Over recent months, commodity prices and resource company share prices have fallen. What’s going on? Several factors are involved. Read on…
The US (22% of the world economy)
In the case of the US economy, we say ‘apparently slowed’, because the weather played a significant part. Unusually mild weather across the north and
north-east of the US allowed construction activity to be brought forward. (As an aside, the first half of this year in North America has been the hottest ever recorded.) Normally, most construction activity stops when temperatures are too low, because concrete can’t be poured nor cement used. The abnormally warm weather meant that construction activity, with associated expenditure and incomes in other non-construction sectors was much stronger than normal.
Later on, when construction would normally have been occurred, in May and June (spring and summer in the northern hemisphere), it had already taken
place, so growth appeared weaker than it in fact was. Economists and financial analysts are calling this period of weak economic activity “payback” because it’s compensation for previous stronger than usual spending and production. In a jittery market, this added to downward pressure on share and commodity prices. It’s still not 100% clear that current weakness is just “payback”, but the signs are good that it is, and that is the Fed’s (Federal
Reserve Bank, the US Central Bank) view.
The Dallas Fed’s survey, for example, showed that the Texan economy was still growing reasonably through June. Texas would not have been directly affected by the weather-induced surge and “payback” because it never gets cold enough there to slow construction. At the national level, despite “payback”, housing starts and house prices have finally (five years after the GFC began!) started to rise in a sustained way. Housing repossessions have plummeted.
Also, initial unemployment insurance claims, a measure of how many newly unemployed workers are signing up for unemployment insurance benefit, have
started to fall again. This time series is a very reliable indicator of the changes in the labour market. It is a sign that growth is resuming.
It is true that the US is facing a “fiscal cliff” in the new year, when automatic spending cuts and tax increases are to be implemented, but this is after the November presidential and congressional elections, and our judgement is that whoever wins, the politicians will blink at the last minute, and extend existing tax cuts as well as not cut spending by as much as is now planned.
Our cautious assessment is that though the US economy is far from experiencing a boom, moderate growth (2-3%) will continue.
Europe (20% of the world economy)
This is the weakest part of the world economy. The European politicians and the ECB (European Central Bank) have no sensible consensus on what to do to restimulate growth and solve the sovereign debt crisis.
Our long-held view has been that Greek government debts are too large to be repaid, and that Greece will ultimately default. But Greece is relatively small. A default is already “priced in” by markets, and is now (in private) expected by EU officials and politicians.
Attention has shifted to Spain. Spain is a lot bigger than Greece: Greece is less than half a per cent of the world economy, while Spain is 2%. A Spanish default and exodus from the Euro currency zone would be the end of the grand dream of European co-operation and unity, a dream dear to the heart of European (especially German!) elites. It would also be far more damaging to the European economy than a Greek default, not just directly, but indirectly via credit markets,
bank failures and collapsing confidence.
It is tempting to write off the European bureaucrats, politicians and the ECB as complete incompetents given their flawed and dilatory response to the crisis so far. Yet the costs of allowing Spain to default and leave the Euro are so high that even the Germans and Dutch are likely to accept that the alternatives are better.
What are the alternatives? First, the mutualisation of European Governments debt, so that Germany and France and indeed the whole of Europe would stand behind Spanish and Italian debt. The Germans are understandably very wary of this: they think that the more profligate European countries would simply use the credit ratings of the prudent northern Europeans to spend even more than they have. So this would have to involve some steps towards centralised fiscal control, and the European community would indeed have become a federation, with a nascent fiscal union. This is a big step, and only an impending crisis of the magnitude of a Spanish default will push the Europeans to do it. Every day that Spanish bond yields rise makes this step more likely, because it makes it more likely that Spain will be unable to pay its bills and will follow Greece down the road to default and exit from the Euro currency.
The other likely step is that the ECB will start acting as a lender of last resort to all Euro-zone banks, in tandem with a centralised bank regulatory authority, and also (more controversially) as a buyer of last resort in government bond markets. Traditionally, these have always been part of the role of a Central Bank. The
recent economic summit in Brussels accepted that the ECB would do this in future, but legislation is still in train to achieve it, and it may take months before the agreement is ratified by all the Euro-zone countries.
In our view, it is very likely that the evolving Spanish crisis will force reforms on the EU. This will cause the European economy to start to recover.
China (14% of the world economy)
The bursting of the US house price/housing market bubble was an object lesson to the Chinese government and the officials at the People’s Bank of China (PBC),
the Chinese Central Bank. The collapse in house prices and the consequent economic crisis in the US is still not past. So, when a year or tow ago, the Chinese house market started to look too strong, the Chinese authorities stamped hard on the brakes. Their decision was made easier by a surge in inflation.
While events in both the US and Europe are important for growth and confidence, as regards commodity prices and resource shares, the key swing variable remains China. China is the world’s largest consumer of raw materials, the world’s largest producer of steel, of cars, of laptops, of whitegoods, and so on. In 2007, the World Bank estimated that China was roughly 11 % of the world economy. High growth in China compared to the rest of the world has increased this to around 14% now. What this means, incidentally, is that even if the Chinese trend growth rate slows from 10% per year to 8%, it will still add as much to the growth in world demand and output (1.1% ) as it did when it grew by 10% per annum.
Chinese growth and world commodity prices are closely linked (see chart).
The authorities in China have been all too successful in slowing the economy. Chinese inflation has fallen from 6% to 2%; house prices have been declining; economic growth
slowing sharply; and there have also been many anecdotal reports of rising unemployment, soaring bankruptcies and other signs of economic stress. Over the last few months, the Chinese government has switched from restraining growth to stimulating it. In June, for example, the annual growth in fiscal spending quickened to 17.7% from only 10.8% in May. Government spending on transportation was up 44%, on electricity generation and supply 22%, on housing 36%.
The PBC has also cut the liquid asset requirements of the banks, and the discount rate, to allow more lending. Further cuts are likely. Unlike Europe or America, China has no fiscal deficit and little debt. It also has the world’s largest gold and forex reserves (over $2 trillion). Chinese consumers have high savings ratios and little debt. There is no doubt that if China wants to stimulate demand it has the wherewithal to do it, unlike its less fortunate counterparts in Europe and North America. Until now the authorities have wanted to restrain growth and they achieved that successfully. Now they wish to encourage growth. After the GFC, the Chinese government successfully pulled
out all the stops to get growth going. They are doing that again.
It is our judgement that Chinese growth is bottoming now, and that therefore, commodity prices are close to their bottom.
As commodity prices start to rise, we expect resources share prices to increase too, and an end to the big sell off. Clearly, insiders remain confident about the
longer-term merits of the China story and investment in resources, as evidenced by the tycoon Nathan Tinkler’s opportunistic bid for Whitehaven Coal —a clear indication of how he sees value in this sector on a longer-term perspective.
As always, we are very happy to discuss your portfolios and investments with you. Please feel free to contact us if you have any queries.
