Shifting Demand and Wealth

We’ve seen an increase in demand for commodities and raw materials in recent years, and in today’s essay, Dr. Marc Faber examines the factors surrounding this shift in demand.

I have great sympathy for the view that over the last 200 or so years investments in commodities performed poorly when compared to cash flow-producing assets such as stocks and bonds. I also agree that, as the team at GaveKal suggests, “every so often, we experience a massive break higher in commodity prices in which commodity indices triple in less than three years,” which is then followed by a period of poor performance.

Still, we need to ask ourselves why in the last 200 years, commodities, adjusted for inflation, were in a continuous downtrend and whether it is possible that something might have changed in the last few years, which would suggest that this downtrend is about to give way to a sustained out-performance of commodities compared to the U.S. GDP deflator.

The other question is of a more near-term nature. Should commodities, having approximately trebled in price since 2001, be sold, or should we expect far more substantial price increases? I have to confess that I have little confidence that I can answer these questions satisfactorily. Still, the following should be considered.

In the 19th century, and for most of the 20th, industrialization was concentrated in a few countries, which for simplicity we shall call the Western industrialized world. The world’s economy was at the time characterized by an abundance of land, resources, and cheap labor (certainly in the colonies and later in the developing countries) and a relatively limited supply of manufactured goods. At the same time, growth and progress was concentrated among a very small part of the global economy – either in the Western industrialized countries or among a tiny part of the population (the elite) in developing countries. In addition, there were hardly any other sectors in the economy where productivity improvements were as high as in agriculture and mining. These factors – abundance of land, labor, and resources combined with huge productivity improvements and limited demand from the then still small industrialized world – may, at least partially, explain why commodity prices failed to match consumer price increases for much of the last 200 years.

Remember that, in the first half of the 19th century, manufacturing was concentrated in England with a tiny population, while the British Empire could draw on the supply of commodities from an enormous territory. Then, in the second half of the 20th century, we experienced the socialist and communist ideology, and in India policies of self-reliance and isolation.

As a result, about half the world’s population remained largely absent as consumers of goods. (How many motorcycles and cars were there in the Soviet Union, China, India, and Vietnam 25 years ago?) But, while largely absent as consumers, people in these countries continued to produce raw materials and agricultural products. Therefore, I suspect that the removal of approximately half the world’s population as consumers through socialism and communism may have been an important factor in the poor long-term performance of commodities compared to the US GDP deflator, and other assets such as equities.

Since the breakdown of communism and socialism, the world’s economic fundamentals seem to have changed very importantly. Initially, the impact of the end of socialism was muted. Production shifted to China, but as had been the case with production shifting from the West to Japan, South Korea, and Taiwan between 1960 and 1990, rising industrial production in former communist countries largely substituted for production in the West. But over time, in countries such as China, rising investments and industrial production boosted real per capita incomes considerably and made way for a tidal wave of new consumers. In turn, these additional new consumers lifted industrial production further in order to satisfy not only the demand from their export markets but their own needs as well. Thus, industrial production and capital spending increased further. This led to additional income and employment gains, further domestic demand increases and so on (multiplier effects).

In short, the opening of China and of other countries has permanently shifted the demand curve for consumer goods and services (for example, transportation) to the right and along with it the demand for industrial commodities and, notably, energy. Now, if all goes well in India (a big if, I concede), then the demand for goods, services, and hence commodities will continue to increase very substantially for another 10 to 20 years. Indian oil consumption has just recently started to turn up. Should its demand now accelerate, as we believe it will do, it is very likely that China’s and India’s oil demand could double in the next eight years.

There are a few more points to consider. For much of the last 200 years, developing countries, where many of the world’s natural resources are located, had trade and current account deficits with the industrialized world. These deficits were a constant drag on these countries’ ability to accumulate wealth. But now, through its current account deficit, the United States is shifting around $800 billion annually to the economically emerging world.

This represents a huge shift in wealth from the rich United States to the current account surplus countries. That this shift in wealth stimulates their economies and consumption, and along with it their own demand for commodities, should be clear. (Rising domestic energy demand in Indonesia amidst falling production has turned the country into an oil net importer!) Now, for most countries a current account deficit the size of that of the United States would lead to some sort of crisis (for example, the Asian crisis of 1997) and then to a curbing of consumption. However, in the case of the United States, which is endowed with a reserve currency, trade and current account deficits are simply financed by “money printing.”

