Don't Write off the Gold and Commodities Bull Run

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Includes: DBC, FDX, FXI, GLD, GSG, IAU, IIF, INP, RJA
by: Shailendra Kumar

Gold has been thrashed during last few weeks with a brutality usually not seen in the financial markets. A violent rally in the US dollar has pushed the yellow metal from a high of $988.30 during mid-July to $800 during this week. The drop has sent the price far below 200DMA levels, a not-too-common occurrence during the course of past seven years. Obviously such action has unnerved even the die hard gold bulls. Some have become so frightened that they are talking about prices as low as $680 and even $600. Some have taken an oath not to return to the gold market, indeed many are not left with enough money to make the return meaningful.

Gold has not been the only thing on the anvil. The whole commodities complex has been run down; from crude oil to natural gas to wheat and lead, everything has been flushed by the resurgence of the dollar. This has obviously led to doubts about the commodities bull run coming to an end. Many people have come to feel that the "things" bubble has finally burst, that the seven year long rally has reached a pinnacle, and that the world is on the cusp of a new era of cheap commodities and upwardly mobile stocks. Many are even betting the future of commodities as an asset class is over, saying few investors would ever care to return to the trading pits in Chicago, Comex and Nymex.

I beg to differ.

But before I present my case, I would like to examine the reasons behind the boom in commodities during past half a decade. The reasons have been obvious ones: excessive monetary expansion, easy credit, fantastic liquidity, a grand housing boom around the world, and a sustained shift of investor money from paper to tangible assets. Apart from these there has been one major factor: the unprecedented demand from many new industrialized countries like China.

China

During the past decade, this Asian giant has emerged as the workshop of the world, manufacturing everything from ear-buds to steel castings to light aircrafts and ships. This demand has been huge. As more ships leave the Chinese ports laden with manufactured goods, many more ships filled with raw commodities take berth.

Remarkably, this demand continues to be there. China, in spite of all the talk about its manufacturing sector facing tough challenges due to the global slowdown, rising production costs, tight credit conditions, power shortages and currency appreciation, continues to produce massive quantities of finished goods. Millions of small and big, low and high value consumables continue to be produced there for supermarkets in every nook and corner of the world.

The recent numbers show that this Asian economic powerhouse is producing and trading finished goods with the same zest as has been seen during past half a decade. According to the latest statistics, during the first half of this year the output of steel has gone up to 299.96 million tonnes (up 12.51 percent year-on-year) and cement production has risen to 648.05 million tonnes (up 8.7 percent year-on-year). Output of large power plants has risen to 1.68 trillion kw/hr, up 12.9 percent year-on-year. Autos imports have risen to $16.333 billion, up 39.64 percent year-on-year, while exports have grown to $24.776 billion, up 39.45 percent. Machinery output has gone up 21.6 percent year-on-year by value. Coal imports have gone up to 24.94 million tons in spite of the average price jumping by 51.9 percent to $70 per tonne. Soybean imports have hit 20.73 million tons even as the average price going up 78 percent to $591.70 per ton. These numbers are likely to grow bigger during the coming years as China continues to build and expand new capacity. The current host of Olympic games has year to date approved the establishment of 16,891 overseas-funded enterprises, soaking up $60.724 billion U.S. dollars (up 44.54 percent y-o-y) of new FDI money.

The same period has also seen the construction of 3.695 billion square meters of floor space. And unlike the United States where the inventories are piling up and new construction slowing down thus resulting in diminishing value, the prices are climbing in China. The latest reports from Beijing show that the housing prices went up 7% in major Chinese cities during July 08. According to the National Development and Reform Commission [NDRC] and the National Bureau of Statistics, the prices of real estate in 70 major Chinese cities rose 7.0 percent in July on the same month of last year. (The price rise was 11.3 percent in January, 10.9 percent in February, 10.7 percent in March, 10.1 percent in April, 9.2 percent in May and 8.2 in June.) Simultaneously, the prices of second-hand houses gained 6.0 percent year on year. I don't need to emphasize that the rising housing prices are an indication of the feel good factor among the people, which automatically translates in construction of more houses and offices and development of infrastructure - all of which leads to extra consumption of commodities.

