“Inflation or deflation?” that is the question markets have been wrestling with for the last year and will likely do so for another few. With reports of the record steep yield curves upon us, it should give us pause to ask which direction we are headed.  Clearly central banks around the world are doing everything possible to ensure inflation is at least positive even the steps might be detrimental the long term health of their economies.  

 

A look at industrial production for the U.S. and other major exporting nations does not seem to justify this view of rising activity.  It is countries like Germany and China that are in an uptrend for production.  As we looked at last week, trade is gradually recovering, even after the end of some stimulus programs.  However, it remains far off the pace of last year and unlikely to cause tightness in labor or the markets for raw materials any time soon. Furthermore yield curves for various countries don’t correlate particularly well to the fiscal responsibility of their nations. 

 

In cycles past a steep yield curve (higher interest rates for holding debt for longer periods of time) was seen as a bullish sign for an economy.  Today it is reported as inflation is right around the corner.  Yet a totally logical argument for inflation is hard to find.

 

           

 

U.S. interest rates have risen in the last month but remain far off 2009 highs.  The rates for 10-year U.S. Treasuries are a good indication of expectations for the long term.  It is fair to argue that if serious inflation does not arise within five or ten years of this crisis, you can’t blame policy actions of the last year for future inflation. Yields on 10-year Treasuries had dropped below 2.5% at the beginning of this year but began a steady rise to nearly 4.0% into June. Yields then slid back down to 3.21% in late November. In the past week they have hovered above 3.5%. 

 

These yields do not reflect future inflation or economic growth simply the expectations of them.  Unfortunately, you can not ascertain from the curve above how much is expectation of growth and how much expectation of inflation.  For that you have to go to the Treasury Inflation Protected Securities (TIPS) market.  I won’t go there for this article but suffice it to say inflation expectations are returning as they did last June. Yet, you have to ask, “Where is it coming from?”

 

 

Most inflation watchers fall into two different camps.  The first, I will call the “Output Gap” camp. This group of investors and economists believe inflation is caused by scarcity in labor and materials.  Inflation is only created when things become tight, in part, by rising prices of raw materials but more importantly by rising wages of workers.  Most folks in this camp look at high unemployment levels and low production levels and conclude above average inflation is many years off.

 

I would call the others the “Money Printing” camp.  They believe that inflation is caused mostly by an increase in money supply.  The more money being created by governments and the private sector, the more there is to chase goods and services.  This bids up prices and causes inflation. Clearly government deficit and debt levels for most industrialized nations are at or are headed to record levels for the Post-WWII period.  Members of this camp look at government deficits of the U.S. or the U.K., remark about central banks printing money, and advise you to sell the dollar or pound and buy gold, the Yuan, or the Euro.  

 

 

If inflation was being driven by scarcity of materials and labor we would need to see at least one of two things: signs of a tightening labor market and/or increasing of production consuming raw materials.  I won’t bother to graph the labor situation as most folks know that official unemployment in the U.S. stands at 10.0% with Europe only slightly better at 9.8%.  Germany stands out in the EU with a rate of just 7.5%.

 

Some economies like those of Canada and Australia are actually adding jobs to the private sector while places like France unemployment is still rising.  As discussed before the much reported decline in the U.S. unemployment rate was more due to assumptions than jobs added to the economy. That leaves industrial production.

           

                                             

Industrial production of German and Japan are returning but remain more than 20% off pre-recession peak. Industrial production appears to have bottomed in most major countries.  In fact, it is the countries that saw the furthest decline that are staging the stronger month-on-month gains as of late.  Yet Germany and Japan remain at production rates that are 20.3% and 21.8% off their monthly peaks in 2008.  This figure is better in the U.S. and the U.K. 12.3% and 14.4% declines respectively but momentum may be stalling out in these places through.  With capacity utilizations as at or near record lows in many countries, it is hard to argue for ‘tightness’ anywhere in the industrial process. The best argument can be made is for Germany but even that case would be weak.

