Thanks to the Thanksgiving holiday, the Labor Department released the latest figures on employment one day early last week. And we are duly grateful that the figures were better than expected. Unemployment insurance claims are a leading economic indicator and, over the past month, UI claims fell by over 34,000 to a level lower than before the recent recession began. And this was just the start of the good news for the economy.
Also encouraging is the slope of the yield curve, the difference between the yield on short-term and long-term bonds. The greater the gap, the faster the economy tends to expand. It’s the most heavily weighted component of the Conference Board's Index of Leading Economic Indicators and lately, the yield on 30-year bonds has been rising, while the yield on short-term bonds has fallen (thanks no doubt to the Fed's aggressive buying program). This has tilted the yield curve in a very healthy direction, suggesting growth will pick up.
A third major leading indicator is the stock market. Despite the recent sell-off, the market remains in a clear uptrend. So things are looking up for the U.S. economy.
Even the U.S. dollar is looking stronger these days. The U.S. Dollar Index seems to have broken out of the downtrend that began in June. Moreover, this has taken place despite the Fed's promise to inject close to $1 trillion into the financial system via bond purchases over the next six months (if you add up all the various quantitative easing programs).
Such rapid money creation might normally sink the dollar, but instead the greenback seems to be getting a boost from the on-going European debt crisis. Europe decided last week on a $115 billion plan to bail out Ireland. That, plus fears that other European nations (such as Portugal) may also need bailouts, sent the euro to a two-month low. And when the euro falls, the dollar rises. It's a war to see which currency can devalue furthest with Europe winning the latest battle.
We suspect the European bailouts will continue. Europe has so far failed to figure out how to reconcile the massive disparities between strong economies like Germany and weak economies like Portugal, Ireland, Greece, etc. Certainly, a sudden bursting of the euro would wreck too high a cost on everyone. Imagine, for instance, if Ireland could pay back its debts to the German banks not in euros but in Irish punts that were worth mere pennies by comparison? It would be a disaster for the German economy.
So we expect Europe will continue to make efforts to save the common currency through its own brand of quantitative easing. The euro could fall to US$1.25 as a result, but it probably won't collapse outright for some time. After all, the most viable economy within Europe remains Germany, a country with nearly 4% annual growth and only 1% inflation. Moreover, Germany benefits greatly by having the euro rather than the Deutschmark as its currency. The euro is quite undervalued in terms of the Germany economy, and that supports German exports. Germany exerts considerable influence in Europe, and it is not about to give up its advantage.
Meanwhile, the U.S. economy seems likely to perform a little better for a time. Of course, that also means commodity prices get more support from higher U.S. demand. China will likely finish its current round of economic tightening within the next month or so.
That suggests the next round in the economy/commodity pas de deux will be led by commodities. Sometime in 2011, commodity prices will make their next big upside move. We could see 3-digit oil prices again and fresh all-time highs in copper, zinc, tin and other industrial materials. It will be like Spring of 2008. Fears of higher inflation will reemerge, and this time higher unemployment will leave the Fed with fewer options. Certainly, it will not risk another economic meltdown. It may try to rein in inflation by reducing its purchases of Treasury bonds, but the degree of tightening will be minor.
What will eventually derail the U.S. economy, and that of the world, will be commodity prices reaching the height where they prohibit further growth.
For instance, there's simply no way the global economy can expand without copper prices going through the roof. Not with the massive infrastructure China is building, nor the inevitable switch to alternative energy, nor India's infrastructure needs, etc. Copper is just not plentiful enough to meet these demands.
The argument that as copper prices rise we will simply mine lower-grade deposits is flawed. Higher copper prices will also mean higher prices for oil and other commodities (as copper equipment becomes more expensive), and that will push the cost of mining copper even higher. The problem is that we've already exploited all the inexpensive resources in the world. As multiple commodities become in short supply, the cost of developing less-rich deposits will become prohibitive.
Already, we are seeing more stories in the news about thefts of copper wires and pipes. With copper priced under $4, most people don't think such items can attract thieves the way high-ticket electronics do. Yet, as copper prices rise to $10 or more, stealing pipes and wires from warehouses or abandoned homes will become a very profitable enterprise for thieves. Higher copper prices will create inflation which will make people poorer. And with high unemployment and rising poverty, we expect more people will resort to such crimes. Companies may have to start guarding their copper like it was gold (and their gold like it was diamonds).
And that's just one metal. Other materials, such as silver may be even more attractive to thieves. Eventually, criminals will be stealing computers to melt them down for the copper, silver, and other metals they're made from.
Our point is that we cannot view any commodity as isolated from the entire economic picture. Past a certain point, scarcity in any commodity promotes scarcity in the rest.
Another story we think you should be aware of concerns last year's Copenhagen summit on climate change. You probably know that the U.S. has little intention of combating climate change by cutting back on carbon emissions. Nor is there much willingness on the part of other Western nations. Surprisingly, the one country that has committed itself to fighting climate change in alignment with the Copenhagen summit is China – the very nation that is engaged in large-scale industrialization and urbanization.
We are a little cynical about China's motives here. In fact, we suspect the country simply wants a good cover story to explain its accumulation of natural resources. China can claim it needs these resources to build alternative energy – and that alt. energy is part of its climate change program.
Deep down, we think the Chinese are as much climate change-deniers as Americans. In fact, we recall a study published in Nature by a group of Chinese scientists that argues climate change could surprisingly benefit China by making the climate within China better suited to agriculture.
Regardless the reason, China will continue buying up commodities and commodity prices will move higher. We may be in a corrective phase right now for commodities and stocks, but it will end. In 2011, base metals and oil are likely to be the strongest investments. Stocks will perform well. Gold may lag these two, but it will still give good returns and will be the safest investment. Gold will take the lead once it becomes clear that high commodity prices are acting as a brake on the economy.