Generally and logically, the bigger the bull, the longer the subsequent bear, and vice versa. Global stock markets, long-dated government bonds and commodities go through cycles that can last for a while, since it takes a long time for the crowd which participated in a market bubble to realise it is not returning after a few years.
Instead, they experience a rolling sequence of medium-term bearish and bullish phases, which persist for at least several months, but seldom more than three years.
This ex-bubble environment leads to a gradual reassessment in which people become more cautious, leading to valuation contraction before those who remain are joined by a whole new generation of investors, who participate in the next cycle of valuation expansion.
So where are we today, in terms of secular bull and bear trends? Two mega-trends became apparent over two and a half years ago – industrial resources (including precious metals) and emerging markets. And they overlap in a number of instances because the economies of many developing countries are primarily exporters of commodities.
Natural resources experienced one of the biggest and longest secular bear markets in modern history, particularly if one adjusts prices for inflation. The main reason was overcapacity, which understandably led to caution by producers. When demand not only picked up once again, but surged as the economies of China, India and other developing countries grew rapidly, supply inelasticity drove resources prices higher, particularly among industrial metals. Following historic lows in 2001, prices for the major industrial commodities subsequently formed secular uptrends.
Of these resources, the most important in terms of economic implications is the energy sector – from oil to coal and uranium. Arguably, crude oil’s bull market was not really underway until it maintained a break above $40 (NYMEX), completing a massive base formation.
Understandably, some analysts do not accept that oil is in a primary uptrend, because this has not happened before. While the price of oil will certainly fluctuate, as we have seen with the recent reaction following the move over $70 as Katrina struck, there are two crucial differences between the current overall uptrend and spikes in the 1970s. Those were caused mainly by OPEC price hikes and production cutbacks. Prices subsequently fell back because there was no real shortage so additional supplies soon flooded the market. Today, the key driver of prices is demand, while OPEC production is near capacity.
I have little doubt that additional oil supplies will emerge from Russia, Canada, Venezuela, Nigeria and some other producers. Moreover, refining capacity for the so-called light sweet crude currently in short supply will certainly increase. Combined, these factors could put crude oil prices in a ranging corrective phase for one to three years, at some point. However, we may not see $40 again and more importantly, the very long-term trend is extremely likely to remain upwards.
Consider this: 3.4 billion Asians currently consume slightly less oil than the 22 million barrels per day used by the United States. Developing Asia’s demand for oil is rising rapidly. The world currently consumes approximately 82 million barrels of oil a day and rising. At the current rate, the world needs to find 30 billion barrels of extra oil per year to avoid depletion of known reserves. There has not been a significant new oil discovery for many years. Some petroleum industry specialists question the ability of producers to increase supply in line with the demand trend.
So we have supply inelasticity and a demand driven secular bull market for oil and alternative sources of energy. This is also true of industrial metals, where the China-led increase in demand is much greater than for oil. No doubt China’s economy will experience an economic slowdown at some point, if not now as some predict, in the not too distant future since all nations experience business cycles.
Nevertheless, China’s government estimates that somewhere between 300 and 500 million people will move from rural areas to the cities by 2020. This unparalleled migration will require massive urban building, requiring (according to some estimates) the equivalent of two metropolises the size of New York City or Greater London every year for the next fifteen years.
India’s infrastructure and urban development requirements are also massive. This has changed the demand trend for industrial metals, some of which are in scarce supply, for at least a generation.
Scarcity, supply inelasticity, and rising demand are also apparent for precious metals. And while industrial usage has not and will not take off to the same extent as we have seen with industrial metals, Asia’s newly and increasingly affluent consumers ensure a rising trend in demand for jewellery. However, what is likely to be the biggest source of demand, which we are only beginning to see, will occur as gold and other precious metals are increasingly remonetised in the eyes of investors.
This is occurring, evidenced by new multiyear highs for the price of gold in US dollars, sterling, euros and yen, because no country wants a strong currency. Why?
First and foremost, it is due to intense competition in manufacturing due to globalisation and the accompanying fear of deflation.
How does a country keep its currency from appreciating? It prints more of it, literally, and electronically through credit creation. The United States certainly did plenty of this in 2001 and 2002, to weaken an overvalued dollar. Today, we live in a world of fiat currencies, paper money – an exceptional situation in the long history of monetary systems.
And there is no going back to a gold standard, because there isn’t enough of the yellow metal, without adding at least two noughts to the price, which won’t happen.
So we live in a world of stealth inflation, where the amount of paper money in circulation is increased faster than the rate of GDP growth – sometimes a lot faster.
Consider the US’s liquidity infusions after the Asian crisis in 1997, with more following the Russian debt default and LTCM collapse in 1998, then because of the Y2K misinformation and paranoia. The Federal Reserve pulled a little of this back in early 2000, only to flood the system again following the NASDAQ collapse.
The next monetary infusion came in response to 9/11, with more added for wars in Afghanistan, Iraq and the new Homeland Security Department. And now we have the Hurricane Katrina aftermath, not to mention myriad pork barrel projects – $10bn here, $30bn there – which are sacred to Congress.
Perhaps much of this liquidity and spending is humane and therefore justifiable. But it certainly torpedoes the US Government’s budget. And how does the United States pay for it? It issues more long-dated bonds and then has every incentive to inflate away much of this debt over its duration.
America has plenty of company. Wal-Mart and numerous other companies spend billions on goods produced in China and other low-cost manufacturers. And what does China do with all those dollars? The government prints more renminbi, which it gives to the Chinese companies in exchange for their dollars. China’s government then buys US Treasuries, to maintain their currency peg, and more recently, the PRC has also embarked on a spending spree for technology and oil.
This sequence of borrowing, printing and inflating is now endemic among countries. Those who resist the temptation, and few do, soon find that their currency has risen to punishing levels in terms of export earnings.
And there is also the cost of energy to consider. Governments can’t control the rising price of oil imports, which push up inflation in the short-term but create a longer-term deflationary risk. What is the most tempting way to deal with this risk? Increase the amount of money in circulation.
Consequently the seeds of a new inflationary cycle have been sown, increasingly since 1997. It takes time for them to germinate and unlike the pre-globalisation 1970s, competition in manufacturing has benefited consumers and kept official statistics of inflation low.This has encouraged governments to inflate even more. We see the consequences in asset inflation, from commercial property and houses to stock markets and raw materials.
And anyone who pays the household bills knows that many prices have surged, including insurance, council tax, food, restaurant bills and education.
Pockets of deflation will persist for years, mainly in manufacturing, which restricts wage increases in many industries. However there is little doubt, although much denial, that a new inflationary cycle is underway.
Punctuated by periods of rising interest rates and economic slowdown, as governments temporarily attempt to rein in prices, inflation will gradually increase in rolling waves rather than linear fashion.
Governments still fear deflation more than inflation and this is unlikely to change significantly, until inflation is fully in the public consciousness and regarded as public enemy number one. This is more likely to occur from 2010 to 2020, rather than in the current decade.
No wonder the price of gold is rising against all currencies.
By David Fuller for The Daily Reckoning
David Fuller, director of Stockcube Research, has been the eponymous analyst and editor of ‘Fuller Money’ since its launch 20 years ago. A writer, lecturer and active trader, he is one of the world’s most experienced and highly regarded independent market commentators, and is frequently quoted by the international press.
To find out more about Mr Fuller’s unique online investment service, see: ‘Fuller Money’