Of course the Chinese are not just buying the houses, they are also buying things to fill them. No wonder, China's domestic retail sales leaped a brisk 23.3 percent to 862.9 billion yuan ( 125.8 billion U.S. dollars) in July this year. According to the National Bureau of Statistics, this brought China's retail sales of consumer goods in the first seven months of this year to 5.9672 trillion yuan, up 21.7 percent, compared with 15.5 percent growth rate recorded over the same period of last year. Here I must pause and inform that unlike India where the growth in rural and urban regions is poles apart, the Chinese growth is more evenly distributed; as a result, while the urban consumption is up 24 percent year-on-year, the rural consumption is only a whisker behind at 21.8 percent up - a very bullish sign, given the size of the rural Chinese population.

Goes without saying, there is little likelihood of Chinese consumption waning to a level where it will contribute to a meltdown in commodity prices. It is true that there may be a miniscule reduction in its commodity consumption arising out of the fall in GDP growth from about 11% to about 10% (as is being widely expected), but that may not be sufficient to bring the prices down to a level that would make the commodity bears rejoice.

Indian Consumption

In fact, if there is a good case of slowing consumption of commodities, it would be in India. In this South Asian country the story is remarkably opposite of China. The agriculture income is shrinking here, as a result of which the rural demand is dying fast. To add to the woes, the industrial growth - the bellwether of the economic growth - itself is diminishing. (The industrial growth slowed down to 5.4% in June 2008, compared with a much higher 8.9 per cent rise in production recorded a year ago.) The growth is likely to slow down further. According to the projections of the latest Economic Advisory Council report, the

manufacturing output growth will slow to 7.2 per cent, pulling industrial GDP growth down to 7.5 per cent, a full one percentage point below that of last year, and 3.5 percentage points less than that recorded in 2006/07. Services sector growth is also expected to slow slightly to 9.6 per cent (down from 10.8 per cent last year).

The uneven distribution of the current monsoon and the delayed revival of the same is also likely to result in loss on agriculture output. Infrequent showers and lower sowing are likely to cut the output of country's kharif crop (the main crop for the country), pushing up food prices and inflation, which is already at a 13-year high number.

According to the latest government data, the total area under all major kharif crops like rice, maize, oilseeds, pulses, cotton and sugarcane has fallen nearly 5% on year to 78.2 million hectares this year up to August 7. (Nearly 60% of the country's cultivable land is dependent on the monsoon for irrigation, and farm-related activities are the main source of livelihood for three-fifths of country's 1.1 billion people.) Pulses production is likely to be the biggest casualty of the extended dry spell across various pulse-growing states. Oilseeds production has also taken a huge hit, with the oilseeds crop estimated to be down by about a whopping two million tonnes. With almost 900 million people spending about 75% of their money on procuring just food articles, there is huge shortage of money to consume other commodities?

If the rural sectors are in mess, the fiscal economy is no better. The country has already taken a big hit due to the dole of oil subsidies. The under recoveries on account of selling petrol and diesel cheaper than the landed cost have already hit the high water mark of Rs. 2,45,000 crore (approx. $60 billion).

According to the EAC report:

The increase in the oil import bill is bound to widen the Current Account Deficit [CAD] in the Balance of Payments. The pressure on the fiscal system will intensify on account of key subsidy elements. Equity and other asset markets have already taken a big beating.Overall, economic growth will slow down.

The fiscal health of the country is so bad that even the otherwise sober EAC report talks about these in a somewhat worried manner.

There are serious fiscal risks arising from growing off-budget liabilities on account of fertiliser, food and oil, along with unbudgeted liabilities arising out of the farm loan waiver and NREGA schemes and the implementation of the Sixth central Pay Commission. These liabilities could amount to 5 per cent of the GDP in 2008/09, over and above the budgeted central fiscal deficit of 2.5 per cent.

What does this lead to? The same EAC report mentions that

the value of crude oil and product imports would rise by 80 per cent to $138.2 billion, while the value of product exports would rise similarly to $47.1 billion. The projected value of merchandise exports and imports is $ 208 and $342 billion respectively, leaving a BoP merchandise trade deficit of $134 billion, equivalent to 10.4 per cent of GDP, a sizeable increase from 7.7 and 7.1 per cent in the last two years.

The report further mentions that

the Current Account Deficit [CAD] is likely to expand to $41.5 billion, equivalent to 3.2 per cent of GDP - a major increase from 1.5 per cent of GDP" and that "the persisting revenue deficit would remain a matter of concern.

India has another matter of concern: that of worsening stock markets. The markets have been showing extreme weakness since the beginning of the year, and the fall seems to be far from over. Being a far too expensive market compared to many other emerging markets, the shocks during the next few months are likely to be severe. A near total absence of alternative to foreign investors makes the things pretty dicey; there is no parallel purchasing power to soak up the FII sales. No wonder, the impending fall in the market is likely to take the popular market index Sensex all the way to 7-8000 within next 6-9 months.

