The Great Inflation Train
Wreck
2004: The Year of the Monkey
Russ Winter and Jim Willie
CB
Feb 25, 2004
[After reading and discussing
the thoughts and analysis of Russ Winter for well more than one
year on Silicon Investor, I concluded that the community which
is interested in world economic conditions should be permitted
to share in his work. I am certain readers will share my view,
after they read his assessment of the current evidence of widespread
and rampant price inflation. -Jim Willie CB]
As this is written in late
February, 2004, almost all market and economic observers are
asking "What has been the effect of the Great Reflation
orchestrated by the Federal Reserve and other central banks?"
Most seem to be fixated on the notion that poor US labor markets
will allow hyper-easy monetary policies to continue on, "patiently"
to quote Alan Greenspan. The authors believe the markets are
badly offside with this benign sentiment, and see something altogether
else in store. We see material evidence of surprisingly high
inflation, bottlenecks, and a worldwide subsistence or sustainability
crisis.
First, a brief and to-the-point review will follow of the impacts
of the Great Reflation within the United States. Extremely low
interest rates have encouraged American households to expand
household mortgage and consumer credit by $1,424 billion between
Nov 2001 (officially the end of the recession) and year end 2003.
During this same period, wages and salaries rose $193 billion.
Household debt expansion grew relative to wages by 7.4 to 1.
We leave the discussion to others, on whether such a debt expansion
or credit bubble in the face of weak wage numbers is sustainable.
Suffice it to say, the numbers speak for themselves in terms
of the success of the low interest rate and tax cut stimulus
on the US economy, at least in terms of job creation. The verdict
is poor, and that's being kind. However, the global effect of
the massive stimulus is quite another story, and that's our interest
here and now. The subject of unintended consequences caused by
the Fed's Reflation Initiative is discussed by Jim Willie in
a recent work: "Broken
Cycle: Permanent Intervention."
The US fiscal and credit policy
has arguably been a major factor in the economic transformation
of Asia over the last several years. It been reported that in
China nearly two million people a month move from the countryside
to the city, in effect creating twelve Asian cities the size
of Philadelphia every year. Although movement from rural areas
to the cities are part and parcel to emerging economies, this
recent Asian experience is in a class of its own. So the question
begs, why has this happened? We believe it has largely to do
with the US credit bubble that has kicked this process into overdrive.
Additionally, years of bail outs, rescues, and market interventions
have contributed to a pervasive sense of global moral hazard.
In China and elsewhere in Asia this manifests itself with the
notion that maybe, just maybe, Americans have invented a perpetual
wealth machine. Perhaps they think Americans really don't suffer
bad years after all, and have actually abolished the economic
cycle, which would be a big improvement over life in rural China,
or Vietnam. Indeed, perhaps they sense such a free ride, that
they pack up and go to work in that stainless steel toenail clipper
factory in town. Once there, they will go with the "free
ride" until such time as significant and unsustainable strains
are put on the global resource supply chain of metals, energy,
water and food. We submit that "until such time" has
arrived. That time is now!
The Great Reflation & Stimulus
(of Asia) has now suddenly created a worldwide spike in resources
and input goods prices, as well as bottlenecks in transportation.
The result is the real threat of a subsistence crisis (henceforth
loosely termed "the train wreck"). One reason for the
spike in resources is the fact the most commodities and resources
are priced in US dollars, and it's no secret that the US Dollar
is the weakest major currency in the planet. The reaction of
the markets is straightforward and clear, we think. They wish
to be paid in real terms. The recent comments of Saudi energy
minister Ali Naimi says it all. "The falling value of the
dollar means that oil prices were artificially inflated."
His use of the word "artificially" may either be an
expressed leap of faith, or perhaps diplomatic politeness? Regardless,
his point is made:
"don't pay us with
funny money."
The second component of the
train wreck is the voracious appetite for input goods and resources
that comes from selling to western markets and from building
an Asian metropolis like Philadelphia every month. The new Chinese
urban dweller is typically not going to a shanty town either.
Standards of living are improving in Asia, and that translates
into even more resource consumption. China became the world's
largest consumer of copper in 2002, and now accounts for 20%
of world consumption and 80% of world growth. Copper inventories
as of this writing (2/18) are at 313,000 MT, the lowest in eight
years. See current primary and scrap metal prices.
