Monday, December 21, 2015

Liquidity is not there says Gary Shilling

Monday, December 14, 2015

Monday, November 30, 2015

Fed's forward guidance may be responsible for more market volatility

The 2008 financial meltdown exposed a lack of transparency in the financial system. The U.S. Federal Reserve, in response, sought to provide more openness and fewer surprises with forward guidance -- early indications of changes in monetary policy to guide investors, businesses and households. The Fed's hope was that providing information about likely changes could reduce market disruptions. 

I have long been skeptical of the effectiveness of forward guidance because future changes in monetary policy are heavily dependent on data that are not yet known. Worse, the Fed has consistently been too optimistic about the economic recovery, making its forward guidance ineffective.

In 2012, the Fed forecast 3.4 percent growth for 2015, but gradually cranked that down to 2.1 percent, the average annual growth rate since the recovery started in mid-2009. It similarly cut to 2 percent from 4 percent its initial forecasts for 2012, 2013 and 2014. 

To assess whether forward guidance has been effective in preventing market disruptions, compare today's economy with the market conditions of the mid-1990s, prior to its use. Of course, there are significant differences in inflation, global growth and other measurements, yet the differences in volatility between then and now are stark. 

The Fed raised short-term interest rates in February 1994 without warning. It pushed rates up six more times by November 1994, doubling the federal funds rate to 6 percent. This caused Treasury yields to skyrocket in what became known as the great bond massacre of 1994.

Yields on 10-year Treasuries jumped 2.3 percentage points to 8.1 percent, for a price loss of 23 percent. The 30-year Treasury-bond yield leaped by 1.9 percentage points for a principal decline of 17 percent. The index that measures stock-market uncertainty reached a high of 23.9 in April, compared with a 10.8 level before the first rate increase.

Ditto for Treasury volatility, which is measured by taking the 20-day moving average of the daily percentage change in yield. For 10-year Treasuries in 1994, volatility rose from 0.5 percent at the start of the year to a peak of 1.2 percent, while volatility in the 30-year bond climbed from 0.4 percent to a peak of 1 percent.

If forward guidance worked, you’d expect less stock and bond volatility now -- even more so with all the Fed’s talk of raising rates. Nevertheless, forward guidance appears to be stirring up markets, not calming them down. Stock and bond market volatilities have jumped to levels vastly exceeding those of the mid-1990's.

The Fed indicated it might raise rates in June, September and now December. From their February lows, yields have risen 68 basis points (100 basis points equals one percentage point) on the 10-year Treasury note and 87 basis points on the 30-year Treasury bond.

The 1994 yield increases were higher. Still, the volatility index jumped to 40.7 in late August, almost twice the 23.9 high of 1994. Similarly, our index of Treasury volatility this year reached 2.9 percent for the 10-year and 2 percent for the 30-year -- more than double the 1994 levels. 

Why are stock and bond volatilities twice as high with forward guidance than without it? Anticipation of a Fed rate rise and China's economic slowdown have roiled stock markets. Also, I believe higher bank capital requirements have led to less liquidity, and therefore higher volatility, in Treasuries. 

But forward guidance is also a culprit due to the Fed’s chronic overoptimism about economic growth and its persistent warnings of an imminent rate increase.

The Fed isn't alone with its embarrassingly overoptimistic forecasts. The International Monetary Fund and the World Bank keep reducing their outlooks for global growth. Economists in the Wall Street Journal’s forecasting surveys have also persistently cut their growth forecasts. 

The Fed’s use of forward guidance has been ineffective due to its inability to correctly forecast economic conditions. And this probably led to more, not less, market volatility. Back when the Fed surprised investors, stock and bond market volatility was half of today’s levels. 

Instead of continuing to do the same thing repeatedly and expecting different results, why not just abandon forward guidance? 

Originally posted on

Sunday, November 22, 2015

Gary Shilling says China economy not headed to recession

As the leaders of 17 countries gathered in the Philippines Wednesday for the annual Asia-Pacific Economic Cooperation forum, Chinese President Xi Jinping stated the obvious. "The Chinese economy is a concern for everyone," he said. "We will work hard to shift our growth from just expanding scale to improving its structure." 

What he means is that China's economic deceleration -- the official growth rate of 6.9 percent is a six-year low -- is the sign of an economy in transition. It's moving from an over-reliance on exports and government-led investment to an economy that is more consumer-led. 

So how's that going? First the bad news: The industrial goods-producing sector of the Chinese economy is in recession and likely to remain there for at least another year. 

Now the good news: The domestic-oriented service sector is likely to keep growing at low, double-digit rates -- and that should result in real GDP growth of 4 percent to 5 percent.  

Until recently, China's economy grew rapidly, thanks to a booming manufacturing sector that imported raw materials and equipment to produce goods that were exported to North America and Europe. Slow growth in the developed world, however, put an end to that ploy. 

China's other stimulus, infrastructure investment, resulted in ghost cities and a pile of debt now totaling 208 percent of gross domestic product. Together, the debt overhang and excess capacity will limit future growth. 

Now, exports are declining after decades of 20 percent annual growth. An earlier housing boom, driven by aggressive bank lending in response to the 2007-2009 recession, has been followed by a decline in construction. Growth in capital investment continues to slow. The industrial sector’s growth rate plummeted from a 22 percent annual rate in the second quarter of 2007 to a mere 0.2 percent in the third quarter of this year. 

You might think all these weak numbers signal that the Chinese economy overall is headed toward recession. I don’t believe so, and here's why: 

Services (which includes consumer spending) grew at a healthy 12 percent annual clip in the third quarter from a year earlier. True, the stock market bubble and housing boom propelled that growth, which is falling back to earth now. 

Still, since the recession, the service sector's share of GDP has grown while the industrial sector's share retreats. Since the first quarter of 2007, services gained 8.2 percentage points of GDP, to 51 percent, while the industrial sector’s share dropped 5.8 points, to 40 percent. The remaining 9 percent is agriculture. Services’ share of GDP first topped that of industry in the second quarter of 2012. 

A major obstacle to consumer spending in China is its high -- and rising -- savings rate. It was 30 percent in the first quarter, compared with just 4.8 percent in the U.S. in September. Chinese households save huge portions of their limited incomes because of the obligation in a Confucian society to provide for one’s family, but also because pensions are limited and China lacks a social-safety net. 

There is evidence, however, that Chinese consumers are spending more. Passenger rail traffic continues to grow by a solid 10 percent. Interest in personal health and sports is growing, and the number of marathons and marathon participants doubled between 2011 and 2014. After a slump in sportswear sales following the 2008 Beijing Olympic games, sales are again jumping. Internet traffic through mobile devices has nearly doubled this year, and movie box-office revenue is up more than 50 percent. 

Sales for technology, alternative energy, education, media and entertainment companies are rising much faster than those in basic industries. Twenty newer Chinese stocks tracked by Goldman Sachs had 23 percent revenue growth in the first half of 2015 versus a year earlier, compared with 2 percent for older companies. 

Further evidence of the shift can be found in employment growth, which is increasing for the services sector and declining for heavy industry. Since 2007, the labor force in services rose 8.2 percent, but just 3.1 percent in heavy industry.  