 

 

If inflation isn’t being driven by tightness in labor or production, we can to look at unfettered government spending as a source of inflation.  The arguments for this are well reported. Governments are indeed spending money they do not have and issuing debt at record levels.  


 

Japan, the United States and United Kingdom have serious structural deficit problems. Budget gaps are a combination of lack of revenue and increased spending. Japan, the U.S. and the U.K. are all on track for budget deficits as a percentage of GDP that exceeds 10%. In all cases, this double digit level is expected to be temporary but the return to pre-recession levels is far out into the future if at all.  

     
                                   

 

Japan’s interest rates are half of its OECD peers.  There are a few problems with this as the explanation for higher interest rates. There is a correlation for high government deficits with higher interest rates in the U.S. and the U.K. Yet the correlation breaks down in the case of Germany and Japan. Japan, the country with worst fiscal deficits and the largest government debt (already over 100% of GDP), has the lowest interest rates of any industrialized nation.  Printing money has been going on for two decades there yet investors still flock to the yen.  Germany, whose government spending is on much sounder footing has interest rates not that much different than those in the U.S. or the U.K.

 

 

 

Industrial production growth continues to outpace.  According to official reports Chinese industrial production in November was up 13.8% over the prior year.  This, of course, is as much a reflection on the weakness of last year as the strength of today.  Above is a set of categories I have followed for prior articles that reflect production for both domestic and export demand.  

 

Production in some categories like automobiles and steel has seen positive growth all year and is now setting new highs.  Other categories like tractors and air conditioners are hovering around 2007 levels with recent growth simply offsetting large negative growth last year.  Chinese exports remain subdued so most of this output is either going to local buyers or is building up in warehouses. 

 

If the government numbers are to be believed, production is up – making it about the only place in the world where ‘tightness’ in labor and/or raw materials might be legitimate.  Additionally, there has been record growth in money supply through bank lending earlier this year. Lastly, China with its currency pegged to the U.S. dollar has effectively imported America’s loose monetary policy.  If there is any place in the world with hyperinflationary risk, it’s China.  The Chinese government does have a way to deal with it through strengthening its currency but so far it appears loath to embrace this path.

 

In the end interest rate curves are a reflection of expectations rather than actual inflation or growth.  As with last June, expectations can come and they can go.  It is only profitable to buy into them if what they are based on comes to pass.  Yet if there are enough traders with the same expectations, these expectations can drive markets for many months or quarters without the true event coming to pass. One just needs to look at oil prices despite being awash in extra supply. Eventually, either expectations are realized or markets correct.

 

So what is the point of it all?  There are legitimate concerns about inflation in the United States and elsewhere.  Yet, if inflation is primarily by driven tightness in labor markets and/or materials, Germany will likely be ahead of the U.S. or the U.K. when it happens. On the other hand, if it is money printing and runaway government budgets that drive inflation, it should be Japan that faces the real test first.  Yet neither of these is priced into the markets.  

 

We all assume price is a reflection of the most likely scenario.  Maybe it is simply a reflection of the most crowded trade.  The most likely scenario is inflationary pressures in China but without a solid government bond market and a free floating currency this is a much more difficult trade.  It is much easier to sell the dollar, buy gold and oil, and report it as the likelihood of runaway inflation in the U.S. Such inflation is possible but more likely to appear elsewhere first.

 

 

                                                                                                      

Mr. Market (global asset markets) has been true to the manic-depressive characterization Benjamin Graham put forth six decades ago. We appear to be lurching between two opposing views. The first is that upon us is a recovery that will drive growth and consumption, leading to runaway inflation and dramatically higher interest rates. “Quick, sell the U.S. dollar.  Increase your commodities exposure!” he warns. On other days the opposing view is in vogue, “Deleveraging will continue for years bringing below-trend growth and deflation.”

