The Rising Liquidity Wave
The Daily Reckoning PRESENTS: During the past year, the ongoing monetary inflation, credit growth and expanding liquidity environment drove up prices in various markets. Apart from rising interest rates and unrest in the Middle East, we did not get any major negative developments on the economic front, which also helped the global markets. Puru Saxena looks forward to the year ahead to see what we can expect from the various asset classes…
THE RISING LIQUIDITY WAVE
Capital markets powered ahead in 2006. As expected, the big winners were the emerging stock markets led by Peru, Vietnam, Venezuela, China and Russia. The laggards, however, were the stock markets of the “developed” world – no surprises here. Over in the commodities arena, several base metals (zinc, copper and nickel), precious metals (silver, palladium and gold) and grains appreciated significantly.
So, how can we explain the simultaneous rise of so many uncorrelated markets?
During the past 12 months, the ongoing monetary-inflation, credit-growth and expanding liquidity environment drove up prices in various markets. Apart from rising interest rates and unrest in the Middle East, we did not get any major negative developments on the economic front, which also helped the global markets. Finally, the U.S. housing slowdown did not curb borrowing and affect consumer spending, thereby preventing a recession. So, what can we expect in 2007 from the various asset classes?
Going forward, I expect the liquidity environment to remain supportive of asset prices resulting in another good year for stocks. If my assessment is correct, emerging market equities and commodities should (once again) be the biggest beneficiaries in 2007. Even the U.S. stock market may surprise to the upside.
This is a pre-election year, and history has shown that during pre-election years, American stocks have done well. Moreover, each mid-term election year in the United States since 1950 has provided investors with an opportunity to profit from a significant rally. The current rally began in June 2006 (prior to the mid-term elections) and if historical patterns remain intact, the Dow Jones should advance strongly over the coming year.
The U.S. economy is currently undergoing a mid-cycle slowdown, and the chances of a full-blown recession are slim. Over the coming months, I expect U.S. housing to deteriorate further, but a crash is highly unlikely. In other words, I anticipate a soft-landing in the U.S. economy. For sure, the world’s largest economy has severe problems (record-high indebtedness and sky-high deficits), however other nations want to sell their merchandise to the United States and are willing to finance its deficits. As long as this continues, the U.S. economy should be able to live on borrowed time.
I am of the opinion that despite a slowing U.S. economy, growth in other parts of the world may remain unharmed. Asia is advancing at a blistering pace, Latin America has turned around and Eastern Europe is developing rapidly. In fact, the “developing” world is expected to outperform the industrialized nations in the future. Accordingly, our managed-accounts are invested in the fastest-growing regions of the world. At present, my preferred stock markets are Brazil, China, Mexico and Russia.
Over the coming year, I expect commodities to resume their bull-market and make headlines all over the world. Despite all the negative news surrounding natural resources, the fundamental factors have not changed. In fact, the recent consolidation has made commodities even more attractive. Global demand for “things” is rising, supplies are tight and monetary-inflation continues worldwide.
As China and India continue to urbanize, it is estimated that more than 150 million surplus workers from rural areas will move to cities by 2020. It is interesting to note that roughly 60% of China’s population and 70% of Indians still live in rural areas. These numbers are shockingly high when compared to a more developed Asian nation such as Korea, where over 80% of the population live in cities!
Back in 1980, over 80% of China’s population resided in rural areas (versus 60% today) and this number is expected to decline further to 40% by 2030. India is lagging in this department as its rural population has not fallen much over the past 30 years, but the downtrend is expected to accelerate in the years ahead.
I am sure you will agree that people in cities generally earn more money when compared to those in rural areas. For example, the per-capita income of rural households in China is US$510 whilst it is US$1,400 in the case of urban households.
Once the millions of Asians move to urban centers and become wealthier over the coming years, they will demand a better quality of life and all the “creature-comforts” you can possibly imagine. These people will want bigger homes, washing machines, televisions, refrigerators, motorcycles, cars and so forth. Now, unless you are a central banker and have the ability to create something out of thin air, it is safe to assume that the demand for all these goods will require an immense quantity of raw materials such as cement, steel, copper, rubber, zinc and energy.
Now that we have established the case for a sustainable rise in the demand for natural resources, let us examine the supply dynamics. Throughout the 1980’s and 1990’s, prices of commodities were caught in a vicious bear-market. The devastation was so severe that the majority of the commodity-producers did not invest in spare capacity. After all, there was no incentive to spend more money and increase supply when prices were falling sharply! So, when the demand for commodities suddenly began to rise 4-5 years ago, nobody was prepared for it. Even today, despite the surge in the prices of raw materials, spare capacity and stockpiles are extremely low.
