The inflation hedge of choice

On Wednesday, the US Federal Reserve "shocked the world" by announcing plans to buy $300bn of government debt and double its purchases of Fannie and Freddie securities. According to the FT, once the Fed's plans are fully realized its balance sheet could swell to $4,ooobn, one third the size of the US economy. Hellicopter Ben, meet Bazooka Ben.

The Fed's actions are an attempt to literally shock life into the credit markets. It may also have the convenient effect of driving down the cost of government borrowing. However, the Fed runs the very real risk of stoking a very big inflationary problem down the road. Weimar Republic the US is not, but the money supply is growing at such a rapid rate that the Fed had better hope the US economy rebounds this year. Remember central bankers, there are unintended consequences to such dramatic monetary easing; like say, a housing bubble (Mr Greenspan, I'm looking in your direction).

What then are some of the likely consequences of the Fed's policy innovations? For one, the dollar was the big loser last week; in fact, it registered its worst week against the major currencies in 24 years. This fed into an accelerating rally in commodities, the moment's inflation hedge of choice. The benchmark S&P GSCI index was up 8% last week. Or take copper, up some 28% this year, a feat completely divorced from the underlying fundamentals. Though, the FT has an article this morning on the actions of a "secretive" Chinese state institution stockpiling copper supplies (which sounds like the perfect plot for Bond film). Oil is back over $50, supported by the OPEC cuts, but boosted in recent weeks by Fed policy. The speculative inflow into commodities, as an asset class, may be small compared to the bubble of recent years, but it is nonetheless paring the steep losses experienced in the second half of 2008.

The sustainability of this rally is highly suspect. With Chinese growth forecast at 6% for the year, and the G7 contracting by 3.2%, the global recession will depress demand for commodities well into the year (with the possible exception of food, but that's another discussion). However, loosey-goosey monetary policy (as A-Rod would call it) comes at a price, with inflation second only to a loss of confidence in US treasuries. Bernanke has demonstrated that he is willing to throw everything in the Fed's arsenal at the credit markets. Until he wins, expect commodities to outperform as an asset class.

(photo courtesy of Shiny Things' photostream)

The copper campaign

Building on Rory's discussion of China's investment in Rio Tinto, it's worth noting that China's most recent move to develop a stake in the international copper market goes back to early 2006, when demand for copper in China far exceeded growth in the industry. By March of that year, investments in copper smelting and the production of copper-based value added products like wires and cables seemed like a safe bet. According to some estimates, demand for copper grew by nearly 87 percent between 2001 and 2006.

If you were reading government publications, you might have thought otherwise. Just months before, in late 2005, five government ministries came together to publish "Proposals on Curbing Blind Investment in the Copper Smelting Industry," citing worries about the stability of copper prices, international copper supply, the environment, and the financial risks linked to loans for new smelting facilities. But news of these worries did not seem to hit mainstream media until August 2006, nearly a year later.

The most recent decline in commodity prices has kept these same copper smelting facilities and copper dependent industries on edge - over the course of 2008, growth in the industry dropped to less than 3 %. In December, Mineweb offered some interesting observations that bode poorly for copper's future. For one, they agreed with many economists that growth in China will no longer be in the double digit percentage range. And while "infrastructure counts for some 40% of copper consumption with the bulk being for power cables," the demand for copper is likely to fall proportionately with growth in the economy. Looking closer, "factory closures, leading to workers seeking new jobs, fits labor intensive infrastructure projects like roads, railways, bridges etc. rather than unwanted electricity generating and distribution capacity." On top of this, many power supply companies canceled orders for copper cables and some provinces have even begun using aluminum for cheaper medium voltage cables.

As the force of the economic crisis become a reality, China stepped forward to make a significant effort that may save the chunk of its economy leveraged by the copper industry. This effort began in January 2009 when China released a stimulus package aimed at infrastructure projects that will inevitably require copper wire and cable. Just a few weeks after this, they bought a huge stake of copper options with the hope of maintaining a supply of cheap unrefined copper. This has become a high profile campaign, but the stakes of unemployment and economic collapse in China is a high profile game that government cannot afford to lose.