On balance, then, China's heavy industry is retreating while services are rising. What will these trends mean for future growth?

Bear in mind that the service sector also is vulnerable. The earlier boost to financial services by the stock market and housing bubbles has been reversed. Also, laid-off workers from private heavy industry and state-owned enterprises have reduced purchasing power. 

Using regression analysis, my firm measured the effects on GDP of various combinations of growth in the manufacturing and industrial sector and the services sector. For the third quarter, the 0.2 percent growth in secondary industries (manufacturing, energy, construction and mining) combined with the 11.9 percent advance in the tertiary sector (services) results in a total GDP gain of 5.4 percent. 

Adding the 0.5 percent GDP contribution from the ever-shrinking primary sector (agriculture), the total comes to 5.9 percent -- still below the (likely overstated) official 6.9 percent growth rate, though not by much. 

Chinese statisticians have no doubt been inflating their GDP numbers since Mao's Great Leap Forward in the 1950s demanded big output gains -- or else. Overstatements are probably greater now that growth is slowing. 

Even if services rose at an optimistic 13 percent, when combined with flat manufacturing growth in future years, GDP would still rise only 6 percent annually. A more realistic flat manufacturing sector and 10 percent growth in services yields 4.3 percent overall GDP, but don’t count on the Chinese National Bureau of Statistics to report a number that low! 

So even Beijing’s newly reduced growth target of 6.5 percent is unrealistic. The 4 percent to 5 percent range is more likely -- and that’s based on clearly overinflated historical numbers.  Still, ongoing growth in the services and consumer sector should stave off recession in China and actual declines in GDP. 

As China shifts from an export- and infrastructure-led economy to one more domestically driven, its impact on other economies will drop. In particular, China’s role as the vacuum for the world’s commodities will continue to recede.

Look for the recent nosedive in commodity prices, be it copper and other nonferrous metals, iron ore, coal or other basic materials, to persist. On the other hand, Chinese food imports may gain as rising personal income levels result in diet upgrades. It takes more grain to turn pigs into pork than it takes to satisfy human nutrition needs directly with corn. 

China will no longer dazzle the world as it did in past decades by taking over global manufacturing and growing rapidly. But at least slower, domestic-led growth will be more sustainable. 


Monday, November 16, 2015

Monday, October 19, 2015

Glencore suffers hit from commodity prices

As commodity prices continue to fall, bankruptcies among producers and industry consolidation will no doubt accelerate.  Suppliers of farm, mining and construction equipment are already troubled. With this onslaught, it's no surprise that Glencore, the huge Swiss company that dominates global commodities markets, lost a third of its value in a single day last week.   

Glencore was founded in 1974 by Marc Rich, the commodity trader and U.S. tax fugitive who died in 2013. Initially the firm, called Marc Rich & Co., didn’t own mining assets because Rich believed they were too volatile. He focused instead on commodity trading and eventually turned the company into the world’s largest trading house. Rich tried and failed to corner the zinc market in 1993-94 and was forced to sell 51 percent of the company in a management buyout to a team that included Glencore's current chief executive officer, Ivan Glasenberg.  

The new company became directly involved in mining operations, yet continued to stress the stability of its trading profits. Glencore's 2011 initial public offering prospectus stated that its trading business is “less correlated to commodity prices than its industrial operations, making Glencore’s earnings generally less volatile than those of pure producers of metals, mining and energy products.” 

It hasn't turned out that way. The nosedive in commodity prices and $30 billion in debt have put Glencore on the ropes, at least in the eyes of investors and possibly credit-rating companies. Despite measures announced in early September to reduce debt by $10 billion through stock sales, dividend cuts, asset sales and cost reductions, the yield on its U.S. dollar-denominated bond maturing in 2022 leaped from 4.6 percent at the end of July to 11 percent recently. Glencore's stock plummeted 29 percent on Sept. 28 and is down 90 percent since its 2011 public offering, done at the peak in commodity prices. 

If Glencore’s huge trading operation can’t protect its mining business, what’s in store for giant, concentrated mining companies like BHP Billiton, Vale, Rio Tinto and Anglo American? Or mining-equipment companies like Caterpillar? And how about smaller, less financially secure firms? Alcoa just threw in the towel on basic aluminum production and split those operations from its downstream, higher-value-added aluminum businesses. 

Investors who are much less knowledgeable about commodities than Glencore will probably continue to be forced into agonizing reappraisals. This includes pension funds that got swept up in the commodity craze a decade ago and hoped further rapid price rises would help them achieve their investment goals in an era of low interest rates. Many elevated commodities into an investment class alongside stocks and bonds. 

I’ve always insisted, however, that commodities aren’t an investment class, but a speculation. Sure, I use such commodities as crude oil, copper and sugar in the aggressive portfolios I manage, but on the short side. Since the mid-1800's, commodity prices, adjusted for inflation, have been in a steady downward trend. The price spikes due to demand surges in the Civil War and both world wars were soon retraced, as were the effects of the oil-supply curtailments in the 1970's. 

Sure, there’s only so much oil in the ground. Devotees of the Hubbert peak theory -- geophysicist M. King Hubbert's idea that world oil production had peaked in the 1970's -- thought that crude oil supplies would have been fully exploited by now, with surging prices as the result. Then came fracking technology and huge new supplies of relatively cheap shale oil. 

I can recall when serious economists predicted that the telecommunications expansion would come to a grinding halt because there wasn’t enough copper in the earth’s crust to make the needed wires. Fiber optics obviously eliminated that problem. 

Human ingenuity and free-market prices have always eliminated commodity shortages, and probably always will. Commodity investments may continue to be rewarding -- as long as they’re based on further price declines.

Monday, October 5, 2015

Many reasons why we could see further commodity price declines ahead

It's hard not to notice that commodity prices have been plummeting. It seems the price of everything that is grown or pulled out of the ground -- from oil and gas to sugar and copper -- has declined 46 percent since early 2011, causing bankruptcies and industry consolidation.

Prepare for further big declines. 

Directly or indirectly, developed countries consume most commodities. Yet economic growth and demand for commodity-based products remain weak as North America and Europe continue to unwind their financial excesses. The earlier rapid expansion of debt, which helped fuel robust growth, is being reversed. 

U.S. real gross domestic product has risen at just a 2.2 percent annual rate since the business recovery began in mid-2009 -- about half the rate you’d expect after a recession. The euro area is limping along at a 1.2 percent annual growth rate, with recovery from the 2007-2009 recession interrupted by a mild downturn in 2011-2013.  Economic gains in Japan’s stop-go economy have averaged only 1 percent.

The world is now eight years into a deleveraging cycle. At this rate, it will probably take more than the historical average of 10 years to complete. 

Meanwhile, supplies of almost every commodity are huge and growing. China joined the World Trade Organization in late 2001 and, not by coincidence, commodity prices took off in early 2002. As manufacturing shifted from North America and Europe to China, it sucked up global commodity output. From 2000 to 2014, China’s share of global copper consumption leaped to 43 percent from 12 percent. China's portion of iron ore purchases similarly zoomed to 43 percent from 16 percent, while aluminum went to 47 percent from 13 percent. 