Prices are rising widely on
the LME (London Metal Exchange), COMEX, and NYMEX, which freely
trade in copper, aluminum, nickel, tin, lead, zinc, iron, steel,
specialty steel, stainless steel, nickel alloy, chrome, titanium,
ferrochrome, cobalt, molybdenum, antimony, manganese, titanium,
tungsten, vanadium, and wolframite.
Even more alarming is the rate
of decline in supply, prompting Pierre Lassonde of Newmont to
state, "at this rate there won't be a pound of copper above
ground on the planet in May." China is one of the largest
consumers of alumina, zinc, lead, and nickel as well. Lead has
the lowest inventories since June, 1991. Nickel is a particularly
vulnerable metal commodity today. Used primarily in stainless
steel production, one week's inventory (15,000 tonnes) above
ground is now available. Stainless steel production in 2003 was
up 8%, as was nickel consumption. China has added one million
tonnes of stainless steel capacity for 2004, which requires an
incremental 40,000 tonnes of nickel. The anticipated 2004 shortage
of nickel is estimated by Inco at 75,000 tonnes, or 10% of annual
demand. There are two major nickel mines expected to come on
stream, Voisey Bay, and Goro, but not until 2H2006. China itself
is not well endowed with resources, particularly the aforementioned.
Moreover, what they do have is difficult to exploit, generally
low grade, and located in remote areas suffering from poor infrastructure.
China has also become the fastest
growing economy for energy. In Dec 2003, crude oil imports surged
23% y-o-y to 2.5 million barrels per day. Demand in China for
crude oil is running 5.43 mb/d. The Energy Information Agency
(EIA) indicated that crude oil stocks for the Pacific (eastern
Asia) in Nov, 2003 was 155 mb, which is roughly 25 mb below the
1997-2002 average. Petroleum inventories in the US are also exceedingly
low at 628.8 mb (on 2/6/2004), some 42 mb below the five year
average. The world can now ill afford a geopolitical disruption
from the usual cast of characters.
Although China once stockpiled
large food and grain inventories, those are largely gone now,
sold cheaply over the last few years to neighbors. The USDA release
of 2/6/2004 stated the following, "Although grain stocks
are still a state secret, MY 2004 ending stocks are forecast
to be less than half of MY 2003, and the state held wheat reserve
is reportedly extremely low. Grain production fell to its lowest
level in a decade in 2003. Demand exceeds production, exports
will decline, and imports increase." Other threats to Asian
food supply would of course be avian influenza (aka "bird
flu") which could wipe out their poultry production.
This brief synopsis gives the
reader a glance into current Asian and Chinese demand characteristics.
Importantly though, how does this translate in terms of impacts
to the global economy, including the US? Primarily by creating
shortages, bottlenecks, overheating and high prices (inflation).
As the Asians scarf up commodities and goods throughout the world,
they have smashed records for global freight costs on almost
a weekly basis. The Baltic Dry Index, a barometer of the dry-bulk
freight market for commodities such as iron ore, grain, and coal,
is now up close to 300% from last spring.
Bloomberg.com: Research
A broker with Clarkson's in
London exclaimed, "You only see this once in a lifetime,
once in two lifetimes." Tanker rates for oil cargo from
the Persian Gulf to the Gulf Coast of the United States are running
$3 per barrel, double the average over the last five years. The
expectation is that demand will continue to run high for shipping
as China will kick off importing large quantities of South American
soybeans from March to May.
If shipping weren't expensive
and in short supply, this is all occurring against a backdrop
of unusually low inventory levels for all kinds of key commodities
around the world. The USDA in February revised world coarse grain
ending stocks down to 100.47 million metric tonnes, the lowest
level in a quarter century. That's about a month of usage (risky)
versus a norm of about two months. This has of course resulted
in large grain prices gains of late, and would be made all the
more critical should important crops come up short, given the
vagaries of nature.
