EP,
Any comments on the following? Remember Andy Xie was one of the few people to predict the commodities boom back in 2003.
Asia/Pacific: The Stir-fried World
Andy Xie (Hong Kong)
The global financial system is running the global economy. First, it is maximizing global growth by pushing up the currencies of high-inflation economies to contain their interest rates, which results in credit growth in a lower inflation and lower interest rate environment. Speculative capital funds the resulting current account deficit.
Second, it is keeping down the currencies of low inflation economies, pushing up their asset prices (mainly property and equity) to boost credit demand. Their current account surpluses are tending to shrink.
Third, it is pushing up commodity prices to give developing economies more consumption power. Their current account surpluses are tending to rise. They usually have resource stabilization funds and are the most effective in recycling money back into the deficit economies.
The trading strategies that affect the global economy ultimately lead to low interest rates and a flat yield curve. The biggest effect is to boost property prices, which boosts aggregate demand. The resulting stronger economy lowers perceived risks and justifies the trading strategies — i.e. such trading strategies shift economic equilibrium to a higher growth path and become self-fulfilling.
Underneath the strong economy is a property bubble. The global asset overvaluation (property, stocks, bonds, antiques, arts, gold, etc.) to GDP ratio is probably 50% above its norm, which puts this bubble at around US$20 trillion, by far the biggest to date in absolute and relative terms.
The trading strategies are essentially maximizing global growth without regard to balance of payments. Without this force, global growth maximization would be constrained by each country living within its means. From an inflation perspective, the global output gap has temporarily replaced national output gaps as the driver for inflation, which makes inflation lag growth more than in previous cycles.
Inflation is the factor most likely to end this cycle, in my view. First, the global output gap could close soon, which would cause inflation to pick up across the world. Second, the substitution between tradable and non-tradable through reallocation of the labor force may cease to work, as some economies prove unable to shift enough workers from manufacturing to service to satisfy service demand.
A financial crisis is the second most likely ending to the current cycle, in my opinion. As the current global economy floats on mountains of structured financial products, it could fall apart on its own. It could take just one incident to reverse risk appetite. And balance of payments would then become a binding constraint again. Global growth rate could revert to 3.5% from the 4.5-5% of the past three years.
Before either happens, I think that further developments benefiting the short-term profitability of high finance are likely. Self-fulfilling prophesies are the norm rather than exception in this cycle.
One main implication of the new world is that, while inflation has been tame so far, it is likely to surprise on the upside as the cycle nears an end. The investment implication is to sell bonds in all economies that have benefited from cheap imports to keep inflation down. Almost all OECD economies fall into this category.
The Globalization of Stir-frying
Stir-frying is a Chinese cooking technique. It involves turning over the cooked food in a wok again and again to minimize the use of cooking oil and make heat spread evenly in the food. The technique was developed in response to shortage.
The term has been used to describe investor behavior in stock, property and art markets in China. ‘Turning it over’ in asset markets is definitely not a response to shortage. It spreads the holding risk among as many speculators as possible in a bubble. It is like passing a hot potato around. The difference is that you touch the potato many times before it drops.
Global financial markets increasingly behave like China’s stock market. ‘Turning it over’ has become a driving force. In this game of rapid turning-over, rumors and concepts drive the market. The irony is that those who are doing this now are based mostly in Anglo-Saxon economies, not China.
The Anglo-Saxon version of ‘stir-frying’ involves generous use of derivatives. In China, investors have tended towards simple warrants to provide ‘vroom’ in a rising market. The use of sophisticated derivatives spreads risks wider than such basic Chinese stir-frying could. It makes the game last longer.
Stir-frying Commodities
Commodities have been flying in 2006. The copper price is up by 41%. In contrast, China’s copper imports fell by 19.4% and copper scrap by 5.4% in the first quarter from last year. The usual argument to square the circle is that China will have to buy later.
The average price of Brent crude price surged 42.7% last year. It is up by 25.2% this year so far. However, the US oil inventory, which used to drive oil prices, is near an all-time high.
China’s crude imports were up 3.5% while refined products fell 16.9% last year. Crude imports did rise by 25.3% in 1Q06 on a low base, but refined products fell by 1.8% from last year.
The gold price is up by 21.5% this year, following an 8.8% increase on average last year. India is normally considered the driver for the gold price. However, its imports fell by 38% in 4Q05 in response to the surging price. When 1Q06 data become available, they are likely to tell the same tale.
According to the World Gold Council, global investment demand for gold rose by 26% to 600 tons, jewelry demand by 5% to 2,736 tons, and industrial demand by 2% to 419 tons in 2005. It is quite clear in this case that investment demand (i.e., inventory demand) is the real driver.
Silver is up by 58.1% this year. Nobody has come up with a story to explain it. The race is on to see who can come up with a plausible story quickest.
To be fair, the commodity world has diversified its stories from China and India to other factors. When I talk to oil bulls, their pitch usually resembles a rap song — “Venezuela, Nigeria, Iraq, Iran!” Everyone is supposed to be terrified and pay up for oil. But, the horror story is not raising risk premiums on risky assets such as emerging market bonds. Nobody seems bothered by the inconsistency.
Lack of refining capacity is another argument that pops up as frequently as Iran. Logically, if refining capacity is the constraint, it should keep refining margins high. Why should it keep crude prices high? But who cares about logic now?
“Look, people pay up even when prices are high. Who cares about anything else?” One oil bull said to me the other day.
In the world of steel, the argument is the opposite. There is plentiful steel-making capacity. Indeed, steel prices are down from last year. But the iron ore price keeps rising. One bull told me that China has itself to blame for making too much steel.