These days there is a lot of noise about the copper “bubble.” It is my observation that asset-bubbles are usually accompanied by an oversupply of the item in question and buildup of its inventories. Yet, if you take note of the copper inventories on the London Metals Exchange, you will quickly realize that the “bubble-talk” is totally absurd! On the contrary, supply-shocks in the near future may cause inventories to diminish further as Bolivia plans to “industrialize” a river that supplies water to Chile’s Atacama Desert, thereby threatening the world’s largest copper-mining district.
I suspect copper (like many other commodities) is simply consolidating within its ongoing bull-market and its price in real (inflation-adjusted) terms is still way below its all-time high recorded in the 1970’s. Over the coming days, copper may decline somewhat more but once the correction is over, I anticipate copper to resume its uptrend. Utilize any weakness in the near future as an opportunity and consider investing in copper-mining companies that have huge reserves and cash flows.
Furthermore, it seems to me that the multi-month consolidation in precious metals is now almost complete and we are likely to see upward moves over the coming weeks. Both gold and silver have built a huge base and they have recently shown strength in the face of a strong U.S. dollar – impressive action. It is my belief that this maybe the final opportunity for investors to buy precious metals and quality mining stocks at these depressed levels – it always pays to buy when the sentiment is negative.
for The Daily Reckoning
January 31, 2007
P.S. As the central banks continue to debase their currencies through monetary inflation, precious metals and other tangible assets should appreciate significantly over the coming years – and I’m not the only one who thinks so. Resource Trader Alert’s Kevin Kerr is positive that there are still big gains to be made in the commodities and natural resource markets – see here for his full report:
Editor’s Note: Puru Saxena is the editor and publisher of Money Matters, an economic and financial publication available at www.purusaxena.com
An investment adviser based in Hong Kong, he is a regular guest on CNN, BBC World, CNBC, Bloomberg TV & Radio, NDTV, RTHK Radio 3 and writes for several newspapers and financial journals.
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Oh, where to begin!
We read the news and confront our first challenge – choosing what to laugh at first!
Consumer confidence is near a five-year high. What to make of it? We don’t know.
It must be because of the ‘savings glut’ that Ben Bernanke believes is boosting prices of assets – especially U.S. Treasury bonds – all over the world.
Ha…ha…a ‘savings glut’…what a sense of humor. Get it? All this cash and liquidity – created out of thin air – he calls ‘savings’!
Meanwhile, the Dow went up yesterday, and unless something remarkable happens today, it will end January barely higher than it began it. The ‘January Effect’ is taken seriously by some. It says that as the year’s first month goes, so go all 12 of them. Which wouldn’t be bad…stock investors would end the year about where they began it.
The big risks are ‘receding,’ says Deputy IMF chief John Lipsky. The man believes the world is in better shape now than it was a few months ago because U.S. residential real estate seems to have stabilized…and the price of oil has come down.
On both scores, it could turn out that Mr. Lipsky is wrong. Yesterday, crude oil jumped to almost $57. And in our opinion, the U.S. housing market remains in a state of suspended animation. No one is sure in which direction it will go when it comes back to life.
But that is the condition of the entire world economy. Whether it will go up or down is not apparent to anyone. What is clear is that huge amounts of liquidity have been added. As near as anyone can tell, this new liquidity – cash and credit provided by central banks and the ever-innovative financial industry – is still increasing at a record pace. And this new liquidity is what gives the financial world the impression of stability…and consumers the confidence that they currently exude.
Which brings us to our second challenge – trying to make sense of it. And we are not the only ones thinking about it. In Davos, Switzerland, the great financiers, economists, and bluffers of our time gathered to try to explain it. The aforementioned Mr. Lipsky was only one of many. All wondered about the effect of new financial instruments – trillions of dollars’ worth of them – on the stability of the world.
The Financial Times takes up an important little piece of the discussion:
“It is widely acknowledged, for example, that mathematical models of risk, which are used to stress-test derivatives, give too much weight to the low volatility of recent times. In other words, they use the recent past as a guide to predicting the future. In financial markets this is the one sense in which history is bunk, since financial shocks have a habit of coming from unexpected quarters.”
The average man – even the average economist – is cowed by the complexity of it. What exactly is the effect of a souped-up, high-tech, optimized financial world, he wonders? Do hyper-sophisticated financial instruments dreamed up by MIT Ph.Ds. in mathematics and to speculators, banks and hedge funds all over the world really disperse risk…making the foundations of the world financial system more solid? Or do they merely increase the risks overall? No one really knows.
And the longer this new Titanic Credit Expansion sails along with no major mishap, the more people settle down into their comfortable deck chairs or order more drinks at the bar. Why worry about it? Why take out insurance or check out the lifeboats? Nothing has gone wrong, so far, they say to themselves. Nothing ever will.