(Photo from planewalker001's photostream)

Lower oil prices make me nervous

I try to avoid making hard predictions on this blog, but regular readers know that I’ve recently made two high profile picks. I’ve argued more than once that political-economic fundamentals suggest that Barack Obama will win the Presidential Election in November handily. Admittedly, that’s looking a bit dicey at the moment, but I’ll still be astonished if Mr. Obama somehow manages to snatch defeat from the jaws of victory in the most favorable electoral climate in almost three decades. I will also petition that the Democratic Party disband and its leaders seek gainful employment in a completely different line of work. Further, I’ve argued that the new baseline for oil prices will be $100/barrel. In recent days, however, oil has crossed the Rubicon and is currently trading around $96. Does that mean I’m wrong?

It’s too early to say definitively, though I don’t think so. But there’s a larger problem: it could very well be a bad thing if oil prices continue to slip.

It is a fact that the global economy runs on oil. It is also true that right now there exists no substitute that could completely replace oil. Therefore, if the global economy continues to grow, which most people agree is a good thing, it also means that oil consumption will continue to grow, which most people agree is a bad thing. But without a substitute, the world will need more oil. 37.5 million extra barrels a day, to be exact, according to the International Energy Agency. That’s on top of about 85 million barrels consumed each day currently.

Without a substitute or sustained economic recession, that oil needs to come from somewhere. The problem, as I’ve mentioned, is that most of the ‘easy’ oil is already being pumped. In a fascinating article today, RI notes that most of the oil majors are pricing new investment projects at a cost of about $70/barrel, which they would like to sell at market for $100/barrel. Simply put, if the price of oil continues to fall, it is likely that they will delay these new investment projects, which could lead to a major supply gap in the future. Rather than a gradual rise in oil prices, we might see a disruptive spike.

Conversely, it is clear that in the face of accelerating climate change and higher energy prices, the world needs to develop renewable energy sources. Say what you will about Tom Friedman, he’s an ideas man and his new book looks like it highlights what will be one of the major political economy challenges of the coming era (n.b. I haven’t yet read it). However, as I’ve also mentioned, declining oil prices likely reduce the impetus for investment in alternative energies.

Understandably, oil companies want to keep selling oil for as long as possible. It’s what they know, it’s what they’re good at, and it’s extremely profitable. In Congressional testimony last week, the President of M.I.T. noted that oil companies invest less than 0.25% of their revenue in R&D, compared with 18% for pharmaceutical companies and 16% for semiconductor firms.

But this is ultimately unsustainable. Anyone interested in developing an energy substitute in a timely fashion must first acknowledge that the era of cheap oil is over. In my opinion, any prolonged forays below $100/barrel are just delaying the inevitable hangover, and very likely making it worse.

(Incredible picture by nzdave)

Tata's fall :: China's rise?

Late last year Tata motors unveiled production plans for the Nano, what was to be the world's most affordable car with a retail price tag of $2,300. Their plans were derailed today by farmers protesting land acquisitions in the special economic zone of Singur, home to one of three Nano factories in India. The debate has been brewing since the government "bought" the land under a 2005 economic expansion policy. It is certainly reflective of the tense nature of labor relations in India but more tellingly, the outdated nature of the Indian bureaucracy and government.

From my own experience in India (and this can be confirmed by anyone who has worked or lived there), anything the government runs is insanely slow. Employing three people to sell someone a stamp and five people to check your train ticket (not to mention the 4 porters relying only on tips) reflects the far reach of the government and its' woeful inefficiency.

Not only is this frustrating but, as Arvind Subramanian explains, it also spells danger for India's growth and development (especially when compared to China). India is certainly ahead of China in education achievements and political freedoms, but unless the government can be streamlined by selfless reformers (about as likely as it sounds), the country's growth will slow in the coming years. The bureaucratic institutions are a legacy of the British and provided many jobs in the early years of Independence but unless the government can discard this colonial legacy the institutional stagnation will lead to economic stagnation. As Subramanian says, it is easier to create markets than improve a state's capacity. That's good news for China and bad news for India.