                                                          

Many economic indicators in the U.S. and around the world have been steadily improving throughout the second half of 2009 supporting the first, more bullish view.  Critics rightly contend, though, that we really don’t know the true health of the economy because of government stimulus which is both artificial and temporary.  Thus, we don’t yet know which of Mr. Market’s views are correct.  

 

A look at global trade through the lens of automobiles reveals that we may be headed for somewhere in between.  Trade has held up rather well after the expiration of stimulus.  As I pointed out in last month’s article, the healthiest outcome for all of us is a return to trade growth without global imbalances worsening.  Trade data is pointing to a recovery that is mild by most standards but that brings with it some much needed correction of these imbalances.

 

           

 

U.S. trade is rebounding but deficit is muted. The U.S. trade in goods (both exports and imports) rose for the fifth time in six months in October. In general, increased trade activity is good as it reflects an increase in economic activity.  Stores are restocking their shelves, customers are buying, and companies are preparing for a 2010 that is better than the year we are about to leave behind.  For the U.S. in particular, though, the trade deficit is a key measure of health.

 

That deficit which the U.S. runs with most countries has widened since bottoming in May.  Relative to a year ago it is down dramatically. Last October was a pretty crazy time (Lehman, TARP, oil prices, etc.) and maybe comparisons with twelve months ago aren’t so appropriate.  Let’s go back two years.

                                                                                                                           

One benefit of comparing to 24 months ago is oil prices (a major driver of the U.S. trade deficit) were similar in October ’07 to October ’09, near $80/barrel in both cases.  In October ’07 the total trade deficit (goods and services) stood at $57 billion versus $33 billion today.  That is a deficit drop of 42% while total U.S. trade (imports plus exports) has declined 11%.  In the past two months U.S. total trade has been above the $300 billion per month level, very close to early 2007 levels.  Yet the deficit is far off the 2007 pace – a good thing for the U.S. and the world.

 

 

Japanese trade has improved, thanks in part to autos. Japan was one of the countries hardest hit by the global recession.  Thanks to its leverage to the automobile market Japanese export sector’s dropped more than 50% in just a half year.  This makes it a great place to see if there was in fact a post-cash-for-clunkers hangover.  This government stimulus program in the U.S. that incentivized new car purchases ended in late August ‘09.  Yet Japanese exports have increased sequentially in September and October.

 

 

A closer look at Japanese automobile exports shows a recovery that has so far been sustained.  Export levels are indeed down from last year but are up nearly 90% from the weakest months and stronger in the last two months than the cash-for-clunkers period of July and August. 

 

 
 

German trade appears to finally be on an upward trend.  Detailed figures for German auto exports are hard to come by but the view of overall trade finally appears to be turning positive.  The trade surplus remains below that of years past but, with a bottom having been put in on exports and imports, a steady recovery may have taken hold.

                                                     
                                           

 

Canada returns to a trade surplus.  Canada is largest trading partner with the U.S. and provides the most energy products to its neighbor to the south.  In October, Canada’s exports slightly outpaced its imports. In hindsight, it seems that the trade surplus Canada became accustomed to in the past decade is linked to global energy prices. With crude oil priced in a range from $50/barrel to $80/barrel the surplus may be marginal.  

 

This may not prove to be much of a problem. With government spending generally under control, immigration fueling population growth, and reserves of oil sands and natural gas increasing, Canada has prospects for economic growth without the need for a trade surplus.  In the end, trade surpluses bring two things: strength to your own currency and/or an accumulation of U.S. dollars.  Canada is clearly happier without the former and probably doesn’t need the latter.

                                
                                                                    

                                                                                  

Canadian auto related exports continue to grow.  Canada is also a key partner in the supply chain for the U.S. automotive market.  The strength of exports related to the automotive market is a good sign that the end of fiscal stimulus won’t necessarily result in a collapse to the days of early 2009.  It also shows that the strong currency that the Canadian government so much frets is not holding this sector back.  