So, at least for a while (but not forever), the shift in wealth to the emerging world won’t have a negative impact on America’s economy and consumption. And, at least for now, rising demand and wealth in the rest of the world won’t be offset by declining demand and shrinking wealth in the United States. On the contrary, the global imbalances arising from “over-consumption” in the United States have brought about a global economic expansion, which, while unsustainable in the long run, is nevertheless firing on all four cylinders at present. Simply put, the excess liquidity which the Fed has created – and which it is still creating, I might add – has led to a global and synchronized economic boom. (If money were tight, the asset markets wouldn’t rise.)

The following point regarding the demand for commodities is frequently overlooked. In the developed countries, commodities account for a very small part of the economy. As a result, price increases for oil and other commodities have a very minor impact on growth rates and on consumption. However, in the commodity-producing countries (Middle East, Africa, Russia, Latin America), commodity production is an important part of the economy.

So, when commodity prices rise, their economies are, as in the case of the Middle East, turbo-charged. GDP per capita then soars and leads to a consumption and investment boom, which then increases these countries’ own demand for commodities. This is particularly true for resource-rich countries that have a large population and also explains why, in the 19th century, when agriculture was still the dominant sector in the

U.S. economy, rising grain prices led to economic booms, while declining commodity prices were associated with crises. (In recent years, financial markets have begun to have a similar impact on economic activity as agriculture had in the 19th century: rising stock markets = boom; falling stock markets = bust.)

In sum, we could argue that the emergence of a large number of new consumers in the world following the breakdown of communism, expansionary monetary policies in the United States, which have led to a rapidly growing current account deficit, the U.S. dollar’s position as a reserve currency, which enables the Fed to create an almost endless supply of dollars, and new demand from the commodity producers themselves, have all led to a significant increase in the demand for raw materials.

I am not predicting here that, from now on, the demand for commodities will always outstrip the supply. In time, new technologies (in particular, in the filed of nanotechnology), which will permit resources to be used more efficiently, and conservation will curtail demand for raw materials. But until the effects of these factors kick in, a tight balance between rising demand and existing supplies could remain in place for quite some time.

Regards,

Dr. Marc Faber
for The Daily Reckoning
May 31, 2006

Editor’s note: Dr. Marc Faber is the editor of The Gloom, Boom and Doom Report and author of Tomorrow’s Gold, one of the best investment books on the market.

Tomorrow’s Gold

Headquartered in Hong Kong for 20 years and now based in northern Thailand, Dr. Faber has long specialized in Asian markets and advised major clients seeking bargains with hidden value, unknown to the average investing public.

“If youth but knew…if age but could.”

– Henri Estienne

Nature in her majesty gives few gifts to the old. They are taken over by disease and exploited by politicians and door-to-door fundraisers, which is to say, they are plagued by parasites. But an old fellow has an edge here and there. He doesn’t have to buy long-term insurance or top quality carpeting; there’s no point in owning things that will last longer than he will. And here in London, if he looks decrepit enough, he can sometimes get a seat on the subway. In the financial world, the geezers have another advantage: they’ve been around long enough to know better.

But Nature grants her favors grudgingly, even in financial matters. There are some markets where even experience is a liability, not an asset. Adam Smith (a nom de plume) wrote about the “Great Garbage Market” of the late ‘60s on Wall Street. He noticed that shares were such bad bargains that the old timers wouldn’t buy them. Only young investors – those too naïve or too dumb to know what they were doing – would buy. So, the wily graybeards put the youngsters in charge of the funds. And the funds soared…until they crashed. After 1968, Wall Street went down, in real terms, for the next 14 years.

The Dow fell 184 points yesterday. All 30 Dow stocks were down. An investor with enough steel in his hair (if he still has any hair) would remember the period of following 1966. It looked then, as it does now, as though stocks had peaked out. But inflation was increasing, disguising what was really going on in the stock market. In nominal terms, stocks refused to go down. In 1968, the Dow even hit a new high. The youngsters came to believe that high prices were not just cyclical, but eternal. They had no experience with inflation, nor with a bear market. Of course, the markets were about to teach them a lesson. And they paid for their tuition, dearly. In real terms, stocks went down by nearly 80% until the next bull cycle began in 1982.