Lack of smelting capacity and strong Chinese demand are the factors cited for the high copper price. But why are the futures prices so high? China’s demand is cyclical. As the current wave of investment in the electricity sector tapers, demand should normalize. Smelting capacity should rise in response to high profitability. There is a puzzle here too.
While arguments supporting high prices are different for different commodities and sometimes contradictory to each other, they seem to work.
But have you noticed that soft commodities are not behaving in the same way? Many have been talking in the same way about cotton, coffee, etc. After brief spikes, their prices have tended to reverse.
What is occurring is that commodities have become chips in financial markets for speculators to gamble. Speculation works if: (1) the negative carry from the yield curve and warehousing cost is low; (2) there are enough speculators to keep prices high for an extended period; and (3) somebody will pay up regardless of high prices. China is touted as the usual victim.
Financial innovations such as exchange-traded funds (ETFs) have made speculating in commodities accessible to retail investors. ETFs, for example, hold copper more than half of the annual growth in global demand. Financial investment in the oil market could be twice as much as China’s annual imports.
Soft commodities cannot join the party because there is substantial negative carry from buying futures. Soft commodities are bulky and perishable, and very costly to warehouse. Regardless of how many bulls try to talk them up, that part of the commodity universe is unlikely to respond.
Stir-frying Emerging Economies
The risk premium on emerging market (EM) dollar debt has collapsed. There is virtually no juice left there. The new game is to buy local currency bonds for higher yield. This trade has the advantage of causing the EM currencies to rise, making the trade more profitable.
This trade can last if it is good for EM economies. In the case of high-inflation economies, it can be. A stronger currency can cause inflation to ease, justifying lower interest rates. Lower interest rates increase property and stock prices, increasing credit demand and boosting the economy. Strong credit growth can lead to current account deficits. But, the carry trades already provide the requisite capital.
Brazil, for example, is a good candidate for this trade to work. Its current account is 1.4% of GDP in surplus. Its inflation is already in single digits due to the appreciation of its currency by one-third in the past three years. Its real interest rate is over 10%. This country is a juicy target for carry trades, in my view. It could really get going when its credit cycle turns up.
India is already advanced in this sort of dynamic. The foreign capital inflow is mainly into its stock market due to the government restrictions on foreign ownership of its bonds. Its stock and property markets have nearly tripled in the past three years. Its current account deficit is already running at 4% of GDP and its credit is growing at over 30%.
The market is already familiar with the borrow-and-spend Anglo-Saxon economies. Global finance is trying to nurture the same habit in as many developing economies as possible.
Global finance is essentially removing capital as a constraint for EM economies to maximize their growth. The method of achieving this is to decrease risk premiums and increase asset prices.
The Proliferation of Self-fulfilling Prophesies
Taking on more risk is profitable if it leads to a virtuous cycle for a while. In the case of Brazil, for example, it could be that a large number of foreign investors are able to push up its currency by another third, and cut its inflation and interest rates by half. That could be enough to create a credit cycle there. Then, once the economy accelerated, asset markets would be likely to follow, strengthening the credit cycle.
The key to the success of self-fulfilling prophesies is herd mentality. When a large number of speculators move in the same direction, they can shift an economy such as Brazil from one equilibrium to another. Without the proliferation of hedge funds and proprietary trading on Wall Street, self-fulfilling prophecies would be few. In today’s world, potential self-fulfilling prophecies tend to happen, as long as they are good for the profit of the institutions behind such trades.
The higher global growth due to financial speculation makes the economic pie bigger. The financial sector is taking the lion’s share of the growth. The earnings growth in this cycle is mostly at financial institutions and commodity companies. Individuals that earn ‘big bucks’ are usually associated with high finance.
Inflation Turns Virtuous Cycles into Vicious Ones
When it becomes profitable for speculators to create a vicious cycle, they will. For an economy, that day happens when the credit cycle is advanced — i.e., businesses and households are already stuffed with debt, and the current account deficit is large. Speculators can push down the currency, which triggers interest rates to rise and the economy to tank, which in turn triggers further currency weakness. As long as its currency declines faster than its interest rate rises, the speculative attack is profitable.
Some peripheral economies such as New Zealand and Iceland may have fallen into this category already. The larger economies such as Australia and the US are not yet there. It would take too much money to create self-fulfilling vicious cycles for them at the moment.
The emergence of inflation will likely be the tipping point, in my view. Global inflation bottomed in 2002 and has doubled since. The level is still low and much of the increase can be blamed on energy. While I do not see 1970s-style high inflation, I do expect inflation normalization.
The two deflationary sources in the past ten years have been the mushrooming number of surplus workers from China’s state enterprise reforms and the decline of Japan’s property market. Both are normalizing.
China’s labor market is still trying to absorb rural surplus labor. However, the SoE surplus labor has been mostly absorbed in this cycle. China can afford to improve working conditions without worrying about losing export market share. Increasing minimum wages and worker benefits (e.g., healthcare and pensions) is a lasting trend.
Japan’s property market has at stopped its decline of the past decade. This has given Japanese households more confidence to consume. Japan’s consumption levels are likely to rise significantly in response to this turnaround in the property market.
When inflation keeps surprising on the upside, albeit gradually, it will decrease demand for money. That will push up bond yields and steepen the yield curve. I believe that we are at the beginning of a major bear market for bonds. Moreover, as globalization has made all the bond markets correlated, there is no hiding place for bond investors.
When the yield curve steepens sharply, it will increase carry costs for commodity speculators. That should be the point at which the commodity bubble bursts. I believe that this day of reckoning is likely to be in 2006 rather than years away |