By the mid-2000's, industrial commodity producers were dazzled by China’s seemingly insatiable demand and made the same big mistake that always occurs in every economic cycle:  They assumed surging demand from China would last indefinitely. 

Producers embarked on massive projects that often take a decade to complete. These included digging copper mines in Latin America, removing iron ore in Brazil and producing coal in Australia. All that new capacity began to come onstream in 2011, just as it became clear that the hoped-for post-recession return to rapid global economic growth wasn’t occurring. 

The downward pressure on commodity prices has been magnified in recent months by the realization that economic growth in China is slowing. This is nothing new, really. China doesn’t grow independently, but has an export-driven economy. It imports raw materials and equipment that it uses to produce manufactured goods, largely for export. 

But muted demand in North America and Europe for Chinese exports has slowed economic growth in China.  Meanwhile, over-investment in ghost cities and building of excess infrastructure, in which China engaged to create jobs, has spawned huge debts. I estimate that the true rate of inflation-adjusted growth in China is about 3 percent to 4 percent, half the 7 percent official number. 

Few investors and most of the media were unaware of China’s dependence on the West and its slowing growth until stocks went off the cliff in June. The Shanghai index is now down 40 percent despite Beijing’s clumsy and heavy-handed efforts to support equities. Devaluation of the yuan soon followed.

With most other currencies also devaluing against the dollar, the trade-weighted yuan is down 30 percent from May 2011, and China wants it to go even lower to spur exports in a softening economy. To prevent the pegged yuan from collapsing -- and accommodate the rush of money out of China -- the government has sold about $400 billion of its nearly $4 trillion in foreign currency reserves to buy yuan. 

Additional forces are depressing commodity prices beyond the general surplus of supply relative to demand. A number of hard-rock miners are so deep into new projects that they are compelled to complete them. Closing down the ventures would be more expensive than the losses they'd incur from selling production at today's prices.

The world’s biggest iron ore producers - Rio Tinto, BHP Billiton and Vale -- continue to produce huge quantities of ore even as prices drop 70 percent to $57 a ton, from $189 in February 2011. The companies believe they can squeeze out less-efficient producers, such as those in India, that may lack staying power. 

Some commodities, especially aluminum, are produced in developed countries like the U.S. and Canada. In textbook fashion, once demand falls and profits nosedive, owners shut down smelters. The drop in supply offsets some of the downward pressure on prices.

But copper, used in numerous manufactured products ranging from autos to plumbing fixtures to computers, is mostly mined in developing nations like Peru, Zambia and Chile.  They need the revenue from copper exports to service their hard-currency debts. So the lower the copper price, the more physical copper they must produce and export to earn the same dollars. And the more they export, the lower the price, in a self-feeding downward spiral. 

Similarly, Brazil subsidized the export of sugar, which is down 67 percent in price since February 2011, and no doubt will be forced to pour more money into the industry. Already, 80 of 300 sugar mills in the South Central region, where 90 percent of Brazilian sugar is produced, are closed. Stockpiles are at a 35-year high. Insolvent mills are trying to sell as much sugar as possible to generate cash, which has depressed world sugar prices. 

Meanwhile, sugar imports in China were down 25 percent in August from a year earlier. Adding to the pressure, the Brazilian real is down 33 percent so far this year. Standard & Poor’s cut the country’s debt rating to junk in September. The dollar-denominated debts of Brazilian sugar producers are becoming next to impossible to service, as a result. 

As with iron ore, the Saudis are trying to use low prices to squeeze out other major crude-oil producers. I previously explained why that could result in per-barrel oil prices of $10 to $20.

As long as market prices exceed marginal cost, more (not less) production is encouraged to make up for lost revenue. Some producers will raise output even when prices fall below marginal costs. 

Russia depends on energy exports to cover import costs and government spending. With the collapse in oil prices and Western sanctions, Russia is desperate to earn foreign exchange.  


Monday, September 28, 2015

World heading towards Deflation

Almost every country is devaluing against the Dollar. It is a reflection of slow growth.............

[Watch the full video below]

Monday, September 14, 2015

More market sell offs could be ahead

Volatility -- the rate at which prices move up or down -- has leaped in many security markets recently. The Federal Reserve Bank of St. Louis's Financial Stress Index, whose 18 components include yields on junk and corporate bonds, an index of bond market volatility, and the Standard & Poor's 500 index, is almost at a four-year high.

I believe the restrictions on bank trading imposed by the 2010 Dodd-Frank Act, including the ban on banks' proprietary trading and increased capital requirements, are a key reason, at least in the U.S. Large banks and other financial institutions simply aren't carrying the big trading positions they once did, and therefore, liquidity in many markets has atrophied. 

Then there's China's stock-market nosedive and currency devaluation. They provided a wake-up call about China's slowing growth and the global effects on commodity prices, emerging markets and money flows. 

Volatility in U.S. markets may also be due in part to the delayed effects of the ending of quantitative easing by the U.S. Federal Reserve late last year. Since stocks began to revive in March 2009, equities have been floating on a sea of Fed money with little connection to the slowly growing economy beneath -- something I dubbed "the Grand Disconnect." 

Then there's the shaky base of corporate earnings growth. With slower economic growth, sales gains have been slight. And business pricing power has been almost nonexistent, with minimal inflation and a strong dollar. So top-line revenue growth -- the foundation for profit gains -- has been largely missing. 

Resourceful American businesses have cut costs ruthlessly to make up for the lack of revenue growth. As a result, profits' share of national income leaped from the lows of the 2007-2009 recession. But profits' share has stalled over the last several years, reflecting the slowing of productivity growth. 

Also, stocks aren't cheap relative to earnings. The price-to-earnings ratio on the S&P 500 index over the last year is 18.2, compared with the norm of 19.4 over the last 20 years. But the better measure is the cyclically adjusted ratio, developed by Robert Shiller, the Yale University economics professor, which uses real earnings over the preceding 10 years to iron out cyclical fluctuations. On that basis, the current price-to-earnings ratio of 25.84 is 55 percent above the long-run norm of 16.6. And since the norm has been about 16.6 almost since 1992, price-to-earnings should run below trend for years to come, assuming the 16.6 remains valid.

The past month's leap in volatility, especially for stocks, reminds me of the prelude to the Oct. 19, 1987, stock-market crash, when the Dow Jones Industrial Average plummeted 22.6 percent in one day and the S&P 500 fell 20.5 percent. The S&P 500 volatility in the 10 trading days before the crash was 1.8 percent, compared with the previous month's average of 0.8 percent. More recently, S&P 500 volatility in the 10 trading days prior to Sept. 4 was 1.9 percent, while the one-month daily percentage change from mid-July to mid-August was 0.5 percent.

So I have to ask: Is the current volatility forecasting big selloffs into inadequate liquidity, as happened in the weeks leading up to the 1987 crash? Beyond the volatile markets, there are other warning signs. Interestingly, computerized trading may also be helping to feed volatility, much as it did in 1987. 