 

So what does this all mean? First, there is a lesson in that the end of a particularly successful stimulus program does not necessarily mean doom and gloom.  Maybe we should be less concerned about letting others expire.

 

So does that mean growth and inflation are right around the corner? Unlikely. Whether it is consumer products from China, automobiles from Japan, or prices of Canadian oil, we are still off from or barely at 2007 levels with meager growth rates.  The trade data supports an improving picture from 12 months ago but still it is a slow grind as markets recover from excesses and imbalances of the past.  As is often the case, the truth lies somewhere in the middle.

 

                                                

                                                

Two North American employment reports were released last Friday. The U.S. unemployment figures were widely reported and showed a decline of 0.2% to 10.0% for the month of November. The second, receiving less attention in the press, were those of Canada which showed a 0.1% drop to 8.5% but substantially more job growth. This week markets are ready to call an end to low interest rates and are speculating again on the timing of the rate hikes from the U.S. Federal Reserve.

                                                                                                      

Contrasting the report with that of Canada reveals some of the weakness in the U.S. version. There are some reasons for cautious optimism on global recovery but not because of the U.S. unemployment report. Unfortunately, rate hikes (which many Asian nations would like to see) are likely to be tied to true job creation. 

 

           

 

Canadian employment grows based on jobs – U.S. based on math. Getting month to month statistics right may very well be a difficult task so I am not trying to call into question the credibility of the U.S. employment figures. However, it is important to understand that the drop in the U.S. unemployment rate was not due more people employed. 

 

The Bureau of Labor Statistics reported a drop in the overall number 11,000 jobs in their highly watched ‘non-farm payroll’ figure. Let’s contrast this to that of Canada where the unemployment rate only dropped half as much (0.1% versus 0.2% in the U.S.). Statistics Canada reported an additional 79,100 workers on the payrolls. Keep in mind also the employment market in the U.S. is almost eight times larger than that of Canada. 

 

So how is it possible to loose jobs and have the unemployment rate decrease? There are a number of reasons including the fact that there are actually two different BLS surveys. But the basic answer is that you just have to assume you have less people in your labor force. Given a U.S. labor force that is about 145 to 150 million workers, simple math says it would have taken 300,000 newly employed folks to truly bring down the unemployment rate by 0.2%. That puts us 311,000 short of justifying the headlines we saw last week. 

 

An alternate, private employment survey (known as the ADP) reported 167,000 jobs lost in November. This job-loss figure was down from the previous months and supports an improving trend picture but does not support a job creation story. 

 

If you want to look to an improving economic outlook, you have to look beyond U.S. unemployment to things like U.S. corporate profits, global trade, industrial production, and indicators like the Baltic Dry Index. 

 

 

Corporate America is improving. A lot has been made about the recovery in global equity markets coming up strongly off lows back in November ’08 and again in March ’09. Yet a look at corporate profits in America says that this is warranted. Total corporate profits fell almost 30% from in 18 months. They have since recovered 21% in the last nine months. I like to look at total corporate profits rather than S&P500 (SPY) profits because it total profits as reported by the BEA captures private companies as well. Profits in the past quarter remain 15% off their 2007 peak. 

 

It is easy to criticize the way in which corporate profits have improved because it has come at the expense of the government/taxpayers (through lower tax receipts and aid) as well as the labor force (layoffs, furloughs, and reduced pay). Yet the improvement has come.

 

 

Trade has bottomed.  It is not only U.S. trade that has bottomed but the picture is similar around the world. The above picture of growing U.S. exports and even faster growing U.S. imports is not a good one for the U.S. current account deficit or for the U.S. dollar but yet it means activity is returning to the market. 

 

I have multiple times pointed out the slow pace at which growth is returning in trade. Shipments are growing far slower than the pace of production increases in exporting nations like China.   The point is that while the recovery is happening it is not living up to the expectations of many.

