The Catalyst!

Skyrocketing commodity prices and a bubble in real estate portend one of two things, suggest Dr. Marc Faber: a serious bout of deflation – or (gulp) rising interest rates! The latter would "kill" the consumer-led recovery predicted by American main-stream analysts.

Although we are, in fact, in a deflationary environment for manufactured goods, principally because of the rising supply of "cheap" consumer goods from China – a shift has taken place in the last two years from a bull market for equities to inflation of hard assets: residential real estate and commodities.

But whereas it would appear that housing inflation in the U.K. and the U.S. is nearing an end, commodity prices appear to have completed a multi-year base and are poised for further gains.

According to the Office of Federal Housing Enterprise Oversight, a federal agency that regulates Fannie Mae and Freddie Mac, its index of prices for single-family homes rose just 0.84% in the third quarter, compared to a rise of 2.39% in the second quarter. Moreover, with the exception of a brief period following the September 2001 terrorist attacks, this index has been rising at a rate of about 2% per quarter during the past two years as declining interest rates boosted house prices.

The report by the Office of Federal Housing actually found that home prices fell in seven states in the third quarter, which compares to price falls in only three states in the second quarter. Similarly, prices fell in 33 of the 185 metropolitan statistical areas studied, compared to 22 in the second quarter. Still, compared to a year ago, house prices rose by 6.2%, which is far higher than the annual average increase of 4.6% since 1980, but is down significantly from the recent 12-month appreciation peak of 9% recorded in the first quarter of 2001.

According to the National Association of Realtors, assembling their reports from a different set of data, home prices rose 9.8% in the 12 months ended in October 2002 – the fastest such pace since 1987.

The point remains…at present, housing prices are rising far more rapidly than incomes, a phenomenon that is obviously not sustainable in the long run, as affordability will become a problem sometime in the future – at least in areas where prices are rising by close to 20% per annum. So, whereas the flight into real estate may be nearing an end, the outlook for commodities is far more appealing. It is worth noting that despite weak global economic conditions and weak stock markets around the world, the CRB Commodity Futures Index has risen by more than 20% this year.

Commodity prices have also been in a bear market for more than 20 years and, in the age of capitalism, have never been as low as just recently.

Therefore, once fundamentals improve, prices could run away on the upside. For example, if synchronized growth around the world should materialize – a scenario about which we have serious reservations, but which is nevertheless a possibility for the short to medium term given central bankers’ propensity to print money – then obviously the demand for all commodities should improve and drive prices higher.

But more importantly, with people like Mr. Bernanke at the Fed, and actually even being a serious candidate for future chairman of the Federal Reserve Board, depreciation of the dollar and a rise in commodity prices is almost guaranteed – particularly if the economy weakens.

In fact, Bernanke’s declaration to the National Economists’ Club in Washington that "The U.S. government has a technology called a printing press," didn’t go unnoticed by the believers in sound money (gold), who subsequently pushed gold prices through an important resistance level. [Editor’s note: Gold traded to $351 at the opening in Hong Kong this morning…and has gained $36 in the last month, or roughly since Bernanke made his speech. Next stop? Who knows, but $414 is the ten-year high set on February 5, 1996…no doubt, an important level to watch. Addison.]

It is unlikely the U.S. dollar will depreciate significantly against the euro and the Japanese yen, although I am of the view that the bearish sentiment towards Europe is overdone. For one, I am a believer that the inclusion of the ten countries from Central Europe and the Mediterranean (Hungary, Poland, the Czech Republic, Slovakia, Slovenia, Lithuania, Estonia, Cyprus, and Malta) into Euroland will be highly beneficial in the long run. It will add to Euroland about 70 million people who will be only too eager to work for far lower salaries than Western Europe’s union-controlled workers. There is finally hope that the workers’ union power in Western Europe will be badly shattered and that growth prospects for this economic zone of more than 450 million people will be very exciting.

Nevertheless, it is not likely that the Euro will appreciate by more than another 10% or so against the U.S. dollar in 2003, since the beneficial impact from this European enlargement will only be felt very gradually. Equally, it is unlikely that the Japanese yen can appreciate much against the U.S. dollar, given Japan’s own economic problems.

Therefore, it is more likely that the dollar will depreciate against hard asset prices, including commodities.

Furthermore, Barry Bannister, in a very comprehensive study on commodities for Legg Mason Wood Walker Inc., shows how per capita oil consumption soared in Japan in the 1950s and 1960s, and later in South Korea from the mid-1970s up to recently.