Junk bonds, which become notoriously illiquid in times of stress, enjoyed huge popularity from 2008 until recently, as investors lusted for yield in an era of low interest rates on Treasuries. But recently, yields have jumped, as have spreads between Treasuries and junk bonds. Junk bond prices, led by energy issues, fell 5.7 percent from April through August, and investors are on track to withdraw money from junk bond mutual funds for the third year. Similarly, yields on investment-grade bonds have been rising, as have their spreads against Treasuries. 

Keep an eye on Treasuries. The night before the 1987 crash, 30-year bond prices leaped 12 points in the stampede to safety. Credit markets often give warnings ahead of major global economic problems and equity bear markets. That was certainly true in 2000 and 2008. 

The economic outlook is uncertain, but the recent leap in volatility in equities and other markets may be warning us of more big selloffs ahead.


Tuesday, September 8, 2015

Global recession could occur if oil price drops again

If oil prices take another dramatic slide, as I believe they will, who wins and who loses? And could plummeting oil prices sow the seeds of the next recession ?

Oil-importing countries are obvious winners from falling crude prices. That includes the U.S., where -- despite a surge in domestic production -- imports still account for nearly 50 percent of petroleum consumption. The net oil-importing countries of western Europe and Asia also benefit from falling crude prices. India and Egypt, which subsidize domestic energy use, will surely benefit. Some of that, however, will be offset because crude oil is priced in U.S. dollars, and those countries' currencies have grown weaker against the greenback.

The windfall for U.S. consumers is considerable, with average gasoline prices down 24 percent to $2.47 a gallon from $3.77 in June 2014. No doubt, prices will fall even more when the summer driving season ends after Labor Day.

Most forecasters believe consumers will spend the windfall, and thus boost the economy. But almost all of the savings from lower pump prices so far have been used to rebuild household assets and reduce debt. Consumers tend to increase their savings in tough times; they've been doing so during the six-year recovery, even as real wages and median household incomes remain flat.

Lower oil prices, however, could come with a downside. As they work their way through the system, deflation could follow. Already, 10 of the 34 largest economies in the world have seen year-over-year declines in consumer prices. The risk is that deflationary expectations could follow, encouraging consumers to withhold purchases in anticipation of even lower prices.

If that happens, excess capacity and inventories would build, forcing prices down more. When buyers' suspicions are confirmed, they further delay consumption, in a vicious downward cycle. The result is little if any economic growth, as deflation-prone Japan has seen over the last two decades.

The losers from declining oil prices obviously include producers and oil-services companies, especially those that are highly leveraged. U.S. shale-oil frackers are taking a hit, and yet they stubbornly refuse to leave the business. One reason is that well-drilling costs are also declining. Another is that oil prices are still above frackers' marginal costs, which encourages them to increase output to make up for falling revenue.

Employees in the U.S. oil- and gas-extraction industry make up just 0.14 percent of total payrolls, but they were paid an average of about $41 an hour in July -- almost twice what other U.S. workers are paid. Since late last year, jobs are down only 4 percent in the sector and weekly pay has declined just 3 percent. With another big leg down in oil prices, vacancy signs may soon appear in the once-booming North Dakota fracking fields.

Further drops in oil prices will add to the woes of African exporters Ghana, Angola and Nigeria. Oil exports finance 70 percent of Nigeria's budget. Ditto for economic basket case Venezuela, where the bolivar has collapsed from 103 per U.S. dollar in November to 701 on the black market. (The official rate remains a fanciful 6.29 to the greenback.) 

Russia depends heavily on oil exports to finance imports and government spending. With Western sanctions over Ukraine squeezing the economy and Russian banks unable to borrow abroad to service their foreign debts, another drop in oil prices could precipitate a rerun of the country's 1998 default. The ruble has dropped to 66 per dollar from 49 per dollar in May, inflation is running at a 16 percent annual rate, and the economy contracted by 4.6 percent in the second quarter versus a year earlier.

With no other meaningful source of foreign exchange, Russia no doubt will continue to produce and export oil even if prices fall below marginal costs. And who knows what President Vladimir Putin might do next to divert domestic attention from this miserable situation? According to Shakespeare, the dying King Henry advised his son, Prince Hal, to "busy giddy minds with foreign quarrels."

Energy stocks are already down substantially on oil price weakness, with stalwart Royal Dutch Shell off 35 percent over the past year. Expect more punishment for speculators and investors who hold oil and related securities if prices drop toward my $10- to $20-a-barrel target.

Persian Gulf stock markets have been hurt and will probably nosedive with further oil-price weakness, especially since they're dominated by retail investors who have used cheap credit to rack up sizable margin debt. The Saudi bourse was the region's top performer this year, partly in anticipation of its opening to foreigners in June. Still, it's down 10 percent for the year so far. Oil provides 90 percent of the Saudi government's revenue and 40 percent of gross domestic product.

The U.S. Federal Reserve has put off raising short-term interest rates until labor markets and inflation data are more to its liking, but it now seems to many that it will take action before the end of 2015. I believe the Fed will hold off on a rate hike until next year, at the earliest. But if it does move this year, and commodity prices tumble, China slumps and deflation sets in, it could soon wish it hadn't.

The combination of all these forces may be the shock that precipitates the next global recession.

Monday, August 31, 2015

Global Growth has been slowing for a while

Slow global growth has been going on for a while but didn’t get a lot of attention until the big drop in oil prices and China’s stock decline and devaluation.

When growth is so slow it doesn’t take much to tip into a global recession, but the jury is still out.

Monday, August 10, 2015

Gary Shiling interviewed by Jim Puplava

Gary Shilling talks with Jim Puplava on the financial markets and market timing.

*Update: Aug 20, 2015 - Added the Youtube link

Wednesday, July 22, 2015

Deleveraging still unfinished, Strong growth for US economy ahead after it

Is the U.S. economy stuck in an endless loop of sluggish growth and high unemployment? Many distinguished economists think so, and there is some evidence to support them. But looking at much the same data, I come to the opposite conclusion: The U.S. could soon experience a period of strong economic growth once deleveraging is over.

No doubt, the economy is now growing too slowly, at an annual pace of only 2.2 percent real gross domestic product in this recovery, which started in mid-2009. That's about half the speed you'd expect after the worst recession since the 1930s. And the sluggishness is global, with tiny growth in the euro area, a pattern of rising and falling economic activity in Japan, and a slowdown in China (where the official growth rate of 7 percent is probably twice the actual number). 

Many forecasters believe slow global growth will last indefinitely. They think developing economies are reaching the limits of easy growth based on emulating Western technology, while advanced countries are increasingly oriented toward services, with less scope for productivity gains. 

The pessimists believe that productivity growth -- it has averaged just 1 percent annually in this recovery, the slowest by far for any post-World-War-II cycle -- is destined for more of the same while the retirement of postwar babies and poor education and training constrain market supplies. 

This camp also points to increased government regulation, income polarization, and too much saving and not enough spending on a global basis as reasons for the slow growth. They note that these trends have been going on for decades, but were hidden in earlier years by the dot-com speculation of the late 1990s, the housing bubble in 1995-through-2005 years, the early-1980s-to-mid-2000s consumer spending spree, and the euphoria in the euro zone after its 1999 launch. 