                      

                                                                          

Convergence of Baltic Dry Index components points to improving economic health.  The Baltic Dry Index tracks the shipping rates for bulk dry goods around the world. As an index of actual economic activity, this measure is less subjective to the speculative frenzy of asset markets. It is still highly volatile. (See here for a description of the primary BDI and also of the impact from iron ore.) Two of the four lower level indices, Capesize and Panamax, are highly susceptible to stockpiling of iron ore while the indices of small ships (Supramax and Handysize) reflect a broader range of shipping activity. The fact that these latter two indices are hitting new highs for the year bodes well for the global economy even if the indices for the larger, more specialized ships have corrected some.

                                                                                  

Federal Reserve should increase rates but likely won’t.  Without true job creation, the U.S. Federal Reserve probably won’t be raising rates soon. This is unfortunate though. An increase to just 0.75% or 1.0% would signal to the markets that recovery is upon us albeit a weak one. Yet at 1.0% rates would still be extraordinarily low. Many Asian countries are unhappy about what looks to them like reckless monetary policy and benign neglect of the U.S. dollar. 

 

With so many Asian currencies formally pegged to U.S. dollar or managed in line with its value, the result is an importing of U.S. monetary policy. Countries are reticent to let their currency float without concern for its strength as they fear it would result in weakening their export sector. These days it seems everyone wants to be a net exporter of goods and we all can’t do that at once.

 

In the Asia-Pacific region only Australia is content with a strong currency. Given that state of affairs Asia and the rest of the world are just going to have to wait for U.S. job creation, which has yet to come. 

 

 

In assessing the U.S. housing market as I do each month, there are many lenses through which to look.  Back in March I wrote that the housing market would soon see a bottom in the various sales rates.  This has happened. Last month it was clear that housing was technically no longer a drag on the U.S. economy but that the market is only being sustained heavy government intervention.

                                                                                                      

Today sales rates are up more than 30%, inventories have been cut anywhere from 22% (existing homes) to 54% (new homes), and interest rates are back to historic lows of April. By almost all measures, the worst of the U.S. housing crisis has past. Yet if the housing market is so healthy all of a sudden, then why are there so many foreclosures looming out there?   

 

Proponents contend that mortgage modification programs (many of which are still in trial phase) will eventually bring the bulk of these loans current after banks capitulate and write down part of the loan principle.  Critics contend that we are just postponing the inevitable and this stock of delinquent loans will eventually result in a wave of forced sales sending the housing market down further as early as next year.  So who is right? Maybe neither is.  History suggests the stock of foreclosures might never totally return to pre-crisis levels.

 

First let’s look at the slew of measures that convey the positive trends in the housing market.  

 

 
 

Existing home sales rate surges past six million. Sales of existing homes jumped more than 10% in October to an annual rate of 6.1 million homes as buyers rushed to close their sales before the tax credit was set to expire at the end November.  Inventories of existing homes have declined and now stand at seven months of supply, no longer an abnormal level.  Even the Pending Home Sales Index released today was up for the ninth month in a row, suggesting momentum isn’t about to stop abruptly.  The graph above overlays existing homes sales and the PHSI with a two month offset to account for the roughly 60 days required to close on a home.   The PSHI has proven to be a reliable indicator future sales.

                                                                                                

New home sales regain some momentum.  Sales of new homes rebounded in October jumping more than 6% to an annualized rate of 430,000 homes. The inventory of new homes for sale continues to decline now stands at 239,000 homes, which represents 6.7 months of inventory. Momentum, which had stalled in this measure as of late, returned in October. With the home buyer’s tax credit now having been extended and expanded, support for the entry level segment of the market should continue through next spring.  

 

This large jump in sales volume and decline in inventory is interesting.  Could it simply be just the market clearing of the large inventory of foreclosed homes?  So far, not so much.

