Commodities: Is It Time for the 'Great Slump'?

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Instead of hyper-inflation, the most likely near-term scenario is a slump in asset prices, as the world economy slows down due to China's efforts to rein back inflation. This will crush the speculative activity that has pushed oil prices to a level that is further slowing down economic growth and depressing demand.
China’s problem is pretty simple: It stimulated its economy using straight demand side and mercantile principles, which included pretty aggressive currency manipulation and easy lending. The result was simple demand pull inflation as internal demand exceeded availabilities. Letting its currency float up may get rid of imported food and commodity inflation, but internal resource constraints probably won’t go away until growth drops to a steady state level that matches the growth of internal resources.
In other economies, this is usually around 5% maximum growth per year. China is targeting 7-8% growth, down from the 10% it's averaged over the last decade, so its ability to tamp down domestic inflation is questionable. In any case, there is a dramatic slowdown going on in Chinese imports which is all that matters to commodities.
China's growing demand for commodities has slowed dramatically as shown by the miss in import growth: 21.8% instead of 28.9% in April. Copper is rumored to have been stockpiled in vast quantities in China and is showing a dramatic drop, 13% lower than a year ago in dollar terms and 20% lower in volume. This may have been caused by a drawdown in domestic stocks due to price appreciation, or it could be the result of generally slowing economic activity. It really doesn't matter which, as the effect on commodity prices should be negative.
What appears to be happening is the commodity space is getting crowded with capacity and prices have appreciated so much that demand is being reduced. The best example of this is oil, which has been in basic oversupply for the last two years yet has shown price appreciation of 70%. At current levels, demand in the United States for oil and distillates is plunging, with gasoline demand dropping at a 2.4% annual rate this week. Refinery capacity at 81.7% is at one of the lowest rates of the recovery and storage is bulging with inventory as shown in the chart below.
5/11/11 Crude Oil Inventories
Adding the other events that are soon to occur (the end of QE2, the end of stimulus, and the continuing drop in housing) to the fact that Congress will not be able to pass any sort of stimulus until unemployment starts to get much worse indicates that the excess money that has been pushing up commodity prices is going away. The Federal Reserve will almost certainly try to pull something out of its hat, but it’s questionable whether QE3 will be effective, given the Japanese experience with quantitive easing. It's scary to note that the 18% rise in the S&P 500 since the beginning of QE2 parallels the 19% QE-induced rise in the Nikkei 225 before it started its 44% plunge to current levels.
On a theoretical basis, the question is whether we're in a liquidity trap (or perhaps if liquidity traps exist), where increases in the money supply don't matter, or on the verge of hyperinflation due to a debased currency. Or perhaps we don't need to think about the theoretical issues and just look at the fact that inventories of commodities appear to be at record levels. Any drop in demand will result in excess capacity, proving once again that the cure for high prices is high prices.
Should we mention the fact that corporate profits are at a record level as a percent of GDP? If corporate profits cycle down, it will push down stock asset prices unless P/Es go to record levels. Without the push of excess cash, higher P/Es are unlikely
Or shall we ponder whether the default of Greece will crush financial stocks? A default is probably a ways off but seems inevitable.
Timing is the hardest part of guessing when asset deflation or the “Great Slump” will occur. There don't seem to be any definite reasons for major drops until QE2 ends in June. At that time, Bernanke might try to pull a few more new tricks out of his academic bag right away ... so there might be a few more months of excessive liquidity. Or perhaps he'll wait for the drop to get obvious before he does anything. The S&P 500 dropped 16% before he announced QE2.
Of course, one of the events I've mentioned could come to a head or the United States could roll over into a double-dip recession, which would get things rolling downhill fast. Actually, it does seem like the United States is headed for another dip, but that's a subject for another post.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.