I've been asked to comment
on the work of a few noted deflationists who are calling for a top in commodity prices here. Their argument
is pretty clear cut: Because inflation is a function of available money plus credit
(their definition), and because credit has fallen, deflation is what comes
next. When looking about for things to deflate in price, commodities are an
obvious candidate for attention because they have risen so much over the past
decade.
In this view, three things
have to be true:
1. Demand for commodities has
to fall below supply. After all, as long as demand exceeds supply, prices
will typically rise.
2. Money, including credit that
would normally be used to buy commodities, has to shrink. That's the
definition of deflation that we're analyzing here.
3. People's preference for
money has to be greater than their preference for 'things,' with commodities
being very obvious 'things.' That is, faith in money has to be there or
people will prefer to store their wealth elsewhere.
These are all just versions
of the old supply/demand argument for commodity prices, except that our
consideration also includes the important element of the Austrian economic
view of demand for money.
There are several reasons
why I think there are serious holes in each of these conditions. Enough to
warrant a healthy degree of caution in one's certainty about what 'must'
happen next to commodity prices. Full disclosure: I continue to have 75% of
my total net worth locked up in gold and silver, so I am decidedly in the
camp that does not believe the commodity surge has yet run its course.
A Technical Challenge
Before we tackle each of
those three conditions from above, let's look at the chart for the Continuous
Commodity Index (CCI) to see what it might be telling us.
First, let's examine the
period after the great bust of 2008 (a liquidity-driven event) and note that
commodities essentially rose during all of 2009 and then formed a classic
'bull flag' formation in early 2010.
![](http://www.24hgold.com/24hpmdata/articles/2011/09/img/20111208CLA16101.jpg)
It should be noted that
calls of commodity "topping" were also made at this time by several
prominent deflationists. However, a topping pattern and a bull flag are very
different beasts. So I was quite content to keep my calls for more commodity
price increases intact at this time, even though they spent six months
trending lower in this consolidating pattern, because the chart looked quite
bullish to me.
And I was watching the
near-daily Fed injections of thin-air money into the system, reading about
surging Chinese demand, and tracking our negative interest rates at the same
time -- all features that are supportive of higher commodity prices.
Note also in the above chart
that the RSI on top was in neutral territory and rising (green line above)
and that the momentum indicator (MACD) was also rising (green line below),
both of which are typically bullish patterns. None of this was at all
consistent with topping. It doesn't rule a top out, naturally, in trading and
markets anything can happen, but these are not the usual signs one expects at
a top.
Now let's expand the chart
out and see what happened next:
![](http://www.24hgold.com/24hpmdata/articles/2011/09/img/20111208CLA16102.jpg)
First, we might observe a
43% run-up in commodity prices over the next eight months following the bull
flag we just dissected. Note that it is almost uninterrupted during the
period from July 2010 to April 2011.
Second, we might ask
ourselves what sort of a pattern we currently have in the commodity index
chart. Rather eerily, because one rarely sees such a perfect repeat of
patterns, what we see is another almost identical bull flag complete with
rising RSI and MACD readings.
On the basis of these
technical readings, I would be extremely cautious in making a call for
commodities to spike down from here. Instead the chart is pretty clearly
calling for another run to the upside. Again, this might not happen, and
commodities could always fall from here, but a bet made in that direction is
fighting a pretty powerful chart.
Now let's turn to the
fundamental reasons that support the idea of a bullish commodities chart.
Condition #1: Supply Exceeds
Demand
A key component of the
deflation argument is that with credit shrinking, demand will drop, leaving excess
market supply that resolves with lower commodity prices. Housing in much of
the Western world, for example, fits this definition nicely. Too much was
built while prices ran too high, and the bursting of that bubble is now
resolving itself through lower prices.
Commodities have a long and
storied history of boom/bust/boom, with supply and demand alternately racing
past each other as the lag times for developing new supply assure too much at
some point and too little at others.
What's new in this story today
is the emergence of a couple of new economic powerhouses with billions of
citizens as new participants at the resource table.
India is one of them, and
the recent 'bad news' out of there was that the Indian economy onlygrew
at 7.7% in the most recent quarter:
Indian GDP growth slows to 7.7
August 30, 2011
India's economy grew 7.7% in
the three months from April to June, compared with the same period of 2010.
