Long Term Trends: Beware the Lurch!

The once-in-a-lifetime stuff going on in the financial markets currently makes it a little difficult to discern several long term trends: the dollar bear, the commodities boom, and the growth in emerging markets. Although they've all abated in the last year, they are all still structurally sound. What we have now is a big counter-trend correction; we hit the wall and bounced back, as it were. Once the global economy stops seeing stars and realizes that nothing's broken, it will continue with a lurch and slowly pick up steam over the next couple years.

The dollar bear is built in because we can't run this country on what we produce here. Although Cheney was widely mocked on the Left for his comment, "The American way of life is non-negotiable", it is nonetheless true that we don't much have a plan B. To rely on domestic sources of oil and those alone would make today's economic troubles seem like 1999. (Oh, Prince. How did you know?) Given that supply has been essentially flat for four years, despite high prices and tremendous growth indicates that supply is unlikely to grow ever again. As the rest of the world — I'm looking at you, China — develops they will increasingly bid against us. We'll see $147/bbl again, probably not this year, and probably not next, but likely while Obama is still in the White House. It's old news, but a trip to Walmart will confirm that we still don't make much of what we buy in stores either. And we won't for a while; all of that would take time to build and put together once it becomes profitable. We need to buy more from the rest of the world than they do from us to continue living as we have, even with a recession-induced reduction in standard of living, and that means the dollar will remain weak. It's been strong recently for two reasons. The first is that we've been exporting a lot of financial assets: both US based investors selling emerging market stocks and bonds, and foreign investors buying US based securities, in particular Treasury bonds. That's just a short term thing. Late this year, or possibly next, the dollar bear will resume. Bet on it. (But beware the lurch!)

The pullback in commodities had to happen: economic growth since 2003 has been based on an unsustainable expansion of debt, rather than real increases in wages; during economic downturns, commodity prices drop due to a drop in demand, and in this case it was exacerbated by the use of commodities as a hedge against a weakening dollar. We have excess capacity in all commodities and that will persist for a while. Nonetheless, all of the things that drove commodity prices to their peak last year — or in 2007 in the case of copper — are still in place. China is building cities. Lots of them. Big ones. All of the factories that are currently shutting down in South China because we and the rest of the world just aren't buying as much anymore will start up again as soon as there are willing customers, and the currently latent demand for energy and materials will return. That's the demand side.

On the supply side, Peak Oil hit the news in a big way last year with the price of oil hitting $147/bbl. It's not just oil however; nearly all commodities have long-term supply problems. It's not so much running out as what's left is hard to get to, expensive to extract, process, and bring to market. As an example, one of the big oil discoveries last year is the Tupi field off the coast of Brazil. It's an offshore field underneath over a mile of water, two miles of sand and sediment, and then another mile of gooey hot salt. It will take ten years and hundreds of billions of dollars to bring the field into production. It will be neither soon nor cheap, and in the mean time, existing fields have an aggregate decline rate of 5% per year. Not only that, but since 1984, we've been using more oil each year than we have discovered. Keep in mind as well that oil is only one commodity. A similar situation holds for nearly everything else we extract from the earth, from copper to water, from gas to potash. We aren't running out, per se, just running out of the stuff that's cheap and easy.

Lastly, emerging market gyrations derive mostly from our troubles. In general, these are export oriented economies, either in goods and services — e.g., China, India, and Vietnam — or commodities — e.g., Russia, Chile, and Iraq — or both &mdash e.g., Brazil. In recent years, commodity exporting countries have seen tremendous growth supported by a huge increase in exports due to high commodity prices. This in turn has increased wealth and the demand for better food, more clothes, more goods, various services, infrastructure, etc. In goods and services producing economies, we find a similar pattern. They all had a good run while we borrowed more and spent, and in response they expanded their capacity to meet a seemingly insatiable market. Now that we have collectively used our available credit, we buy less, and as a result demand in export economies has dropped precipitously.

We've seen growth in emerging markets because they offer underutilized labor, inexpensive land, and weaker regulatory oversight. The various global trade agreements of the past two decades have enabled investors to exploit these benefits more easily, resulting in entire industries being exported from, say, the US to China. Additionally, unlike a developed economy where selling a few more microwave ovens each year is difficult because only so many break and there are only so many new households forming, an emerging economy has a much larger potential demand for new microwaves because the market is not yet saturated. Hence, provided the economy is able to supply jobs and incomes, there is the potential for vastly greater growth than in developed countries. These two features — favorable investment climate and potential consumer demand — have driven emerging markets. As soon as aggregate global demand resumes, these features will reappear.

The key part in all of this the return of aggregate demand, the willingness to buy and to invest. It's impossible to say when that will happen, but it won't be soon, given that the recession metastasized into something much worse after the credit markets locked up due to the collapse of Lehman in September: huge drops in shipping volumes for ship, rail, truck, and airfreight, a loss of 40% of all financial assets worldwide, rapidly rising unemployment, etc. The conventional wisdom however expects something late this year. The National Bureau of Econometric Research recently declared that the recession started in December 2007. Since recessions generally last a little over a year, and since this one is the worst we've seen since the 70s, the market expects it to end sometime in the 3rd quarter this year. That seems a little early to me. Since equities usually begin rising three to six months before the economy begins growing again, there's the expectation of a bottom and and big rally in equities this spring. We may get the rally, but if the recovery doesn't materialize, we'll have a much deeper bottom afterwards. Furthermore, all of the above in this post is known, to a greater or lesser degree, throughout the financial and investing community. The counter trend has certainly muddied the gestalt view, but with the least sign of recovery in demand, we'll see a rapidly weakening dollar, a short spike in commodities, and a spike in emerging stocks and bonds. Those spikes will be driven by the desire not to miss the rally, to get in at the bottom. The first little bit of hopeful news about aggregate demand is all it will take.

That's the lurch. It will be early. Bet on it.