But the reason nothing has gone wrong so far is merely because the tide of liquidity is still in flood mode. The world is awash in moolah…dinero…dough…bread. Nothing is too absurd. Roman Abramovich, one of London’s richest men, is building a new yacht for $400 million. Blackstone has upped its bid on Equity Office Properties to $38 billion. And a property in Montana that hasn’t even been built yet will be the most expensive spec house ever put up. Tim Blixseth is putting up a house that will be sold for $155 million – a new world record, we believe. The place will be located near Bozeman at the Yellowstone Club, a private ski resort that Mr. Blixseth developed.
Pretty daring move for Mr. Blixseth. But who can lose with so much money around? So far, people who have made bad bets – whether in industry, speculation, or in private finance – couldn’t go belly up. Lenders wouldn’t let them. Except for a couple extreme cases – such as the hedge fund Amaranth – whenever speculators or homeowners began to run short, new cash and credit were offered, on new and better terms. Asset prices rose, giving them more to borrow against.
Again, the Financial Times:
“Academics such as Harry Kat of the Cass Business School at the City University in London have produced evidence that many hedge funds are, in fact, pursuing trading strategies that can be relied on to produce positive returns most of the time as compensation for a very rare negative return. They are encouraged to do this by a fee structure that does not require the fund managers to pay back their earlier profit share to investors if an extreme event strikes and wipes out the fund.
“At the same time, big financial institutions have no incentive to incorporate the potential costs and risks to the system of their own collapse in their market pricing. They prefer others to incur the costs of providing the ‘public good’ of financial stability, while under-insuring against the risk of failure and under-investing in systems to enhance financial stability.”
In other words, when the inevitable end comes…neither the hedge funds nor the big financial institutions will be able to absorb the losses.
The real test won’t come until the credit cycle turns. Then, we’ll see how good these new risk-reducing, profit-enhancing wonders really are. Then, we’ll see how many people really want a $155 million ski chalet. Then we’ll see which of the hedge funds is still hedging.
It should be interesting. Of course, we don’t want to give away the plot…but we already have a little soupcon of how it will turn out.
Chuck Butler, reporting from the EverBank world currency trading desk in St. Louis…
“I saw a report claiming that Big Ben Bernanke was hoping the ‘credibility’ that he earned in his first year would allow him to carry out his theories. Credibility? Who told him that he had built credibility?”
For the rest of this story, and for more market insights, see today’s issue of The Daily Pfennig
And more thoughts:
*** “The world isn’t pricing risk appropriately,” said Steven Rattner of the Quadrangle Group. “Investors are not being paid for the risks they’re taking.”
Mr. Rattner is almost surely right. Yesterday, you could have bought a ten-year U.S. Treasury note and gotten a yield of 4.88%. Had you bought a two-year note, you would have gotten a higher yield – 4.97%. Logically, the longer term lending should produce the higher yield. Time is the partner of risk. If you walk the earth long enough, you will surely be struck by lightning. A trip to the local bar, on the other hand, is fairly low-risk.
You’d think investors would want to be careful with their money. Instead, they seem eager to throw it away – giving fund managers a big portion of their gains…lending to borrowers who have no way to pay them back…buying stocks at record prices and property at absurd ones.
Of course, all this is subject to change…come the credit contraction.
*** Oh dear, dear reader…if all the world’s hedge fund operators, tort lawyers, politicians, headline-hogging prosecutors and world improvers were laid to end to end…how far would they reach?
We don’t know…but it sounds like a good idea.
A McKinsey report commissioned by Senator Charles Schumer and Bloomberg reports that settlements of securities class actions have been rising every year for several years. In 2005, the total bill hit $3.5 billion, a number that doesn’t include $6.2 billion in WorldCom-related settlements alone. In 2007, settlements in Enron-related suits will add about $7 billion more. All of which is causing capitalists to look at American in a new light.
It used to be that ‘political risk’ was something that caused globally minded entrepreneurs to eschew dangerous Third-World countries. Now, political risk is a major factor discouraging companies from doing business in American.
A CMR report: “Foreign companies commonly cite the U.S. enforcement system as the most important reason why they do not want to list in the U.S. market.”
The economy is getting old. Parasites are all over it.
Lawyers, regulators…Wall Street…Washington…the idea is no longer to expand production and build wealth. The idea-du-jour is simply to redistribute wealth – from the lumpen to the elite…from the old manufacturing economy to the new financial economy…and from the future to the present (by loading up future generations with debt).
George W. Bush, the Army of Heaven, Osama bin Laden – they’re all reactionaries…trying to stand in the way of the Next Big Thing…which is MONEY. Most people today don’t really care about world conquest. What they care about is getting and spending. We want money and we want it now.
According to James Oliver, almost everyone in the English speaking countries now suffers from ‘affluenza’. Have you fallen victim, too, dear reader? If you agree with the statement: “My life would be better if I owned certain things I don’t have now,” according to Oliver, you’re part of the new Money Generation.
But if you are afflicted, don’t worry too much about it. A cure is coming, whether you like it or not. Again, it’s called a Credit Contraction.