Generally, age and sagacity pay off in investment markets. Cycles can run for a long time. Longer than you can remain solvent, warned Lord Keynes. Maybe longer than you can remain alive, we add. Occasionally, during bubble periods particularly, what is called for is youth and witlessness; in other words, something of a redundancy. This was the case in the share market in the late ‘90s. Who but a reckless neophyte would buy a dot.com with no earnings, no business plan, and no clue? Many people did. And then, they doubled their money as the silly thing soared! Who but a callow newcomer would buy un-built condos in Florida, expecting to flip them to a greater fool before the lights went on? Many people did, and they, too, plucked money off the trees…for a while.

In fact, according to the latest figures, the young whipper-flippers in the real estate market may still be making money, but barely. According to figures from California, property prices rose 10% in the last 12 months even though there were also large increases in inventories and large decreases in sales. Sales actually fell 21.4% during the same period.

How can prices rise while buyers disappear? Well, housing markets do not clear like a trading pit in Chicago. Owners are reluctant to believe that they can’t get their prices. They hold. They wait. They hope. Inventories of unsold houses increase. Here we have yet another version of the Law of Limp. Speculators may be jacking up prices with lightning speed on their properties, but they drag their feet bringing them back down. But unlike the phony legerdemain of the centrally controlled dollar or the phony bookkeeping of federal finances, the market for housing is broad and real. It can be ignored, for a while, but it can never be denied. When sales decline and prices rise, something has to give. Either the inventory is gradually cleared away so that tighter supplies can support higher prices, or prices fall. What will happen in California? Will the youthful speculators win their bet? Will prices continue to climb? Or, will the grumpy contrarians finally be proven right?

We can’t say for sure. But we have a feeling that it is time for the kids to take a beating. As many as 40% of the houses bought last year were second houses – meant either for vacation or investment. That is a lot of houses to carry in anticipation of a quick resale. As the teaser rates on new mortgages kick out, and taxes, condo fees and other costs kick in, our guess is that our youthful speculators are going to get a kick in the pants.

The youthful speculators in the financial markets might be in for painful derrieres as well. Last week, we had to laugh out loud at our own magazine. MoneyWeek included a profile of a 32-year-old fund manager in London, said to be a “born stock picker.” At that age, he was only eight years old when the last bull market in shares and bonds began. The bear market that preceded it started six years before he was born. He was only 13 when Alan Greenspan took over at the Fed. He was only 16 when the Japanese market started to tank. And he was only 18 when George Bush the elder vomited on the Japanese prime minister.

Still, his fund has gone up nearly 150% in the last three years. And, you can’t argue with success, can you? “Investors could be forgiven for thinking that their money would be better places with a more experienced manager,” said the article, in a bit of understatement. But when we raised the issue with the staff writer, he protested: “Wait a minute, at 32-years-old, he’s probably about average age for fund managers.” Probably true. Which made us wonder: What kind of a market is this? Is it a garbage market, suitable only for kids, hustlers and mental defectives? Or, is it a serious market for serious investors?

As usual, we don’t have an answer, but we have a feeling. It’s the same one that comes to us after missing lunch, or looking at a chart of bond yields. Our feeling is that the long period of falling interest rates is over. For the next long period, which could last 20 or 30 years, money will be harder to come by; real rates will be headed higher, which will mean the bubble days may be over. The codgers may get another chance to say, “I told you so.”

[Ed. Note: No matter where the market goes, or what interest rates are doing, it’s always a safe bet that there is money to be made in natural resources and commodities. Let our own commodities guru, Kevin Kerr, show you the easiest way to get in on the natural resource market – by trading options. His system is foolproof, and his track record speaks for itself:

The Perfect Trading System for Beginners

You can also check out Kevin on CNBC’s Kudlow and Company tonight from 5:00 – 6:00 p.m. (EST).

More news from our currency counselor…

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Chuck Butler, reporting from the EverBank world-currency-trading desk in St. Louis:

“Yes, the heat is on the ECB. They made the markets wait in May for a rate hike. And now, we’re sneaking up on June. As I said yesterday, I believe the ECB will make that rate hike at their meeting on June 8, 2006.”

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And more views from Bill Bonner…

*** “Indianapolis is the 12th largest American city,” starts a note from our small cap superstar, James Boric.

“And, as a native Hoosier, it’s one I have spent quite a bit of time in over the years. But I have to tell you; I was shocked to learn it boasted the highest foreclosure rate in all of America – beating out Atlanta, Denver and Los Angeles, cities that have ballooned over the last decade.