 
 

Foreclosures were not the driver of the jump in sales in October.  Many critics argue that home sales figures are being driven by homes in foreclosure.  From September to October the number of homes sold through foreclosure sales declined slightly (according the RealtyTrac.com) while the sales of underlying homes jumped during a month that tends to be seasonally weak.  Foreclosure sales in October represented just 26.2% of all sales, the second lowest monthly reading in 2009.

                                                                                  

Those that want to be critical of this measure are best off looking at the raw (non-seasonally adjusted) sales figures. Factoring out those 130,000 sales attributed to foreclosure, a market following a more typical seasonal pattern would have seen 35,000 less homes sold in October versus September.  Instead the number of homes sold in October jumped up by roughly that amount rather than declining.  

 

You could argue it was simply these 70,000 home buyers chasing the tax credit that moved the annual rate from 5.5 million to 6.1 million.  Jumps in seasonally weak months can a have large impact on annual rates. The fact that there were an extra 70,000 homebuyers that were willing to be incentivized to jump into to the market still says something positive.

 

 

Rates are back to historic low levels. The Freddie Mac weekly survey of mortgage interest rates registered a rate of 4.78% for 30-year fixed rate mortgages last week.  This matched the low set back in April of this year. It has taken a trillion dollars of purchases of mortgage securities by the U.S. Federal Reserve to achieve these rates but the rates are low and the trend is in the right direction to help the housing market.  This relief is only temporary as the buying program is scheduled to end by March 2010. 

 

So what about the millions of homes in foreclosure? They aren’t yet showing up on the market.  Neither are they being permanently modified into affordable mortgages as evidenced by the U.S. Treasury Departments renewed pressure on mortgage servicers yesterday. They just keep building in backlog now approaching four million loans according to the Mortgage Bankers Association.

 

 

The backlog of loan delinquencies just continues to build. Since 2007, there has been a steady increase in loans considered “seriously delinquent” (more than 60 days late in payments).  Since the beginning of this crisis roughly 200,000 properties per month have begin the foreclosure process but only half that amount actually finish the process. The rest stay in the backlog which is now approaching four million. 

 

The U.S. administration estimates that 3.2 million of these loans are eligible for modification programs. To date the number of permanently modified mortgages is less than 2,000. There are more than 650,000 currently in trial phases. 

 

If these efforts to modify these mortgages fail (in the past such mortgages falling into default again at rate of more than half), the expected result is a wave foreclosure sales.  This tidal wave has been forecasted for more than a year now but has yet to hit shore.  

 

The answer to whether the housing market truly recovers or takes another leg down in 2010 rest squarely on what happens to this backlog of four million properties. In years past these situations would quickly lead to foreclosure and sale of the property by the bank or loan holder.  At least that is what I thought until I looked more carefully.

 

Of course, this assumes that during previous housing cycles the market eventually capitulated – banks evicting delinquent homeowners en masse to clear the market and return to normal.  Isn’t that the lesson to be learned when an economist harkens back to the Resolution Trust Corporation, created to deal with the 1980s Savings & Loan Crisis?

 

I was surprised to find that history does not bare this out.  Good data for inventory of delinquent mortgages and foreclosures goes back to 1979. This is far enough back to capture the past few recessions and the last big housing bust in the early 1980s.  

 

 

The 1981-82 recession also saw big jumps in foreclosure starts and stock of delinquent loans. The last time a housing collapse combined with a recession and double digit unemployment was 1982.  While the numbers back then were an order of magnitude less than now, the rate of foreclosure starts did jump from .13% in the second quarter of 1980 to twice that in 1986.  The stock of homes with delinquent mortgages climbed almost four fold in that period as more homes went into foreclose than came out through a eventual eviction/sale or through the mortgage becoming current again.  

 

Despite the strong growth in the economy that began back in 1983 and continued for the rest of the decade, the rate of foreclosure starts never fell back to the original levels.  

