The New Inflationary Epoch

Doug Noland who writes the prescient and superb Credit Bubble Bulletin at Prudent Bear picks up on our theme regarding some of the causes of current and future commodity inflation (See Food for Thought and Inflation's Early Warning System Validated) in his 05/09/2008 post:

Especially since the Fed’s Credit System Bailout, anticipating Heightened Global Monetary Disorder has been a key CBB theme. The ongoing relevant question: how much would (in particular) China, India, Russia and Asia be willing to pay to procure adequate supplies of food and energy for their populations and economies?The obvious answer is “we have no way of knowing”, but the market is becoming increasingly cognizant of the reality that today’s massive international reserve positions provide virtually unlimited purchasing power. The bidding war has begun in earnest, in what increasingly appears A New Inflationary Epoch.

Noland observes the international reserves positions of BRIC (Brazil, Russia, India and China), OPEC nations and other countries are significant, and almost exponentially have grown in the last decade, and provide a handy bankroll with which these countries, mostly authoritarian regimes, may buy social peace, continuing:

I don’t believe it is mere coincidence that crude has posted about a 30% y-t-d price surge at the same time as international reserve positions have expanded at about a 30% annualized rate - to a stunning $6.769 TN. Over the past 4 ½ years, official international reserves have ballooned an unprecedented $3.921 trillion, or 138%. During this period, crude prices surged almost 300%. Chinese reserves ballooned more than four-fold over this period to $1.68 Trillion; India’s reserve position tripled to $303bn; and Brazil enjoyed a four-fold increase to $189bn. After beginning 2004 at $73bn, Russian reserves have almost reached the half Trillion mark ($493bn). And in just the past year, OPEC reserves have inflated 42% to $490bn. To be sure, the world is awash like never before in excess “liquidity” for which to bid up prices of critical tradable resources.

Evidence of the firepower of international reserves already is registering in various commodity indices, and in our daily lives in the form of higher food and fuel prices:

The CRB Commodities index closed today at an all-time high, sporting a y-t-d gain of 19% and one-year rise of 37%. The Goldman Sachs Commodities index, also ending at a record high, has gained 28% so far this year and 68% over the past 12 months. During the past year, soybeans have gained 85%, corn 72%, and wheat 68%. Prices for iron ore, steel and hard commodities have experienced similar price inflation. Gasoline prices are up almost 40%, natural gas about 50%, and heating oil about 90% over the past year.

But countries seeking to quell any possibility of social disorder can explain only a portion of the dramatic disruption of global commodities markets in the last 12 months. As the residential mortgage bubble began bursting a year ago, a tsunami of speculative liquidity seized on commodities markets as the next great bull market opportunity for huge profits.

...the leveraged speculator and sovereign wealth fund communities remain awash in financial resources that embolden huge speculative positions in various energy and commodities markets – essentially “front-running” real economy purchases. It’s turning into a battle royal – and a prime dynamic of A New Inflationary Epoch. Perhaps others recall the commercials that seemed to run nonstop on CNBC during the 1996/97 Asian crisis: Make easy currency trading profits from the collapse in the Thai baht, Indonesian rupiah, the Malaysian ringgit, and the South Korean won. I remember thinking at the time how repulsed Asian policymakers must be at the thought of retail U.S. speculators shorting their currencies, while their citizens and economies suffered through such devastating financial, economic, and social upheaval.

Led by fast-money hedge funds, Wall Street isn't far behind as new "financial products" are rushed to market to capture the ultimate source of liquidity necessary in all bubbles: the gullible finances of Main Street. A number of commodity indexes now are widely followed, including the energy-dominated Goldman Sachs index, a Dow Jones-AIG index and the (Jim) Rogers International Commodity Index, and a couple of dozen or more Exchange Traded Notes (ETNs) have been introduced in the last year or so. (See Elements ETNs, iShares Commodity Indexed Trust, iPath DJ-AIG ETNs.)

Not to be outdone, this month Morgan Stanley is introducing its Commodities Alpha Fund to "high net worth" investors, which it describes as "an actively managed mutual fund that offers high net worth investors the opportunity to gain direct access to the potential return and portfolio diversification benefits of the commodities market and the expertise of MSIM’s Quantitative and Structured Solutions investment team."

No doubt the phrase "potential return and portfolio diversification benefits...and the expertise of MSIM’s Quantitative and Structured Solutions investment team" figured prominently in Morgan Stanley's promotional literature to clients for previous investment products such as Structured Investment Vehicles, Residential Mortgage Backed Securities (hey they're AAA-rated!) and Collateralized Debt Obligations.

Other Wall Street firms soon will follow with similar offerings to its "retail" clients, of which these firms require an abundant supply to suck up even more casino liquidity to blow this emerging bubble into stratospheric proportions.

These clients, as in the dot.com bubble fewer than 10 years ago, and the currently deflating housing bubble, will scramble en masse to throw money at the latest get-rich-quick investment opportunity, only to be burned yet again when the commodity bubble pops (and it will). " 'Deal faster,' cried the losers," I once overheard in Las Vegas. Some things will never change.

