Commodity price surge — inflationary or deflationary?

Posted: July 25, 2008, 11:47 AM by Jacqueline Thorpe

Economics, credit crunch, oil

The battle rages on over whether the dramatic run-up in commodity prices in recent years is inflationary or deflationary. Two veterans duke it out below.

DAVID ROSENBERG, chief North American economist at Merrill Lynch, and bond bull extraordinaire had this to say about the U.S. in a publication released Friday:

"All one has to do is pick up the newspaper to see that autos, housing, or practically anything you want to buy in a department store is experiencing ‘fire sale’ conditions. It is important to note that commodity bubbles in an environment of stagnant growth in wages and the money supply, as we are now in, are actually deflationary since they put more pressure on the consumer and the profit margins of corporations that have commodities as key inputs into the product or service they sell. This is why we find it very difficult to depict the current or prospective backdrop as inflationary.

"The end of a two-decade secular credit cycle that turned parabolic in its late stages (from 2001 to 2006) is a very important development. The forces that are now building to downsize balance sheets in the banking sector and lower debt in the consumer space are going to be deflationary in terms of the constant selling of assets and consumer durable goods that this liquidation process entails. This fits into the true definition of deflation more than anything else, since inflation or deflation is always a monetary event. In other words, the amount of money that households have to spend either through wages or credit is what ultimately determines the general level of prices."

TIM BOND, head of global asset allocation at Barclays Capital in London, says this in a report this week:

"There appears to be a growing market consensus in favour of putting the disinflationary cart firmly in front of the inflationary horse. We refer to the increasing frequency one hears earnest talk of the “deflationary-inflation shock".

Mr. Bond does not buy it because:

"1) The US and European credit bubble caused inflation in asset prices, not consumer prices, because 80% of the borrowing was spent on assets – a much greater
misallocation of capital than occurred in the 1997-2001 investment boom."

"2) The deflation of the credit bubble is causing deflation in asset prices, but the impact on consumer prices, via demand, is and will be limited to the loss of construction employment and activity, together with a negative wealth effect."

"3) The negative wealth effect is quantifiable, pointing to a rise in the household savings rate to around 2.5%. Because changes in savings behaviour happen
gradually and because this year’s tax cuts have provided scope for the savings rate to rise quite sharply without detracting from consumption, consumer spending
growth will be slow, but far from negative."

"4) Acceleration in real and nominal consumer spending in Asia is likely to more than offset the slowdown in US consumer spending over the next year or so. If present growth rates are sustained, the increase in total Chinese consumer spending in 2008 is likely to be slightly larger than the increase in US nominal consumption. In the narrower definition of retail sales, the increase in Chinese sales over the past 12 months is more than 3x the increase in US retail sales."

"5) The prevailing economic condition of a mid-cycle slowdown is therefore likely to prove insufficient to quell the rise in global inflation pressures. Much more
aggressive policy responses are needed, most notably across Asia. In Europe and the US, a more hawkish policy response is likely to be needed to contain rising
inflation expectations."

"6) Investors should not be distracted or trapped into dismantling portfolio inflation defences by either the current growth slowdown or by the vagaries of the spot oil
price. Interest rates are likely to rise, bond prices fall and equity PE ratios drift lower. These are the main trends and any summer reversal will, we believe, prove to
be a counter-trend bounce."

In the end, much will depend on how big the U.S. and European slow down will be.

Jacqueline Thorpe

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Base metal markets "temporarily stalled"

Posted: July 25, 2008, 11:30 AM by Peter Koven

Mining

The past several months of economic uncertainty have taken their toll on base metals. While copper has held up well, other metals such as nickel and zinc have plunged back to earth.

In a research note titled "Seasonal Weakness or End of the Cycle?," Paradigm Capital analysts Dave Davidson and Jacob Willoughby take the view that most of the base metals are "adequately priced" based on their current supply/demand situation. But they also revised their price targets on most metals upward to reflect the rapid rise in capital and operating costs that is plaguing the mining industry.

The analysts pointed out that the U.S. economy, if not already in recession, is certainly close to one. As well, there are legitimate concerns about how well Chinese demand for metals will hold up. But they also noted that the movement of bulk commodities around the world continues at near-record levels.

"While the miracle of global synchronized growth has dissipated, we are of the strong belief that after a few quarters of slow, but positive growth, the world's economy will re-engage and continue to fuel the global commodity boom. It is our view that the commodity cycle has temporarily stalled, not ended," they wrote.

They noted that inventories for most metals remain low, though lead and zinc are two exceptions. But they "fully expect" prices to consolidate around these low levels over the next couple of quarters (though with plenty of volatility).

They have raised their mid-term and long-term price targets for copper, zinc and nickel, while also making some minor upward revisions to lead and cobalt. In the case of zinc, they added to the speculation that more mines will close because of the high prices, saying they fully expect some "high profile closures."

These are their average price forecasts (per pound of metal):

Copper
2008: US$3.35
Long-term: US$1.75

Zinc
2008: US$1.00
Long-term: US80¢

Nickel
2008: US$12.00
Long-term: US$7.00

Lead
2008: US$1.05
Long-term: US70¢

Peter Koven