In other words, when countries industrialize, the demand for commodities inevitably increases very rapidly. Economies that are based on manufacturing and the production of goods tend to be heavier users of industrial commodities than service-based economies. Therefore, if the rapid pace of industrialization in China continues, and picks up in India and Vietnam, then per capita demand for oil and other commodities is likely to increase very dramatically and drive all commodity prices much higher.

Lastly, commodity prices have always had a tendency to spike up during wars. With the prospects of a war in the Middle East increasing, we would not be surprised by a strong rise in commodity prices in 2003.

Thus, the following potent combination makes for a fairly convincing case that we’re on the eve of an explosive rise in commodities prices: the 20-year commodities bear market coming to an end; characters like Mr. Bernanke at the Fed; rising budget deficits not only in the U.S., but also in other industrialized countries; rising demand for commodities in Asia; and the possibility of a nasty and long-lasting conflict in the Middle East, which may in the end involve the entire region, including Saudi Arabia and Iran.

Indeed, if commodity prices do continue to rise, then interest rates will rise and bond prices will decline. Interest rates and the CRB Index are closely correlated – that is, when commodity prices rise, interest rates tend to follow, and vice versa. The recent rise in commodity prices, which so far has not been accompanied by rising interest rates, is therefore unprecedented and would suggest that, sooner or later, commodity prices will collapse once again in a serious bout of deflation…or interest rates will suddenly increase meaningfully.

I am leaning towards the latter scenario, thanks to Mr. Bernanke, who reflects very much the thinking of mainstream American policy-makers and self-promotional economists – such as CNBC’s Larry Kudlow – who continue to believe that easy money and aggressive interest rate cuts can solve all the world’s economic ills and that a new, powerful equity bull market is just around the corner!

If commodity prices are indeed at the very beginning of a secular bull market, as I believe, then such a rise will inevitably be accompanied by rising interest rates.

In fact, the very big surprise for American economic policy-makers, investors, and consumers who have just been on a borrowing spree could be that, in 2003 and 2004, interest rates will rise quite considerably and "kill" the refinancing boom that has taken place in the last couple of years as a result of rapidly declining interest rates. If interest rates were to rise, refinancing activity would inevitably slow down…and with it "consumption" growth.

Peace on Earth,

Marc Faber,
for The Daily Reckoning
December 27, 2002

P.S. I might also point out that refinancing activity could decline even if interest rates didn’t rise but just stayed at their present level, as it is likely that most homeowners have already refinanced their homes.

Editor’s note: Dr. Marc Faber, editor of The Gloom, Boom and Doom Report, has been headquartered in Hong Kong for nearly 20 years, during which time he has specialized in Asian markets. Dr. Faber is a member of Barron’s Roundtable and a major contributor to:

Strategic Investment

Where’s the surprise, we keep asking ourselves?

So far, stocks, gold, Greenspan, and the dollar have done pretty much exactly the opposite of what most people expected of them, just as we thought they would.

"Stocks almost never go down three years in a row," said the experts at the beginning of the year. But stocks went down again in 2002. With only 3 trading days left, the Dow is having its worst December in history.

Gold buyers, meanwhile, are having a good time. Gold was supposed to go nowhere – because that’s where it always goes, we were told. Nowhere was fine with us, here at the Daily Reckoning, since other investments were falling…but, as Addison pointed out in yesterday’s essay, yellow metal did even better than we expected. Gold funds have been the best performers of the year – and gold itself has done even better.

Mr. Greenspan was supposed to be hiking interest rates in 2002 in order to trim off the buds of a blossoming boom. Instead, he cut rates by 50 basis points…and then the Fed launched a massive PR campaign to convince the public that deflation posed no threat whatsoever to the economy.

"Buy…buy…buy…today," Fed governors seemed to say, "we’ll make sure prices are higher tomorrow…"

On the other hand, at the beginning of this year most sensible economists saw the threat to the dollar. The U.S. has to import 80% of the world’s available savings annually in order to keep the dollar steady. Many people noticed that this was not likely to continue.

And so the dollar fell – as expected.

What worries us is that everything seems to be going just as we thought it might. Like a man who has just had a good night at cards, we worry about what will happen to us on the way home.

Where’s the icy patch in the road? Where’s the drunken teenager? Where’s the speed trap?

"There’s a crack in everything God made," said Emerson…even in our own predictions. More tomorrow…



Eric Fry on Wall Street…

– Investors returned from the Christmas holidays in a festive, stock-buying mood, and their buying pushed the Dow more than 100 points higher shortly after the opening bell. But by late afternoon, investors’ bubbly disposition had turned as flat as a day-old glass of champagne. The Dow finished the day 15 points lower at 8,432, while the Nasdaq fell 4 to 1368.