I agree there have been some profound economic changes in recent decades. I attribute them largely to globalization, with more and more goods and services production shifting to economies with much lower labor costs. Not coincidentally, since the 1990s there have been much slower post-recession recoveries than normal for payroll employment. 

Many other reasons have been advanced for slow economic growth indefinitely. Harvard economists Carmen Reinhart and Kenneth Rogoff concluded in a 2010 paper that when central government debt exceeds 90 percent of GDP, the economies of developed countries contract at a 0.1 percent annual rate. Since people saw the Reinhart-Rogoff high-government-debt scenario playing out right before them, they believed that chronic slow growth was inevitable. 

Glenn Hubbard, dean of Columbia's business school and a former chairman of the president's Council of Economic Advisers, and Tim Kane, a former chief economist of the Hudson Institute now at the Hoover Institution, express even more basic concerns in their book "Balance: The Economics of Great Powers From Ancient Rome to Modern America." They believe great powers fall into the trap of "denying the internal nature of stagnation, centralizing power and shortchanging the future to overspend on their present."

Harvard's Larry Summers, the former U.S. Treasury secretary and National Economic Council director, is concerned with "secular stagnation." By that, he means chronic slow growth due to slow labor-force expansion and muted productivity growth. 

Then there's Robert Gordon of Northwestern University, who, in the tradition of Thomas Malthus, believes that all the big growth-driving technologies are fully exploited. He cites past marvels, including Edison's electric light bulb and power station, which spawned all manner of electricity use, from consumer appliances to elevators. He sees nothing to rival the economic impact of the automobile, telephone, phonograph, motion picture, radio, television, air conditioner, jet plane and interstate highway system. 

Computers and the Internet are essentially fully exploited, he and other techno-pessimists believe, meaning the 1891-through-2007 years of 2 percent annual output growth per capita are over. And with postwar babies leaving the workforce, America's lousy education system and growing income inequality, real annual GDP growth of only 1 percent is likely. The vast majority of Americans, he thinks, will see their incomes grow just 0.5 percent annually. 

The recent weakness in productivity is especially worrisome for slow-growth adherents. For only the third time in the last three decades has productivity suffered two consecutive quarterly declines (outside of recessions). Without productivity growth, the only way the economy can advance is by adding hours worked. Without productivity growth, the only way individuals can increase their real income is if others lose some of theirs. So productivity growth has social as well as economic significance. 

Many economists, including those at the Federal Reserve Bank of Atlanta, attribute slow productivity gains to subdued capital spending growth in recent years and the resulting aging of capital equipment. The Atlanta Fed researchers conclude that the rise in GDP in the recovery, weak as it has been, is due primarily to more hours worked and not more output per hour. 

A hotly debated academic explanation for slow capital spending is that real interest rates, as measured by Treasury yields, are too high to induce businesses to spend on new plants and equipment. And since nominal interest rates can't go below zero, real rates -- the difference between nominal rates and inflation -- can't be pushed into negative territory to encourage investment when inflation is essentially zero.

Real interest rates (as seen in yields on 20-year Treasury notes) have declined since the early 1980s: from a lofty 9.5 percent in August 1983, when investors feared more double-digit inflation, to 1.9 percent in December 1990, when disinflation set in. Since then, real rates have risen a bit, to 2.9 percent as of July 1, but have been negative on three occasions in recent years. 

One reason real rates have been weak recently is the global financial deleveraging that started in 2008. Banks worldwide, with pressure from regulators, are borrowing less, as are U.S. consumers. Then there's quantitative easing, first by the U.S. Federal Reserve and now by the Bank of Japan and the European Central Bank. When central banks conduct quantitative easing by purchasing large quantities of government bonds, it tends to push down interest rates.

Another reason given for weak real interest rates is the declining rate of population growth, a phenomenon normally associated with real rate declines. Then add in the polarization of income, which shifts money into the hands of big savers and away from lower-income, heavy-spending folks. The postwar babies have been notoriously poor savers. Now, the need to save like crazy for retirement reduces consumer spending, which further depresses interest rates. 

The same goes for the mountains of excess cash corporations are hoarding. When capital investment shrinks, it can't offset reductions in consumer spending, and that pushes interest rates and economic growth down. 

A fundamental concern among those who forecast slow economic growth indefinitely is that adequately trained workers won't be available even if jobs are offered. They believe the labor market is supply-constrained. The number of people out of work six months or more remains huge, and after six months, skills get rusty. Others never gained the ability to compete in today's global, digital world, which has favored a few who tend to have high incomes as a result.

Also, when the recent recession squeezed business revenue and decimated profits, many corporations eliminated their training programs to save money. Besides, with so many qualified people who were unemployed and available, why pay to train new ones?

With slow economic growth and no inflation, business revenue growth has been muted. So the route to profit gains has been through cost-cutting, and most business costs are ultimately for labor. Meanwhile, globalization and automation are eliminating many U.S. middle-income jobs. Real wages and median household incomes, as a result, have been flat in this recovery.

Pessimists also point to declining U.S. population growth, which is approaching zero, and the likelihood that the trend will persist. Adding to these concerns is the declining share of the population over age 16 that is in the labor force, i.e., either employed or actively looking for work. 

About 60 percent of the decline in this total participation rate since its February 2000 peak is due to demographics: Postwar babies are retiring and women are no longer entering the job market en masse. In addition, many working-age people don't see job opportunities and have dropped out of the labor force. 

In the future, employees will need to be much more productive to cover their needs and those of retirees. Otherwise, there will be intergenerational conflict when it comes time to split an inadequate economic pie. In the U.S., the ratio of those in the working ages -- 15 to 64 -- to those over 65 is projected to drop from 5.2 in 2010 to 2.9 in 2040. 

Monday, July 20, 2015

Bullish America and US stocks longer term [VIDEO]

Gary Shilling interview on Bloomberg and why Gary Shilling is bullish USA long term.

Monday, July 13, 2015

Slow growth wont last forever

I don't agree with the slow-growth-indefinitely forecasts.

I've long said that, until global deleveraging is completed, gross domestic product will continue to grow by about 2 percent annually. I've also noted that reducing debt levels after a financial crisis, especially one caused by a borrowing binge, normally takes about a decade. This episode is eight years old, and at the rate things are going, it may take longer than 10 years. U.S. household debt relative to after-tax income has fallen to 102 percent from 130 percent, but it's still a long way from the 65 percent norm.

Nevertheless, the process will end at some point, and I continue to believe it will be followed by rapid real economic growth of at least 3.5 percent a year. That growth will no doubt be fueled by today's new technologies, including computers, the Internet, biotech, telecom, semiconductors, robotics and 3-D printers. 

Note that the Industrial Revolution and railroads started in the late 1700's and grew explosively, but from zero starting points. It was only after the Civil War that they became big enough to drive the U.S. economy. 