 

 

Even during the decade of the 1990s rates of foreclosure starts held steady and gradually increased despite the great prosperity of the 1996 – 1998 period.  The housing and mortgage lending market grew accustomed to the new levels of foreclosures and an increasing number of homeowners behind on their mortgages.  This just became part of doing business and a cost of expanded homeownership in the United States.

 

The market eventually settled out at .45% of current mortgages each quarter becoming behind in payments and falling into foreclosure.  By the end of 1999 (at the height of the dot com wealth boom) half a million homes were seriously delinquent on their mortgage. These became the new pre-crisis levels that we refer to when looking at problematic mortgages today.  Even if you adjust for a larger housing and mortgage market today than in 1980, you still come to the conclusion that the market never corrected back to pre-crisis levels.

 

I am not specifically arguing that we will have more than four million homes in foreclosure indefinitely but that history suggests that it is a distinctly possible outcome here.  Many observers are waiting for government-sponsored mortgage modification programs to succeed.  Others are expecting this to fail and bracing for the onslaught of foreclosed properties to hit the market.  We might be waiting a long time for one of these two outcomes to be realized.  

 

Four million homes seems to me excessive but the ‘new normal’ (defined by Mohamed El-Erian of PIMCO as a protracted period of U.S. economic growth below potential) could very well include a couple million folks struggling to stay in their homes; never fully becoming current on their loans but never being evicted either.  With the U.S. government putting its sovereign credit rating at risk to fight asset price deflation and keep the voting public in their homes, it is possible the market will never clear like we learn it should in economic textbooks.

 

                                                

 

In the two months since I discussed the Baltic Dry Index (BDI), the index has rebounded strongly including having set new 12 month highs in the past week. Through much of 2009, the story of the Baltic Dry Index has been one of Chinese iron ore purchases. Recently, in a positive sign for the real economy, other factors are starting to play a role. As we will see below these Chinese purchases have not abated and remain a key factor. To that factor, though, we can add two more.

 

One big question on investors mines recently is how much of the market activity reflects true improvements in the real economy and how much is simply a result of cheap money flowing around the globe creating asset bubbles. Unlike indices that track asset markets of equities and real estate or recently popularized asset markets of oil and gold, the Baltic Dry Index reflects activity in the real economy. The index tracks rates for dry goods shipped in bulk around the globe. For a detailed explanation of the index please see my article from September.

                
                            

                                                            

Baltic Dry Index has reversed its slide and is now hitting new one year highs. This Baltic Dry is actually quite volatile. Its inherent volatility comes from the fact that above a certain point cargo vessels can not always be quickly pressed into service as shipping volumes increase. New vessels are ordered multiple years in advance. A shortage of just a few ships on an important trade route like that between Australia and China can quickly drive up rates. 

 

The period from June through September showed that price gains are every bit as short lived as in the fickle stock markets. The answer to the question of whether a rise in the BDI is a good indicator of economic health is rooted in what is driving the move. Thankfully this can be gleaned by looking at the components of the Baltic Dry.

 

           
The Capesize Index has had the most influence on the overall BDI. Of the four lower level indices used to calculate the overall Baltic Dry, the Capesize Index has had the most pronounced movements for the year. Capesize is the largest category of vessel and used primarily to transport iron ore. Swift rises in Capesize index earlier in the year were driven by Chinese stockpiling of iron ore, the raw input to steel production. 

 

Such a move for the Capesize index once again indicates increased activity in the shipment of iron ore. Since the end of Chinese stockpiling efforts was declared by BHP Billiton’s (BHP) management back in their August earnings call, the destination of these ships might not be obvious.

 

Some of the most important shipping routes are between Port Hedland in Western Australia and destinations throughout Asia. Port Hedland is the primary launching point for BHP’s iron ore mined in the Pilbara region of Australia. 

 

In its last fiscal year, Port Hedland was the origination point for 154 million tons of iron ore, roughly 50% of all such Australian exports. The shipments of iron ore from this port alone represent nearly 1.5% of Australian GDP. The fact that this port is 11% busier than last year goes a long way in explaining why the global downturn had only a minor impact on Australia.