It was India's weakest
growth for six quarters, but still better than had been expected.
The manufacturing sector
grew 7.2%, an improvement from the previous quarter, butwell below the
10.6% in the second quarter of 2010.
While the 7.2% growth in the
manufacturing sector was downplayed in most articles in comparison to the
prior 10.6% growth, it is useful to remember that a 7.2% rate of growth
translates into a full doubling over just ten years' time. In other words, in
ten years, India's manufacturing sector -- the one that consumes lots and
lots of natural resources -- will be consuming twice as much of everything as
it does now.
It is this massive rate of
growth that is eating into the world's remaining resources and creating
competition for most basic natural resources.
As big as India is, and as
fast as its rate of economic expansion is, it is dwarfed by China on both
counts:
SINGAPORE/BEIJING (Reuters)
- UBS cut its 2011 and 2012 growth forecasts for China on Thursday to reflect
weaker growth prospects in developed economies, saying the central bank may
relax policy if the world's second-largest economy falters.
UBS now expects 2011 gross
domestic product growth of 9 percent, down from its earlier
projection of 9.3 percent. For 2012, it sees GDP growth of
8.3 percent, down from its previous forecast of 9 percent, it said in a
report.
(Source)
Again, while the emphasis in
this article is on weakening growth, we should also be sure to note the
absolute rate of growth here.
Global slump? What global
slump? China
is slated to grow its already huge economy by 9% this year (2011). If that
rate of growth were sustained, China would double its economy in just eight
years. Twice as much of everything would be consumed in just eight years.
When you are talking about
1.3 billion people doubling their intake of economic goods and services in
just eight years, you are talking about the fastest absolute increase in
demand placed on natural resources ever seen in world history. Faster and
faster and faster; more and more and more.
What sorts of news items
might we expect to accompany such a proposition? Perhaps some like these:
China's corn demand
mindblowing
August 17, 2011
China's struggle to meet the
growing demands of its middle class is fueling a sudden surge in
demand for corn, sending vast ripples across the U.S. farm belt and
potentially upending the grain's trade flows around the world.
China's need for corn --
which forms the basis of sweeteners, starch and alcohol as well as feed for
livestock -- was on stark display in July when the nation ordered 21
million bushels of U.S. corn in one hit, more than the U.S.
government thought the country would buy in a year.
Corn prices, which have nearly
doubled over the past year, climbed another 1% Tuesday.
China's appetite
for oil imports increases
BEIJING, Aug. 15 (UPI) -- China's
dependence on imported oil grew to 55.2 percent in the first five months of
this year up from 55 percent last year, reports state-run news
agency Xinhua, citing figures from China's Ministry of Industry and
Information Technology.
In 2009, however, China's
dependence on imported oil rose to 33 percent.
![](http://www.24hgold.com/24hpmdata/articles/2011/09/img/20111208CLA16103.jpg)
(Source)
China's Natural Gas
Consumption Climbs 32 percent
Industrial Info Resources
reports China's apparent natural consumption reached 11.1 billion cubic
meters in July 2011, an increase of 32 percent from July 2010 and
a 3 percent increase from June 2011, according to data issued by the General
Customs Administration of China (GCAC).
As consumption increased, the import volume of natural gas
also jumped from 15 percent to 25 percent over
the same time period.
Securing uranium
supplies still essential to China’s energy security
China has 14 operational
nuclear reactors and according to the World Nuclear Association, 77
more reactors are either planned or under construction with aim
toward increasing nuclear capacity to 80 GWe by 2020, 200 by 2030 and 400 GWe
by 2050.
However, the nation’s
domestic uranium resources don’t even come close to the amount needed
to fuel such an expansion. To secure uranium reserves, China has been
aggressively moving to sign supply contracts and joint venture
mining agreements as well as to purchase uranium mines overseas.
By 2020, China is expected
to account for 20 percent of global uranium demand, according to
Resource Capital Research.
There are loads of similar
articles covering China's aggressive expansion into Africa's resource plays,
energy deals across the globe, and arable land where it is available. We're
seeing exactly what you would expect from a major economy expanding like
crazy: a rapidly growing, or, shall we say, exponentially
increasing hunger
for natural resources.