Secular Stagnation

Productivity is a complex phenomenon. It comes in waves that are often unrelated to the current economic situation, so recent weakness shouldn't be extrapolated. Even in the Depression-era 1930's, output per hour rose at a healthy 2.4 percent annual rate, higher than the 2.1 percent growth of the Roaring '20s. Many of the tech advances of the 1920's -- electrification of factories and homes, increased use of telephones, the dawn of the radio era -- weren't exploited until the following decade, when they became must-have conveniences. 

In the current setting, companies may have compensated for anemic revenue growth by cutting costs so much that productivity growth, which normally would have been spread out, was concentrated in 2009-2010. Recent productivity weakness probably indicates that companies have reached the bottom of the cost-cutting barrel. The leap in profit margins since the recession has also topped out in the last two years; corporate profits have now begun to decline. So businesses will no doubt turn from reducing costs to promoting productivity. Companies will probably redouble these efforts if wage increases push up unit labor costs. 

At the same time, companies will probably increase research-and-development spending and reinstitute labor-training programs as the supply of unemployed skilled workers shrinks. The need for trained workers will be enhanced by the growing use of robots, which generates jobs in design, engineering, maintenance, marketing and logistics. 

Solutions to the current crisis in higher education may end up promoting productivity, as well. Students and their tuition-paying parents now know that a college degree no longer guarantees a job that pays well. In this regard, two education developments are encouraging. First, many colleges are emphasizing degrees in the STEM (science, technology, engineering and math) fields, where jobs are waiting. Second, German manufacturers have transplanted their apprenticeship program to plants in the southeastern U.S., where they coordinate worker training with nearby community colleges. American businesses are beginning to copy this model. 

As for the Reinhart-Rogoff argument -- that high government debt depresses GDP -- it's probably the other way around. Slow economic growth depresses tax revenue and raises government social spending, thereby causing bigger deficits and debt levels. 

The argument that growth is stymied because companies have cut capital spending may also be missing a larger trend. Much of the spending to build new tech and social-media companies, such as Google and Facebook, isn't counted as capital outlays. The brains of the entrepreneurs and developers substitute for capital spending. A high-tech startup in a garage or a college dorm doesn't register in government data the way a new auto plant does. Many successful startups didn't need much more than a laptop, and most of the money they raised went to advertising and marketing, not building factories.

Fed economists believe that the pricing of high-tech equipment may result in understated business investment. Not surprisingly, capital equipment prices have fallen 21 percent since the early 1980's. Furthermore, the correlation between capital spending and productivity is, contrary to the belief of the slow-growth advocates, weak to nonexistent. This is shown by the correlations between private, fixed capital investment and productivity with a series of leads and lags.

From the first quarter of 1948 to the fourth quarter of 1990, the strongest relationship was between capital spending and productivity growth three quarters later, which makes sense. But the statistical fit, according to my firm's research, was very poor. Even that weak relationship broke down between the fourth quarter of 1990 and the first quarter of this year. The best fit was between productivity growth now and capital spending 16 quarters later, which defies any causal explanation.

So there doesn't appear to be any meaningful statistical relationship between capital spending and enhanced productivity. Spending money on more machines doesn't do the job, suggesting that productivity flows mainly from new technology such as robotics, better management, more motivated employees, better logistics and, probably, dumb luck. 

The pessimistic argument that American corporations have been buying back stocks instead of investing in plant and equipment carries some weight, but dividend increases still leave the payout ratio (the percentage of net income paid to shareholders) for the S&P 500 at 42 percent, well below the long-term 52 percent average. It can be argued that low interest rates make low dividend yields (dividend per share divided by price per share) acceptable. In any event, the dividend yield for the S&P 500 index is now just 1.97 percent, well below the earlier 3 percent norm. 

True, government regulation is excessive, as the slow-growth advocates maintain. Since 1970, more than half of Americans have relied on government for meaningful income; in 2007, it was 58 percent, according to my firm's research. Yet voters haven't used the ballot box to accelerate their government goodies. 

Apparently, Americans still believe they can get further on their own merit than by pushing government to redistribute income in their favor. And if I'm right about a coming economic boom, they will have even less reason to rely on government largess. 

Originally published

US stocks recovery is over says Gary Shilling

The Fed’s QE drove U.S. stocks, but it’s over. Corporate earnings in this recovery have been based not on solid revenue growth but on profit margin increases that have flagged as underlying cost-cutting and productivity gains atrophied. 

In the portfolios I manage, I have shifted to European and Japanese stocks, figuring that the bulk of QE money will end up in equities, as it did in the U.S. In the last 12 months the S&P 500 is up 9% versus 12% for Europe’s Stoxx 600 and 38% for Japan’s Nikkei. China’s quasi-QE, plus the recent individual investor switch from real estate to stocks, has already hyped the Shanghai index, which is up 150% in the last 12 months.

Monday, June 29, 2015

China real estate bubble deflating

China has also embarked on indirect QE in response to slowing growth. Chinese officials are permitting banks to use local government bailout bonds as collateral for low-cost loans from the central bank, while local governments can sell new bonds with explicit government guarantees. Three interest rate cuts since November and two reductions in bank reserve requirements have not spurred credit demand. 

Meanwhile, Chinese companies and local governments remain heavily indebted as the real estate bubble deflates.

Monday, June 22, 2015

QE results in Europe and Japan will be similar to what happened in USA

In January the European Central Bank unveiled its long-awaited quantitative easing program, pledging to purchase a total of €1.1 trillion in securities through September 2016 at a pace of €60 billion per month. It could buy even more if inflation remains below 2%.

These asset purchases will push the ECB’s balance sheet a bit over the €3.1 trillion peak it hit in June 2012 at the end of its last round of easing, when it lent €1 trillion to 800 member banks, which used the money to buy their sovereign debt. Like all major central banks, the ECB wants 2% inflation as a cushion against deflation, which has plagued Japan for 20 years and virtually eliminated economic growth as consumers wait for still lower prices before buying.

To gauge the efficacy of European easing in spurring growth, look at the Fed’s adventures with QE in the U.S. In reaction to the Great Recession and global financial crisis, the Fed and all other major central banks chopped reference interest rates essentially to zero, but closely regulated banks didn’t want to lend and creditworthy borrowers didn’t need more money. So after bailing out Wall Street, starting in the fall of 2008, the Fed moved on to QE, ultimately buying more than $3.5 trillion in government and mortgage-backed securities when the program ended last October.

Those who sold securities to the Fed used the proceeds largely to buy stocks, which has pushed the S&P 500 up 211% from its March 2009 bottom. That helped household net worth rebound 51%, but real GDP has averaged only 2.2% annualized growth since the recovery started in mid-2009, about half the rate you’d expect after the deepest recession since the 1930s.

The problem is that stocks are predominantly owned by high-income folks, who don’t spend much more as their assets rise. The central bank is no doubt frustrated by QE’s lack of success, but monetary policy is a blunt instrument. The Fed can move interest rates and buy and sell securities. That’s it. In contrast, fiscal policy can pinpoint aid to the jobless by raising unemployment benefits.

