The Consumer Driven Commodity Bull Market

A couple of weeks ago, I wrote an article in which I stated the following:

It is important to note that there are two components to the Chinese commodity demand. The first component is the demand for commodities as a result of industrialization and foreign investments. The second component is a result of consumer demand. Read "China, Jim Rogers, and Commodities"

In this article, I will focus on the "consumer demand" factor that will push commodity prices to record highs over the next several years. I will also highlight some of the commodities that should soar during this stage. In the next couple weeks, I will write more about the mentioned commodities in my free commodities newsletter.

I also wanted to inform my readers that I recently started a managed futures division for Archer Financial Services, Inc. You can access our Commodity Trading Advisors database for performance information on hundreds of managers or open up a commodity trading account.

A Tale of Two Economies: Emerging vs. Developed

It is much easier to understand the impact that the emerging consumer will have on commodities (and their respective economies) when one examines the impact that the developed consumer currently has on his economies. In terms of raw data, consumer spending accounts for just over 60% of GDP in Europe. This number is even greater in the United States, where personal consumption accounts for greater than 70% of GDP. In comparison, personal consumption in China only accounts for 37% of GDP. The other two components are exports (27%) and investments (41%).

In the United States, the consumer has been responsible for the direction of the US economy over the last decade. After the dotcom collapse, the US consumer contributed to GDP growth by spending money on goods and services. While this "economic boost" was artificial in nature, largely due to the housing bubble, a record amount of mortgage equity withdrawals, and rising credit card debt, it did ultimately contribute to record corporate earnings and a rising stock market.

Unfortunately, this trend did not last. I once stated that I believed that "corporate profits will dry up as quickly as the consumer says 'I can't afford to make my mortgage payments' or 'I have cut back on my spending because my adjustable rate mortgage just went fixed'". This is exactly what has happened over the last year.

Also, consider the following comment that I made in January of 2006:

"Wall Street pundits will again try to spin the GDP numbers into a positive, but I believe that this is the beginning of an inevitable recession....In the future, those that can afford to pay the additional mount on their higher mortgage will have to "tighten their belt" and not spend as much money in the economy. Consequently, they will hold on to their car a couple of years longer, not frequent their local restaurant as often, and cut back on their overall spending." - Wall Street Journal, January, 26, 2006

While many analysts vehemently disagreed with my comments two and a half years ago, it is clear that my analysis was correct. Yesterday, the unemployment rate jumped to a 6 year high! Also, we are now in the midst of record foreclosures, retail sales are waning, and consumer confidence is at the lowest level in 12 years!

When I made my comment in 2006, my logic was simply based on the fact that the US is a consumer driven economy. Of course, with 70% of GDP based on consumer spending, you did not have to have a doctorate in economics to figure this out. Nonetheless, while many analysts were focusing on "record corporate" earnings to gauge the future of the economy, I was focusing on the consumer. In this case, the consumer just happened to be artificially living outside his means.

The Emerging Consumer

So what about China and other emerging economies? Well, as you can see from the GDP data (37% personal consumption, 27% exports, and 41% investments), consumer consumption does not make up the majority of the economy. As I mentioned a couple of weeks ago, the primary growth in China has been a result of industrialization and investments. Nevertheless, 37% does make up a significant amount of GDP growth. As a result, the Chinese consumer does have an impact on its economy.

Another interesting point about the above data is that it really shatters the myth that a US recession will significantly impact China's economy. Proponents of this theory have argued that if the US and other western economies are no longer importing goods from China, then their economy will suffer. What the above data shows, however, is that the Chinese consumer (37%) is more responsible for GDP growth than the non-Chinese consumer (27%).

Several years ago, McKinsey & Company issued a report on the urban Chinese consumer. According to the report, "China's economy is on the verge of an important transition in which its consumers will begin to take their place on the world state." The report went on to state that by 2025 China will become the third-largest consumer market in the world.

Indeed, if you look at the present consumer landscape in China and other emerging economies, you will notice that the environment is much different than that in the US. Vietnam, for instance, recently announced that their January to July car sales more than doubled. In the US, car sales declined by 13% in July. China also reported that retail sales were up 23% in June- a 10 year high.

Clearly, the divergence between the consumer in the US and the consumer in emerging economies is substantial. A big reason for why this is the case is that industrialization ultimately translates into the creation of a wealthier and more educated working class. Thus, one-third of the world's population will now have more money to spend on consumer goods and services. To illustrate this point, imagine this scenario that I outlined in my Commodities Book:

"In China, a major U.S. company decides to open a manufacturing plant on the outskirts of a city. In order for their plant to run at maximum capacity, they will need to find 2,000 workers. Soon the word is out that the company is paying 20 percent more than what the local farm worker earns. The jobs are immediately filled, and 2,000 people are now making more money. Since most of these workers have no debt, they now have additional income to spend. With the additional discretionary income comes a change in lifestyle. Some of the workers might eat out more often; others might purchase more expensive food products, such as meat; still others might actually go out and purchase the washer and dryer that they have always wanted. Regardless of their expenditure, the end result is the same. Average Chinese consumers are way on the way to westernizing their lifestyles."

This type of wealth creation will occur not only in China, but also in most of the other developing economies. Citizens who typically spend money only on necessary expenditures will begin to indulge in the consumption of goods and services that are standard in most western economies. In fact, if you look at other historical examples of industrialization (that occurred in the United States and European countries), a similar type change took place.

In addition to the spending by these factory workers, there will also be a trickle-down effect as these workers now have more money to spend in the local economy. When they go out to eat, the local restaurant owners benefit. When they buy new clothes or electronic gadgets, local merchants will earn more. In short, the new wealth and spending habits of the factory workers will translate into additional wealth for the business economy. In turn, this will eventually lead to further spending, further growth, and a continued demand for commodities.

The above scenario is reaffirmed by the following statistics released by National Bureau of Statistics of China. According to survey of 65,000 urban families, year-over-year per capita income grew by 14.4% in the first half of 2008. Not surprisingly, per capita consumption also grew by 13.7% during the same period. In short, as the Chinese are making more money, they are spending more money.

From Lower End To Higher End

While per capita income is growing at high percentages, it is important to realize that per-capita income is substantially lower than the per-capita income of developed economies. As a result, while the average emerging consumer might now have more money to spend, they do not yet have enough money to buy a new car, spend money on gasoline, purchase high end electronics, or start living the "western-style" lifestyles.

Instead, the additional income that they are receiving will most likely fall into areas that are more cost-effective, like food, travel, education, and lower end electronic/consumer goods. During this market environment, food commodities (meats, coffee, sugar, grains, cocoa, etc.) will likely be the primary commodity markets that will benefit from the per capita income growth of the emerging consumer.

Emanuel Balarie

Jabez Capital Management

www.commoditynewscenter.com