I fear this confidence is at odds with mounting political risks. By upping the ante on trade frictions and protectionism, politicians are shifting the odds into the danger zone of global rebalancing and the dollar crisis that might trigger. It wouldn't be the first time a rush to globalization sowed the seeds of its own demise.
Hang in for the ride.
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