The questionable outcome of the Fed’s experiment with QE suggests that the ECB’s efforts may do little to boost growth for the 19 countries in the euro zone. Japan may also see little benefit from QE, by which Prime Minister Abe, elected in December 2012, hopes to stimulate the economy. The program will continue until the inflation rate reaches the Bank of Japan’s 2% target. As with the Fed’s QE, the results so far are disappointing. Real GDP rose at a 3.9% annual rate in the last quarter, and all but 1.9% of that was due to inventory accumulation, which may spawn offsetting production cuts in the future.


Monday, June 8, 2015

Gary Shilling on the power of deleveraging [VIDEO]

Deleveraging is so powerful that it is swamped all the monetary and fiscal stimuli that we have and the result is very slow growth about 2 percent GDP growth, a little less than half of which you would expect.

Monday, May 18, 2015

Gary Shilling on King Dollar

The dollar reached a peak against major currencies in 1985, then slid 52 percentage points over the next 25 years. It's been rising since August 2011, yet has recovered only 8 percentage points of that 52-point slide. Of course, there’s no assurance that the dollar will regain its 1985 peak, yet there are concrete reasons to expect it to remain strong over the long haul.  

The dollar has been the primary trading and reserve currency since World War II and is likely to remain so for decades. Rapid growth in the economy and per-capita output weigh in the dollar’s favor. American financial markets are broad, deep and transparent, as is the economy. Despite the dollar's decline since 1985, its credibility is substantial.  

And there is no real substitute for the dollar as a global currency. 

Monday, May 11, 2015

Japanese markets attractive investment

Japanese stocks remain attractive as the Abe government strives to stimulate economic growth while trashing the yen.

Wednesday, May 6, 2015

Bad weather is usually blamed for low sales

Many economists blame severe winter weather, the usual scapegoat for disappointing retail sales.

Tuesday, April 28, 2015

Savings by US consumers will rise higher probably

Much of the money the U.S. Federal Reserve pumped into the economy through massive bond-buying was used to purchase equities, which pushed up their value. The Fed hoped this would enhance households' net worth, induce more consumer and business spending and generate jobs. But the hoped-for “real wealth effect” was muted because equities are held mostly by high-net-worth people who don’t change their spending habits appreciably as their portfolios rise.  

Household net worth has risen along with home prices, albeit very slowly. Prices are still 17 percent below their April 2006 peak. Since the start of the recession at the end of 2007, the value of residential real estate has been flat, while stocks are up 37 percent. 

Those who thought consumers would immediately spend their energy savings apparently didn’t know that the household savings rate spiked after the tax cuts and rebates in the 2008 and 2009 stimulus measures. Households only later spent some of their windfalls. That’s true today, too: The household savings rate jumped from 4.5 percent in November to 5.8 percent in February. 

Savings will probably continue to climb as consumers, who earlier lacked the money to save, use their energy windfall to replenish savings and reduce debt. Baby boomers were negative savers in the 1980's as they established households and spent heavily on cars and home furnishings. Their low-saving habits persisted into middle age, and now they must save with a vengeance or work until they die. 

The recent weakness in retail sales also may be the result of intensifying deflation. Retail prices were down 3 percent in February from a year earlier, according to the U.S. Commerce Department. Consumers may be adopting the deflationary mindset that has plagued Japan for two decades. Japanese consumers are trained to wait for still-lower prices before buying. Meanwhile, inventories and excess capacity mount, forcing prices down further. That confirms consumers' suspicions, so they wait for still-lower prices. The result has been slow or zero economic growth since the early 1990s. 

Deflationary expectations are a worry for the world’s central banks, many of which want inflation around 2 percent as a cushion against deflation. Their worries are valid: Inflation is running well below target. 

History shows that when times are tough, U.S. consumers increase, rather than decrease, their savings. Plummeting energy prices are providing the extra wherewithal. Investors who anticipated purchasing-power gains would lead to greater consumer spending must be sadly disappointed. 

Monday, March 30, 2015

Treasury prices can go higher

The U.S. Federal Reserve sounded an “all clear” for Treasury securities at its March 18 meeting. With continued problems in the U.S. labor market, stagnant real wage growth, flagging retail sales and deflation worries, the Fed won't be raising rates anytime soon. Treasury prices, then, are sure to rise. 

The coming rally will draw strength from steps that central banks in Europe and Japan are taking to boost exports by devaluing their currencies, which drives investors to the U.S. What's more, government-bond prices, even for Spanish and Italian debt, are higher than in the U.S. It won't be long before investors narrow those gaps by purchasing Treasuries.

The Fed started the springtime rally last week when it effectively signaled it wouldn't soon increase interest rates by cranking down forecasts for the federal funds rate and inflation. The economy, the Fed said, is now “moderating” instead of “expanding at a solid pace.” 

The central bank also cut its 2015 economic growth outlook to 2.5 percent from 3.4 percent, much like the repeated downgrades of its gross domestic product forecasts for 2012, 2013 and 2014. 
The Fed's post-meeting release dropped the statement that the Fed would be “patient” before raising interest rates. To make sure no one thought that meant an imminent rate increase, Chair Janet Yellen said: “Just because we have removed the word ‘patient’ from the statement doesn’t mean we’re going to be impatient.” 

The Fed’s dual mandate is to promote full employment and price stability. It hasn't accomplished either. Payroll employment has accelerated, with almost 282,000 new jobs a month in the last 11 months, significantly higher than the average of about 185,000 between October 2010 and March 2014. 

But most of the new jobs are in low-paying sectors such as retailing and hospitality, not high-paying fields such as manufacturing, utilities and information technology. Also, with corporate revenue growing slower in this business expansion versus other recoveries, the route to larger profits has been through cost-cutting. Most costs, directly or indirectly, are for labor. 

Real wages and median household incomes, as a result, have been flat, which slows down consumer spending. Households are putting away rather than spending the savings from the recent drop in gasoline prices. Retail sales fell in December, January and February, while the household savings rate jumped. 

The Fed defines its second mandate, price stability, as 2 percent inflation. Many other central banks use the 2 percent inflation target as well. They don’t love inflation, but they fear the deflation that has plagued Japan for two decades. As prices fall, potential buyers anticipate further declines by putting off purchases. Excess capacity and inventories mount and depress prices further. That confirms consumers' suspicions, so they further cut spending, to the detriment of economic growth. 

After the Fed’s March 18 announcement, Treasury bond prices leaped. I continue to believe that the 30-year Treasury yield, now 2.59 percent, will drop to 2 percent in a year, for a total return of about 15 percent. For a 30-year zero-coupon bond, I expect about an 18 percent return. I also look for the 10-year Treasury yield to drop from the current 2 percent to 1 percent, producing a total return of about 10 percent. 

With the odds falling for a Fed rate increase in the near future, investors are beginning to concentrate on the shrinking issuance of Treasury notes and bonds, which fell to $693 billion in February from $1.7 trillion in the 12 months ending May 2010, as the fiscal 2014 federal deficit declined to $483 billion from $1.4 trillion in fiscal 2009. On the demand side, foreigners continue to charge into Treasuries as the ultimate safe haven in a sea of global economic and financial trouble. Their holdings have jumped by almost $232 billion from January 2014.