“How could this be?

“Until the 1980s, Indy was known as the agricultural and manufacturing hub of the States. It was a working-class, blue-collar town that wasn’t afraid to get its hands dirty. Unfortunately, a lot of the manufacturing jobs (think auto, steel, pharmaceutical and major equipment) have recently been moved offshore to places like India and China. And while agriculture is still a big business in Indy, retailing and insurance have taken the place of the old manufacturing jobs.

“The problem in Indianapolis is that the blue-collar workers who lost their manufacturing jobs are not the people getting the insurance and retail jobs. (Ironically, a lot of foreigners are migrating from China, Korea and India to Indianapolis to fill those positions). And those blue-collar workers are the people feeling the pressure of the latest housing glut. After all, when they no longer have a niche to fill in the local economy they inevitably lose their jobs, go bankrupt and have to foreclose on their homes.

“It’s a vicious cycle. And it’s one that has to change in the classrooms.

“Indianapolis has long suffered ‘brain drain.’ Less than 20% of all Hoosiers have a college degree. And of those that have graduated from an Indiana college or university in the last decade, 100,000 have left the state to pursue their career (yours truly included).

“You can’t have a vibrant economy when a large portion of your most qualified workers are skipping town. Couple that with the fact there is a glut of about 19,000 homes in Indiana and it’s no wonder you have so many home foreclosures.

“The combination of weak housing prices and an uneducated and unemployed population is deadly.”

[Ed note: In his NY Times bestseller Demise of the Dollar, the lesser of your two evil editors, Addison Wiggin, surmised that the U.S. economy was being ‘hollowed out from within.’ Boric’s observations on the fate of Indianapolis’ blue-collar workers offer, at the very least, anecdotal evidence the thesis may be correct.

*** Gold fell in overseas trading on Monday, below our target price of $650. Then on Tuesday, it bounced back. Is it time to buy? Is this the best price we’re going to get? Maybe. Personally, we are waiting to see how this correction develops. If gold shoots back up, we will have missed a fine buying opportunity. If it drops down to $600, we will have an even better one. Take your chances. Buy on dips. Be happy.

*** Now, the LA Times has decided to take a look at CEO compensation. In a study of 100 large California companies, the paper found that executive compensation has risen to 6.6% of net income. Why would shareholders give so much of their money away? We venture an answer: It is late in the game and because they are not really capitalists. They are but pseudo-capitalists…capitalist wannabe’s…lumpencapitalists. They have let themselves be out-maneuvered by the managers they employ. Instead of properly exploiting the working classes, the new “mass capitalists” are being gouged by their managers. Shame.

*** It is the last day of May. We recall, for no apparent reason, Mays past. At Owensville Elementary school in Southern Maryland the little girls would put on white dresses with garlands in their hair and dance around the maypole. For those who don’t remember it, the maypole was a tall lean mast erected in the playground. Paper streamers of white and red were attached at the top. As the music played, the girls would skip around, half to the left the other half to right, weaving in an out, so that the maypole itself was finally entirely wrapped up. Then, the girls would switch directions to unbraid it. The dance has ancient roots somewhere in the British Isles, we are told. It is a pagan festival, probably celebrating the arrival of good weather (perhaps the weather was better back then) and probably accompanied by lascivious, licentious behavior that wouldn’t be tolerated today, at least not outside a private club with an admission fee.

Charming little Owensville Elementary, with its wooden walls, shingle sidings, and six tiny classrooms has vanished. During the 1960s and 1970s, education was centralized into large buildings of cement, steel and glass…with ideas and methods every bit as drab and clunky. Now, we imagine, there are metal detectors at the entrance, drug counselors, and professional educators. The maypoles are gone, too, or so we’ve heard. They were considered too retrograde, too cute, too innocent, too European. Enlightened school boards have decided to emphasize other things, things thought to be more relevant and socially redeeming, such as multiculturalism, recycling, and sex hygiene.

And now, our own take on a thought from a dead man, G.K.Chesterton:

All centralized systems mean the rule of the few; and educational machinery is among the most centralized of all systems. If the modern American really wants to know what his fathers meant by democracy, he will never learn it in school. He must make the supreme and awful sacrifice. He must get out and think.