While this number may look astonishing to many, the fact remains that the foreign investors are going to be less and less in love with a whole lot of emerging markets in general and with India in particular, owing to its fast deteriorating fiscal topography and worsening credit ratings. Already the valuations of many stocks in the US are proving to be much better and there are firm indications that a gradually a lot of money is on the move from emerging markets (which are saddled with shooting inflation rate and plunging indices and currency valuations) to otherwise developped markets.

How soon I see the Indian stock market crashing? In less than one year. The only thing that needs to be speculated upon is the manner of the fall; whether it will be a sheer "off-the-cliff" drop or a series of minor falls interspersed with those typical bear market sucker rallies. Whatever the case may be, one thing is clear: the foreign investors are not likely to be in a mad rush to enter the Indian markets.

Even the EAC report is not so sanguine about it. According to its best case scenario, the

Portfolio inflows are estimated to be $4.1 billion in 2008/09, which is very large reduction from 2007/08.

Even this number may prove very optimistic, and my estimates say that within 6-9 months the Indian market may emerge as the most battered market within the fabled BRIC group of countries.

The fall of the markets will turn the push on the rupee into a shove. This is what has been happening throughout this year. Every major fall in the stock market has been followed by erosion in the health of the rupee.

Looking at the fiscal problems that are growing by the day, and looking at the fragility of the Indian stock markets, it doesn't take much to forecast that the Indian rupee will soon quoting at 47-48 against the US dollar, a loss of about 15% from the current value. The EAC expects the rupee to be playing weaker in months to come.

The main global shocks important for India are from elevated commodity (oil, food, and base metals) prices, a significant slowdown in the global growth momentum, turbulence in international financial markets, and a possible reversal of the USD towards an appreciation path over the next 2-4 quarters.

My own estimates say that the rupee will dip easily to the aforementioned levels within two quarters. Extreme conditions may even take the rupee all the way to 50 against the dollar, and yes I am not even ruling out a reading of 55 within 12-15 months from now. (These levels may look surprising to many, but the thing worth remembering is that if a mere $6.5 billion worth of stocks sale could shave off more than three rupees off its exchange rate, what would another $10-20 billion sale would do, given the fact that crude oil price, in spite of recent fall, still continues to be above $110 – a very, very unaffordable price for a country having a trade deficit amounting to 10 percent of GDP.)

These levels would cause more harm to the Indian balance sheet and make imports a truly painful experience. This would automatically lead to a curb in consumption of commodities. However this should not translate as a relief for commodity bears; the Indian consumption was never a great contributor to the global commodity price rise even as Indian was erroneously blamed for the same simply because it's population numbers are comparable to those of China. (Even the likes of Mr. Bush recently blamed India for rising food prices a couple of weeks back; without considering the fact that India is home to more malnutritioned people than the entire population of United States.)

In closing I must say that the consumption of commodities around the world is likely to stay on course, and thus not lead to a meltdown in their prices. In fact after the July-August shakeout we must expect more sudden spikes on the upside, given the fact that a whole lot of commodity investors have left the commodity bourses, thus leaving the trading pits to a few commanding punters and extremely agile commercials - certainly not the most benevolent entities in the markets. The supply side story meanwhile may get further skewed with the passage of time.

The current crash in commodity prices is likely to discourage many farmers, miners, and producers from producing their stuff owing to reduced profitability. Take for example the mining of gold; the landed price for several gold miners today is about $800 an ounce, a cool two percent more than the current price of $787 (as on 15th August '08). Certainly if the price on COMEX was to plunge to $600, as many savvy chartists are predicting, these miners would not have any incentive to mine and refine gold, thus leading to supply side glitches.

Similarly, thousands of farmers who are already screaming that the rising costs of farm inputs are leaving them with nothing much to sing about are likely to feel increasingly discouraged to grow agri-commodities in the light of recent - and shall I say engineered - commodity price crash.

Does it mean that the prices of commodities will remain high for long? My answer is affirmative. I feel the real crash in commodity prices will be seen only when the supplies increase remarkably or the demand wanes extraordinarily or the global money supply shrinks considerably. The prices of commodities will fall when the workers working in mines, farm fields and factories would willingly accept a wage cut. Commodity prices will fall when the prices of all the inputs for farmers and mining companies will fall by at least 50% from the current levels.

All of these, I don't need to emphasize, seem to be a tall order – a reason why the news of commodity bull run termination for the time being needs to be taken with a pinch of salt.

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