Factor #1 – Chinese stockpiling continues. The Port Hedland Port Authority provides detailed data on its operations monthly. Of the 14.9 million tons of materials shipped last month, two-thirds (67.5%) of it was iron ore headed for China. Of the 107 ships that left from that port last month, 87 of them were carrying iron ore bound for China. Such shipments are running 42% ahead of 2008 levels.

 

We know that stockpiling is going for the simple reason that, while iron ore imports to China are up strongly, this has translated into only modest increases in steel output. Steel production is only running 8% to 12% of 2008 levels depending on the type. This is impressive for sure when compared with the output from Asian countries but it in no ways accounts for increased imports of iron ore.

 

 

Stockpiling can come in two different forms. The most obvious is China’s outright purchase of iron ore that is set aside in holding facilities for use at a future date. 

 

The second is the shut-in of domestic production. Iron ore and coal production in China is considerably more expensive than that carried out by the global mining giants BHP, Rio Tinto (RTP) and Vale (VALE). 

 

By purchasing mostly from abroad and mothballing domestic sites, China is saving the domestically mined commodities for some future date when global commodities prices are higher. China is effectively trading in its American dollars for hard assets – not a bad use of its reserves.

 

It is likely that the shift that occurred at the end of the summer was to go from the first more overt type of stockpiling to the second more subtle.

                 
                                                                       

 

A more detailed look at the split of iron ore shipments to China and other destinations out of Port Hedland reveals a continued healthy appetite for this raw material. Shipments to China have come off from their peak from May to July but remain at very elevated levels compared to last year. In the year 2008 shipments averaged a little over 6 million tons per month. Even at the peak of global growth last year, China’s shipments from this key port never amounted to 8 million tons monthly. For all of 2009 they have never been below that 8 million ton/month level. 

 

One difference is that new iron ore supplier Fortescue Metals (FSUMY.PK) began shipments through this port in 2008 and is now running at full volume. Their shipments go all to one place: China.

 

Factor #2 – Iron ore shipments to other Asian countries are returning. So far this year shipments to other destinations like South Korea and Japan this year have been running 30% below their 2008 levels. This drop is in line with the decrease seen in industrial production. China filled the gap left by other countries for the first half of this year. Since August shipments to Japan and South Korea are returning – on top of a demand from China that subsided only slightly. This results in a steady increase in cargo each month requiring more ships which in turn drives up shipping rates.

 

There is no way to tell if and when the Chinese demand corrects back to levels in line with its industrial output. The large miners BHP, Rio, and Vale play a large role in determining the price. Hopefully this year has taught them that raising the price too high (as they did in 2008) brings more domestic raw materials to the Chinese market. Keeping the price steady leaves them all in a good position.

 

Factor #3 – Broader measures of shipping rates are climbing. Unlike the middle of the year, the indices for the small vessel types Supramax and Handysize have started to climb substantially. Ships from each of these categories are used to transport grain and other foods as well as industrial materials such as scrap iron, concrete, and steel. 

 

Increases in shipment rates do not mean that the global consumer (particularly in the West) is back to his old habits. However, it does mean that demand to ship goods is returning slowly. This is a good leading indicator that the real economy is healing.

 

Unlikely when we looked at the Baltic Dry Index two months ago, there are multiple factors driving the increase. Chinese stockpiling of iron ore and other raw materials is a gift for the mining industry but it is artificial and could correct at any time. The other two factors: non-Chinese demand for iron ore and rebounds in shipping rates for small vessels indicate that global trade is starting to rebound. 

 

There is no denying that much of this rebound is driven by government stimulus programs that are unsustainable. Additionally, global asset markets are commodities prices may be too far ahead of this move but I, for one, would rather see the trends in the “real economy” headed in the right direction. 

                                                             

Disclosure: No Positions