Corn (CBOT): Daily
Commodity Futures Price Chart: May, 2004
Soybeans (CBOT): Daily
Commodity Futures Price Chart: May, 2004
Wheat (CBOT): Daily
Commodity Futures Price Chart: May, 2004
As of this writing there is
growing concern about drought in the hard red winter area of
the US:
Commodity
Weather Forecasts: U.S. Palmer Drought Index
Low inventories run the gamut
in food now. The USDA semiannual report on cattle supply came
in at 94.882 million head as of Jan 1, 2004, the lowest level
since 1959. Year end US soybean stocks were just reported to
be the lowest in twenty seven years.
Should the US be complacent
about food and energy prices? We think not. American consumers
have enjoyed a multi-decade benefit of lower real prices and
bountiful crops. Chart 1 illustrates this. See the Details.
Notice the steady decline in
spending on nondurable goods (food and energy). Note that spending
on durable goods has stayed steady, the same. Also note how money
once spent on the nondurable food and energy goods sector has
been diverted into supporting the service based economy (chart
4). Finally note the story in chart 3, which shows the couple
percent drop in money spent on energy goods, the benefits of
the cheap fuel interlude of the 1980' and 1990's. The next stage
of the US version of the energy train wreck may be gasoline.
StockTalk: The
Epic American Credit and Bond Bubble Laboratory (#8145/8245)
We feel that the other major
element of the 2004 train wreck will be food inflation (conveniently
excluded and dismissed by the Federal Reserve). Good cropland
cannot be turned on like a switch either. In one high potential
region, the cerrado of Brazil, it usually takes a half decade
of land development to lower soil PH levels sufficiently to grow
crops like soybeans. Additionally, these resource regions lack
good storage and transportation systems.
FOCUS: Miners
Face Delivery Cost Pressures Amid Boom
The big communist era stockpiles
(and dumping) are gone. Plus modern farming is energy intensive,
a special problem right now.
So referring back to our charts,
we can see that prior to the train wreck now underway, US consumers
spent 3 or 4% on energy goods, and 14% on food. In dollar terms
that is about $300 billion on energy and $900 billion on food.
Now calculate a shift or diversion to 5% on energy, and 16% on
food, and an extra $200 billion in consumer spending is needed
for subsistence items. Although farm value constitutes 19% of
food dollar costs, other input items are also seeing price inflation:
packaging making up 8% of food dollar costs, transportation and
energy making up another 8%. Taken from the December PPI and
Bureau of Labor reports, the energy components y-o-y of the CPI:
For PPI food inflation, the
seasonally adjusted annualized rate for three months:
What would a subsistence crisis
look like? Perhaps much like January, 2004 retail sales numbers,
which saw more spending diversions.
So the train wreck scenario
can be described as a demand pull inflationary event driven by
runaway demand from Asia into crude goods and commodities held
in short supply. This in turn is now leading to serious cost
push inflation into intermediate and finished goods. An additional
speculative element, even a hoarding component has been emerging
and shown itself. Like other carry trades engendered by one percent
fund funds rates, commodity trades are "no brainers"
for practically any monkey on the planet. Simply borrow cheap
in US dollars and pile into commodities and goods in short supply.
This has been a winning trade on both the dollar short trade
and the commodity long trade.
Ludwig von Mises described
this behavior as the "crack-up boom" and said, "Once public opinion
is convinced that the increase in the quantity of money will
continue and never come to an end, and that consequently the
prices of all commodities will not cease to rise, everybody becomes
eager to buy as much as possible and restrict his cash holdings
to minimum size. The advantages of holding cash must be paid
for by sacrifices which are deemed unreasonably burdensome. This
was present in the great inflations of the twenties, and was
called the flight into real goods (Flucht in die Sachwerte).
If the credit expansion is not stopped in time, the boom turns
to crack-up boom: the flight into real values begins, and the
whole monetary system founders."
To the author the current inflationary
outbreak has a certain crack-up boom feel and smell to it. For
those who are paying attention, it certainly has been rapid.
Given that the US Fed and Wall Street have chosen to fiddle as
the evidence gushes forward, the reader will need to depend on
other more reliable sources outside the Land of Oz (aka The Fed)
to gauge this inflation. We would suggest going real time into
the trenches with purchasing managers as an excellent starting
point.
