Economic Warfare

by Dan Denning

This week began with continuing evidence that the bull markets in energy, raw materials, and China are stronger and more durable that your average cyclical bull market. That’s because they’re not your average cyclical bull market. In fact, they are quite the opposite.

In a recent meeting with colleagues back in Baltimore I noticed how often the word “war” kept coming up. Of course, I was the one who kept using it. A war over oil. A war over water. A trade war over food and grains. You’re starting to see the economic equivalent of war (total economic warfare, as I’ve called it) for one simple reason: more than ever before, people are competing for the same scarce resources.

This competition is what drives bull markets across the board in commodities, in emerging markets, and in Asia. Holding true with the spirit of any competition is the end result of winners and losers. And if the winners are the investors who identify the right themes, the losers are the investors who stick with the old themes.

Everyone is probably tired of hearing that point by now; however, it is relevant enough to stress again, even if it just to prevent itchy fingers from calling a broker and saying “buy.” American stocks are in a long-term bear market. You can chase the rallies, although I recommend doing so through options on index and exchange traded funds and only if you can afford to lose the money.

But a better long-term strategy is to identify where the bull markets of the future are now and where they are going to be in the future. Then invest in them regardless of the institutional buy-and-hold, the mutual fund bias of the entire investment industry (excluding certain newsletters, of course).

I previously mentioned a deep-seated bull market in energy. Energy stocks keep rising because energy is both in great demand and tight supply. The demand, despite what some pundits are saying, is still being driven by China. China is consuming raw materials at a ferocious rate. And, after all, it takes energy to keep factories running and construction sites humming.

During my visit to China, I was shocked at their poor air quality. Turns out it wasn’t a seasonal phenomenon. For example, Hong Kong’s air pollution index hit a record high earlier this week. There are now over 160 days a year when visibility in Hong Kong is less than five miles. According to a Reuters story by Katie Hung, one day in August of this year, visibility in Hong Kong harbor fell to less than 500 yards (there were eight collisions in the harbor that day.)

The culprits are factories in Shenzhen. But don’t expect poor air quality to slow down Chinese demand for raw materials. For example, a recent Goldman Sachs report states that iron ore prices may increase to $28.53 a ton due to rising Chinese demand.

This all continues to validate our strategy of China profits without the China risk, namely, buying the Western companies doing business with China and taking a pass at speculating on U.S. listed shares of Chinese companies. Why?

Cherry-picking the winning Chinese companies on U.S. markets is a gamble. Although you can make money, you can also get burned when white-hot speculative demand gives way to misplaced skepticism, as it did earlier this year.

The fundamental economic story in China – over one hundred million rural farmers migrating to the urban coast – yields some obvious investment strategies. For example, BPH Billiton (BHP) is up a modest three percent from where it was in March. But you’d be hard pressed to find a better China-proxy than BHP.

BHP knows the demand for raw materials in Asia is a multi-year boom. Earlier this month it announced plans to increase it’s metallurgical-coal production in the next ten years. It’s going to cost the company over two billion, not chump change. But then, the profits won’t be either.

Metallurgical-coal is the kind of coal that is converted to coke for manufacturing steel. Anyone, or any country, that wants to produce more steel needs more metallurgical coal. BHP happens to be the world’s largest supplier of sea borne metallurgical coal (it produces about 58 million metric tons today.)

With official estimates that Chinese demand for steel is expected to grow by 20 million tons a year for the next five years, the Chinese are going to need a lot of metallurgical coal and iron ore. BHP, shipping from Australia, is in the right place at the right time.

Risks? A Chinese collapse? A war over Taiwan? A banking sector debacle? An aging China with a healthcare crisis and no way to pay for 200 million hard-used seniors over 65? Any of these situations are possible.

China faces an enormous test, the likes of which is new in history. They must transition hundreds of millions of people from subsistence-level; labor-intensive farming, and move them to cities that already have 15 million inhabitants, and have these rural farmers undertake labor-intensive manufacturing.

It’s a mass migration no government could possible conduct. However, one way or another, the market will have to manage it. The market is not a school-crossing officer or social worker. It does not wait to make sure every last person keeps up. In other words, China’s transition is likely to be volatile, and in human terms, awfully difficult to muddle through for the old, infirm, and those without savings or a family network.

Then again, China has 5,000 years of Confucian and Taoist teachings in its cultural DNA. Those native institutions of social organization may help it through what would otherwise be a demographic catastrophe.