Noland concludes the world's forces of speculative finance today are focused on energy, commodities and the “emerging” economies:

Unlike tech stocks/junk bonds, and U.S. mortgages/houses, it is today extremely difficult to meaningfully increase the supply of energy, agricultural commodities, and many natural resources. Moreover, the longer this boom is sustained the greater the demand for energy and commodities from the likes of China, India, greater Asia and the Middle East. And the higher prices rise, the greater the tendency for hoarding and problematic supply disruptions – only aggravating supply/demand imbalances and emboldening aggressive speculation. And unlike previous inflation manifestations that tended to remain largely contained within asset markets, today’s virulent energy and commodities inflation will spawn broad-based secondary price effects. As recent trends corroborate, inflation begets only greater inflation.

The reality that powerful inflationary psychology has taken hold - and that the world’s leading central banks show no inclination to confront this worsening problem - motivates tonight’s title, “A New Inflationary Epoch.”

And so we proceed from bubble to bubble to bubble. Now that the Federal Reserve and other central bankers have provided the illusion the impending global financial meltdown, which reached crescendo in mid-March, has been stanched and the crisis has passed, its back to business as usual as Wall Street scrambles to take advantage of this latest opportunity for big-time profits.

Wall Street cannot create more oil, gold or grain, but - watch out - in can create the paper necessary, and in vast quantities, to give its dupes very good clients the illusion of a new source of easy wealth.

Food for Thought

By now you know there’s a rice shortage, or so you’ve heard recently. Sam’s Club and Costco last week imposed limits on the purchase of imported Asian rice – 80 pounds per person per day – which, naturally, has encouraged hoarding behavior among its predominantly food-service buyers of this commodity, and which, in turn, may create the actual, self-fulfilling shortage being reported. (Mind you, there’s plenty of domestic rice available for sale, only Asian imported rice is being restricted.)

The specter of global food shortages is arising like ethanol fumes wafting from a gas pump, and food hoarding behavior, begun in the last few months at a country-level, is entering the psyche of our consumer society whose previous idea of shortages – few remembering the gas lines of the 1970s – consists of a lack of Cabbage Patch Dolls, Tickle-Me-Elmos, X-Boxes or I-Phones.

Significant price movement in grain commodities in the last year have led to a number of nations – Egypt and other Middle East states, the Philippines, Mexico – buying large quantities of wheat, corn, rice and soybeans, while grain producers in other areas of the world are beginning to impose grain export restrictions to insure adequate supplies, and therefore less chance of social unrest, in their own lands. China, which has an abundance of U.S. dollars with which to shop, will spare no expense for food and fuel.

Suddenly in North America, amidst growing concerns about global food shortages, the ethics of using food for fuel calls corn-based ethanol into question as a viable alternative energy to reduce our dependence on imported oil and creates another reason for the developing world, which also wants what we have in terms of diet, housing and transportation, to question our national policies.

Numberwise, First Quarter 2008 advance Gross Domestic Product (GDP) growth of anemic 0.6% annualized, identical to Fourth Quarter 2007, was reported on April 30^th and pessimists determined to find a recession in there somewhere find the devil in the details of residential investment (housing) and durable goods (cars, furniture, appliances), where both categories now are negative.

Some contend pessimists merely are better-informed optimists and so seem obliged to observe that only an undesirable build in non-farm private inventories prevented the Q1 GDP report from becoming the first of two consecutive quarters of contraction necessary for a textbook recession, but cooler heads studying the report will notice the bifurcation between economic segments and regions of which we first informed you in January in our briefing entitled “A Tale of Two U.S. Economies.”

Clearly housing in some parts of the country is well-past recession, more like full-fledged depression after nine consecutive quarters of contraction since peaking the final quarter of 2005. Rising energy costs now are more apparent in “household operation” and transportation components of GDP although, while impacting economic growth positively, they represent more of a redistribution of disposable income away from other consumer spending, as evidenced by the smallest annualized rate of growth (1.0%) in personal consumption expenditures (PCE) in 17 years.

So statistically we are not yet in recession as of the end of March 2008, but, as the pessimists will note, the consumer side of the economy is showing early signs of exhaustion. $120-a-barrel oil, which may by summer translate to a national-average $4.00+ gallon of gasoline (record $3.61 average now) and brewing consumer inflation likely will tip the scales to recession later this year.

Warren Buffett again has said the U.S. economy is in recession and that it “will not be short and shallow.'' Former Fed head Paul Volcker described “today’s financial crisis (as) the culmination…of at least five serious breakdowns of systemic significance in the past 25 years,” and warned the U.S. has become “addicted to spending and consuming beyond its ability to produce.” But to optimists and pessimists alike, in many parts of the nation it does feel like a recession, albeit a slower moving phenomenon than previously forecast, and perhaps the first pressing issue of the November winner of this never-ending 2008 presidential election.

The Federal Reserve, invoking lending powers not used since the Great Depression, has calmed the financial waters following the collapse of investment bank Bear Stearns in mid-March and having conferred upon borrowers and investors another 25 basis point rate cut late last month bringing its short-term rate to 2.0%, likely will rest. Although wary of downside risks to growth and “while the economy remains weak and the inflation outlook remains uncertain,” the Fed’s rate cuts and last-resort lending efforts over the past several months "should help promote moderate growth over time and to mitigate risks to economic activity."

Time for a “pause that refreshes” as the nation’s central bankers step back from the winter’s financial landscape of discontent to see exactly what they hath wrought, thus signalling a lesser likelihood of future interest rate cuts. So let it be written, so let it be done…but don’t forget to spend your tax rebate, a big slug of which should be received this month, the economy is counting on you.