– Gold stocks bucked the trend as the XAU Index of gold- mining stocks soared more than 4%. The yellow metal itself added $2.10 to $349.40. Gold is one hot commodity these days. The increasingly precious metal has gained ground on 10 of the last 11 trading days, and has jumped $34 in less than a month.

– The yellow metal has soared 24% this year, which means that it is only three trading days away from registering its biggest annual gain in 23 years. Maybe gold is still "real money" after all. The world’s best-known imitation, the U.S. dollar, continues its dreary slide. Yesterday the dollar fell about half a percent against the euro to 103.6 cents per euro – a new three-year low for the struggling greenback.

– "We are still very early in a major dollar sell-off," Bridgewater Associates asserts. "The U.S. needs to attract 80% of the world’s available capital just to keep the dollar stable." The job of attracting wheelbarrows full of foreign capital seems to be getting harder every day, especially because foreigners aren’t as eager to buy U.S. assets as they used to be.

– "The U.S. has been the beneficiary of a virtuous cycle of foreign investment," Bridgewater explains, "in which a strong dollar and strong financial markets led to further foreign investment in the U.S., which led to a stronger dollar and stronger financial markets. This virtuous cycle is in the process of flipping to a vicious cycle, as poor performance of U.S. assets leads to a drying up of foreign demand for them, which in turn creates a drag on U.S. assets, and this vicious cycle is only in its early phases."

– In 1990, foreign-owned assets amounted to 33% of U.S. GDP, but today they are valued at over 70% of U.S. GDP. For example, foreigners own more than 30% of the total U.S. Treasury market, along with large slugs of the corporate bond market.

– "These holdings are so big and so much larger than U.S. assets abroad," says Bridgewater, "that they are a long- term risk to U.S. financial markets…The recent slide in the dollar…indicates that the global demand to hold dollar assets is waning and falling short of the financing hurdle presented by the U.S. current account deficit…The combination of a weak dollar with rising gold and commodity prices smells like monetary inflation."

– That distinctive odor seems to be wafting through the U.S. financial markets, which is one reason why bonds are unlikely to be star performers in 2003. This year, while stock market investors suffered a third consecutive year of misery, buyers of bonds had themselves a splendid time.

– Both the 10- and 30-year bonds produced a total return greater than 12%. Not too shabby for boring old fixed- income. But the best days for the bond market are probably in the past, at least that’s the message from commodity markets. Oil has been a particularly vocal "messenger." Yesterday, oil prices surged to new two-year highs above $32 a barrel.

– Gold over $350? Oil over $30?…Hmmm…Smells like inflation.


Back in Ouzilly…

*** Consumers are expected to keep borrowing…spending…and blowing themselves up. But what’s this? The latest week shows a sharp drop in mortgage applications. One week doesn’t make a trend…but the trend has to start sooner or later, we think.

"The best for housing is probably behind us," said Sung Won Sohn of Wells Fargo.

*** "Retailers Set to Cut Post-Holiday Prices," says the LA TIMES.

"Car dealerships ratchet up end-of-the-year discounts," adds the Kansas City Star.

Inflation? What strange sort of inflation is this…where commodities’ prices rise…and manufactured items fall? Marc Faber takes a stab at an answer below…

*** A few years ago, Francis Fukayama published a much- discussed essay inspired by the collapse of communism. The triumph of democracy, peace and prosperity meant the ‘end of history,’ he argued.

Fukayama has such a talent for getting things wrong; he should have been a Wall Street strategist!

We pass this along today, dear reader – a gratuitous reflection that has little to do with your investments – merely because we happen to be thinking about it.

Fukayama misunderstands both what the collapse of communism really meant…and how history actually works.

History is an account of the madness of crowds, not the march towards democracy. In the 20th century, the world became more and more democratized…and the cost of communications decreased. Both trends headed in the same direction – towards bigger crowds, madder than ever. That is why the world’s worst wars were fought in the 20th century and not before.

Nor did the collapse of communism bring an end to these trends. The cost of telecommunications continues to drop…while life in America and elsewhere is more collectivized than ever before – and thus more subject to the madness of crowds. The means of production are no longer owned by a few rich capitalists, but by millions of small, collectivized lumpenshareholders – through mutual funds and pension funds. Health care decisions are determined not by individual patients and doctors, but by functionaries working for the U.S. government. The economy itself dances to tunes called, not by buyers and sellers with their own money at stake, but by bureaucrats at the Federal Reserve!

And foreign policy? Never before has American military policy been so entangled with so many people, places and ideas so completely foreign to so many voters. And yet, rarely has a president had so much popular support.

On every front…domestic, economic, monetary, military…never before have so many people had such a great opportunity to get together and make a monumental mess of things.

Do not weep for the death of history, dear reader; it has only just begun.

The Daily Reckoning