Perhaps a slump in the
Western economies will suddenly flood the world with enough resources to
cause a commodity crash, but perhaps not.
A Paradigm Shift
The supply-and-demand
argument rests on the time-tested notion that with increased demand, new
supplies are brought to market. This has more or less always been true,
although astronomical prices will not get you a passenger pigeon and rising
prices seem unable to drag more giant Bluefin Tuna from the seas. The point
there is that the usual supply and demand argument falls apart in the
presence of limits.
Jeremy Grantham, who
previewed my book last fall and provided a blurb for its jacket cover, has
been all over the news lately talking about a profound structural shift in
natural resources:
Grantham concludes that the
world has undergone a permanent "paradigm shift" in which
the number of people on planet Earth has finally and permanently outstripped
the planet's ability to support us.
Specifically, Grantham says, the
phenomenon of ever-more humans using a finite supply of natural resources
cannot continue forever--and the prices of metals, hydrocarbons (oil),
and food are now beginning to reflect that.
In other words, Grantham
says, it is different this time.
Grantham believes that the
trend of the last 100 years, in which the prices of almost all major
commodities have steadily declined, is permanently over. And from here on in,
humans will be competing more--and paying more--for ever-scarcer resources.
From a societal standpoint,
the news is far worse. Grantham believes that the planet can only sustainably
support about 1.5 billion humans, versus the 7 billion on Earth right now
(heading to 10-12 billion). For all of history except the last 200
years, the human population has been controlled via the limits of the food
supply.Grantham thinks that, eventually, the same force will come into
play again.
![](http://www.24hgold.com/24hpmdata/articles/2011/09/img/20111208CLA16104.jpg)
(Source)
Instead of oil being in a
spiked-top formation ready to fall back to its prior range of $20-$30 a
barrel, Grantham argues that oil has shifted to a new price level. I have
argued the same thing, not by using price charts, but through the fundamental
analysis of oil supply in the context of Peak
Oil coupled with an understanding of the marginal cost of producing a new
barrel.
If it costs $70 - $80 to
produce a new barrel of oil, the price cannot fall much below that for very
long.
So on the first deflationist
point that supply of commodities will soon greatly exceed demand, I have to
conclude that until and unless we see China's and India's economies fall off
a cliff, the impact of bringing an additional 2.5 billion consumers to the
global buffet of natural resources will provide ample pressure to prevent a
sustained crash in prices. Perhaps we'll experience a short-term correction,
especially if the Fed is stingy with its still-unannounced QE III program,
but a long-term crash seems highly unlikely.
Condition #2: Money Plus
Credit Shrinks
The second key deflationist
assumption is that the supply of money plus credit will decrease. Central to
this argument is the idea that it's insufficient to track the money supply
alone and that it's essential to include the expansion (and/or contraction)
of credit as well. This makes sense on the surface, because credit allows
people to buy things and buying can translate into price pressures. More
credit means more buying pressure; less equals the opposite.
But I have a number of
difficulties with this view over the long-term. (Hey, credit has to be paid
back at some point, right? So it's roughly neutral over the long haul.) This
explanation is especially problematic for me when it is used in an overly
broad way by lumping all credit market debt into a single spot and then
saying, "There. Look. It's fallen. Credit is down, and that's
deflationary."
The trouble I have with this
view is that not all credit has the same impact on demand. Some credit leads
to demand that directly impacts the CPI (inflation), and some does not. When
we are talking about inflation, what most people care about is the price of
things they use or consume (cars, food, gasoline, health care, houses, etc.),
rather than financial instruments or paper assets (stocks, bonds,
derivatives, etc.)
Let's put it this way: If
you give someone a billion in dollars in credit, it matters significantly
whether they go out and buy ten thousand silos of corn or one twentieth of
the next ten-year Treasury bond auction. In the latter case, nothing much
happens to everyone else's inflationary experience, but in the former case,
the price of corn goes up. A lot.
In other words, credit
extended within and among the financial community mainly flows within and
among the paper assets of the world, while non-financial credit goes to
consumers, businesses, and governments that use the credit to buy real
things.