Please review the following
Purchasing Magazine Online links:
ISPI gains 2.5% on major metals price
push
And another round of sheet
metal increases for April:
UPDATE - Nucor, ISG raise prices on
sheet steel
OSB leads new explosion in lumber pricetags
Market mavens agree that aluminum ingot
is inflating
Steel mavens forecast spike in sheet
prices
Industrial leadtimes are skyrocketing
Diesel prices explode at pumps nationwide
LDPE is inflating
Cobalt tops January's movers and shakers
list
Heating oil costs expected to go up
Look out for price hikes in chemical
industry
Shipping rates are up
Trucking rates to rise
Another excellent source for
tracking input goods inflation is the weekly commodity update
put out by EDC.
Weekly Commodity Update from Feb 16,
2004
The charts speak for themselves.
Note the big price surge in 2X4 lumber, and oriented strand board
over just the last five weeks:
Strand Board:
1-9-2004: 310
2-13-2004: 486 (this product was below 200 last spring)
2 X 4 lumber:
1-9-2004: 337.5
2-13-2004: 394.50
And finally, overlay charts
showing three component indexes of commodity and input inflation:
CRB Commodity Price Indices
The JOC-ECRI industrial price
index shows petroleum and metals especially going parabolic of
late:
JoC Online: Industrial Price Index
Apparently the Fed would have
one believe this is all benign, and that other factors such as
wages and labor are all that matter. To us, slack wages simply
spells a further "squeeze" on heavily indebted Americans,
not low inflation. And unfortunately, in the real outside of
the Land of Oz, the impact of these shortages and bottlenecks
are becoming acute. We recently spotted a news account from the
Korean Times that describes our train wreck theory perfectly:
StockTalk: The
Epic American Credit and Bond Bubble Laboratory
This 1/6/2004 steel shortage
article
out of the Middle East really caught our eye too.
And how have the increases
in input prices played back in the USA? Inflationary, given the
evidence. It looks like those Chinese-made stainless
steel toenail clippers, might be getting more expensive, or soon
to be in short supply?
Import prices:
Nov 2003 +0.5%
Dec 2003 +0.5%
Jan 2004 +1.3%
Even using the familiar trick
of excluding "volatile" energy, import prices for the
last three months rose 1.1%, equal to 4.4% annualized. Even export
prices demonstrated the new inflationary footprint, rising 1.2%,
equal to 4.8% annualized.
China may have to pass costs
on as well, given their own emerging inflation.
StockTalk: The
Epic American Credit and Bond Bubble Laboratory (#8006/8245)
Perhaps a timely yuan currency
repeg might make at least those expensive imported commodities
more affordable in US dollar terms? Can China afford to absorb
the new costs of exporting to America? A rather unnoticed change
in Chinese tax law makes that even more difficult now than otherwise.
Effective Jan 1, 2004 rebates on tax payments that Chinese businesses
could claim for products sold outside of China were cut. For
instance, on microwaves, small appliances, and air conditioners,
the tax rebate will drop from 17% to 13%. We will be watching
closely for Chinese price increases to protect their already
thin margins.
How about US based firms selling
at home? That question is up in the air, and a critical piece
of the picture. Early evidence is mixed. We believe most of the
crude and intermediate goods producers are passing on these new
inflationary costs. At the finished goods level, we are still
looking for strong evidence. The February Empire Sate surveyed
showed that prices paid were strongly on the increase: 39%, versus
decrease of only 5%. Prices received were punky: increased 15%,
versus decreased 11%. This would suggest that at this stage a
great cost squeeze is on finished goods outfits and possibly
retailers. Perhaps these pressures will encourage US based firms
to speed up the outsourcing of the one input cost they truly
control, labor. Certainly that topic could be the grist of further
articles from the authors or others?
Russ Winter and Jim Willie
CB
February 24, 2004
Russ Winter
is a money manager and private investor. He lives in Oregon.
Jim Willie
CB is a statistical analyst in marketing research and retail
forecasting. He holds a Ph.D. in Statistics. His career has stretched
over 22 years. He aspires to one day join the financial editor
world, unencumbered by the limitations of economic credentials.
____________
321gold Inc
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