[Note: One
aspect of financial credit takes us to the world of shadow banking, where
financial institutions and purely financially oriented participants buy and
trade financial instruments generally just within and among themselves, often
with tremendous leverage.]
Whether credit-default swaps
(CDS), traded within and among the shadowy world of purely financially
motivated entities, are trending up or down in price has almost zero impact
on the price of molybdenum or corn. Therefore it is important for us to
separate credit into its financial and non-financial components.
On this basis, if we look at
total credit market debt broken out into its two main components (financial
and non-financial), we see that instead of credit falling in general, it has
fallen only in the financial world, but has climbed by an amount almost
exactly offsetting it in the non-financial sectors:
![](http://www.24hgold.com/24hpmdata/articles/2011/09/img/20111208CLA16105.jpg)
Yes, financial-sector debt
has fallen by $3 trillion, and that is a drag on total credit
market debt, but as explained above, we wouldn't expect this to have much of
an impact on inflation for anything other than paper assets. Non-financial
debt, on the other hand...
![](http://www.24hgold.com/24hpmdata/articles/2011/09/img/20111208CLA16106.jpg)
...has rather steadily
climbed uninterrupted before, during, and after the Great Recession. Credit
market debt within the physically consumptive portion of the economy has
climbed by nearly $3 trillion, almost perfectly offsetting the non-financial
decline. But the offset is just an interesting observation that really tells
us nothing about the inflationary or deflationary effect of credit
expansion/contraction on the things that are tracked in the CPI.
So on the basis of credit
alone, I find the deflationary argument to be weak. There's been $3 trillion
of new credit created in the consumptive portion of the economy since the
start of the financial crisis in 2008, and it's almost entirely thanks to
government borrowing. Not too shabby.
Money, Money, Money
Turning to money itself, the
deflationary argument becomes a lot more difficult to sustain. Money is
measured by the Federal Reserve in various ways that are called the
"M's." M1 is the narrowest version, representing cash in and out of
the banking system and demand accounts (savings and checking) at the bank. Just look at M1 lately:
![](http://www.24hgold.com/24hpmdata/articles/2011/09/img/20111208CLA16107.jpg)
The increase in M1 since the
start of the financial crisis (red box) is the same as the entire accumulated
supply of money that existed in 1992 (green box). That is, as much M1 money
has been created in the past three years as was created from the founding of
this country through 1992.
It's really hard to square
up that data with a deflationary argument. I have to assume that at least
part of the reason for the big increase in M1 is people like you and me
taking cash out of the bank, necessitating the printing and distribution of
more cash.
M2 represents a slightly
broader definition of money:
M2 includes a broader set of
financial assets held principally by households. M2 consists of M1 plus: (1)
savings deposits (which include money market deposit accounts, or MMDAs); (2)
small-denomination time deposits (time deposits in amounts of less than
$100,000); and (3) balances in retail money market mutual funds (MMMFs).
(Source)
A chart of M2 reveals a
steadily increasing rate of money creation that has been especially intense
over the past few months:
![](http://www.24hgold.com/24hpmdata/articles/2011/09/img/20111208CLA16108.jpg)
There is absolutely nothing
deflationary in the M2 chart. It is exactly what we would expect to see from
a culture that placed a man at the monetary helm on the basis of his promise
(Jackson Hole, 2002) to run the printing presses if deflation came knocking.
Because M2 includes time
deposits, which are generally locked up (in CDs and such) and therefore not
immediately available for use, and it excludes institutional
money funds (that might be used to buy things), it might not be the best
indicator of money that can trot out of an account and create inflationary
pressures.
For a better measure, I
prefer MZM, or money of zero maturity, which includes institutional
money funds and excludes time deposits. Here's a chart of MZM:
![](http://www.24hgold.com/24hpmdata/articles/2011/09/img/20111208CLA16109.jpg)
Yes, there was a little
wobble downwards in MZM right after the end of the last recession, but over
the past two years (red dotted lines), we note that a trillion dollars in new
MZM has entered circulation (blue dotted lines). Again we might note that it
took all of US history until 1982 to create the first trillion of MZM money
stock, but only two years for the most recent trillion.
|