 And there’s plenty of money available to buy Treasuries, with quantitative easing taking place in Japan and the euro zone. The Bank of Japan is buying up to $100 billion in securities a month, while the European Central Bank recently began purchasing $65 billion a month. As those central banks deliberately drive down their currencies, they encourage investors to flock to Treasuries.

There is another compelling argument for substantial rallies in Treasuries: The gaps between their yields and those of most developed countries are astoundingly wide. Those gaps are ridiculous -- unless you believe Spain and Italy issue higher-quality government obligations than the U.S.! Only Australia, among 17 developed foreign countries, has a higher 10-year bond yield than does the U.S., by 0.32 percentage point. 

These yield gaps scream to be closed, and no doubt will be, by a rally in Treasury prices. With the Bank of Japan and the ECB buying up sovereigns, yields in those regions will probably fall further. 

Investors in the euro zone and Japan can get better returns by buying Treasuries as opposed to their own sovereigns. They will get better capital appreciation as Treasuries rally. And they profit further as the dollar continues to rise against the yen, euro and almost every currency. 

What am I missing?

Wednesday, March 11, 2015

Copper prices have further downside risks

The commodity price boom that began after China joined the World Trade Organization in 2001 has turned to bust. Copper prices are down 41 percent from their 2011 peak and probably have a lot further to go. 

So why are copper producers ignoring all the obvious economic signals -- lower demand, excess supply and falling prices -- and ratcheting up production? The answer is that producers have powerful incentives to increase output. 
(Disclosure: Gary Shilling manages investment portfolios in which copper is shorted, so I have a financial interest in falling copper prices.) 

Let me explain. Think back to the early 2000s, when it was accepted wisdom that fast-growing China would soak up most of the world’s commodities. China, indeed, has been buying more than 40 percent of annual global output of copper, tin, lead, zinc and other nonferrous metals. It's been gobbling up 50 percent of seaborne iron ore and huge quantities of coal. And it has built large stockpiles of crude oil. 

As manufacturing shifted to China from Europe and North America, the Middle Kingdom became a much bigger buyer and user of commodities than its domestic economy required. 

The jump in prices led commodity producers to invest in big new operations in Australia, Brazil and elsewhere. Many of these projects came online just as global demand slowed in a classic boom-to-bust commodity cycle. 

But even as China's commodity-intensive exports to North America and Europe atrophy and China's own infrastructure spending slows, excess capacity keeps building. The reason: It’s not economical to suspend some of these projects due to high sunk costs and shutdown expenses. Some producers, moreover, may not be free to slash output as prices swoon, especially if they’re government-controlled and need foreign exchange to service sovereign debts. 

To see how market versus non-market forces are interacting, compare two widely used metals, aluminum and copper. Aluminum prices are down 32 percent from their April 2011 top, much less than copper's 41 percent freefall. Six of the top 10 aluminum companies are in Russia and China, where government decisions, not economic forces, often prevail.

The government and state-owned enterprises in China push aluminum output to provide employment and to achieve other national goals, such as self-sufficiency in aluminum. In Russia and India, the goal is to generate revenue from aluminum exports that can be exchanged for currencies needed to pay down debt; in Brazil, the driver is substituting domestically produced aluminum for imports. 

Aluminum production in these emerging economies has been booming. Even though half of China’s output is produced at a loss, the Chinese government buys excess metal from smelters to avoid bankruptcies, bad bank debts and unemployment.

 Much of the surge in aluminum output, however, is offset by cutbacks in the U.S., Canada and Australia. Alcoa, for example, is closing high-cost plants around the world. Since 2009, the aluminum industry in developed countries has shuttered more than 50 smelters. These moves have kept global prices from plummeting. 

By contrast, copper is produced mainly in the developing countries of Chile, Peru, Congo, Zambia and Russia. China is a net exporter of aluminum but an importer of copper. China had been building copper stockpiles but apparently that has slowed, along with China's slackened growth. The premium paid for copper on the Shanghai market over the London Metal Exchange was $85 a ton at the end of January, down from $160 a year earlier.

Copper output in developed countries has been restrained by falling prices, except in the U.S. and Australia, where output has risen because the marginal cost of production is even lower than market prices. Copper inventories are rising as output grows in Chile, China, Russia and other countries. In Chile, the world’s largest copper producer, stocks rose by 170,000 tons in the second half of 2014, the highest in a decade except for a brief spurt in 2013. 

Copper is used in almost every manufactured product, from plumbing fixtures to autos to machinery. Some 56 percent goes into electrical equipment and construction, which are weakening as China's economy shifts from an emphasis on manufactured exports, infrastructure and construction to consumer spending and services. 

Since copper is traded in dollars, the strong greenback makes it more expensive for non-U.S. buyers, putting more downward pressure on prices. At the same time, since about 93 percent of copper is produced outside the U.S., labor and other production costs are dropping in dollar terms, encouraging yet more output.  

The upshot is that about 20 percent of mined copper worldwide is unprofitable at current prices.  A global copper surplus is likely this year, the first since 2009, with supply exceeding demand by 500,000 tons, or 2 percent of annual refined production, according to Goldman Sachs. The International Copper Study Group, made up of copper-producing and consuming countries, says demand will rise just 1.1 percent this year while output jumps 4.3 percent. 

In an atmosphere of falling commodity prices, copper will probably continue to be weak; it's a favorite short in portfolios I manage. The lower the price of copper, the more developing economies must produce and export to get the same number of dollars to service their foreign debts. And the more they export, the more the downward pressure on copper prices. That forces them to produce and export even more, in a self-reinforcing downward spiral. 

Look out below.

Sunday, March 1, 2015

Big declines for Oil ahead

At about US$50 a barrel, crude oil prices are down by more than half from their June 2014 peak of US$107. They may fall more, perhaps even as low as US$10 to US$20. Here’s why.

US economic growth has averaged 2.3 per cent a year since the recovery started in mid-2009. That’s about half the rate you might expect in a rebound from the deepest recession since the 1930s. Meanwhile, growth in China is slowing, is minimal in the euro zone and is negative in Japan. Throw in the large increase in US vehicle gas mileage and other conservation measures and it’s clear why global oil demand is weak and might even decline.

Oil prices

At the same time, output is climbing, thanks in large part to increased US production from hydraulic fracking and horizontal drilling. US output rose by 15 per cent in the 12 months through November from a year earlier, based on the latest data, while imports declined 4 per cent.

Something else figures in the mix: The eroding power of the OPEC cartel. Like all cartels, the Organization of Petroleum Exporting Countries is designed to ensure stable and above- market crude prices. But those high prices encourage cheating, as cartel members exceed their quotas. For the cartel to function, its leader -- in this case, Saudi Arabia -- must accommodate the cheaters by cutting its own output to keep prices from falling. But the Saudis have seen their past cutbacks result in market-share losses.

So the Saudis, backed by other Persian Gulf oil producers with sizable financial resources -- Kuwait, Qatar and the United Arab Emirates -- embarked on a game of chicken with the cheaters. On November 27, OPEC said that it wouldn’t cut output, sending oil prices off a cliff. The Saudis figure they can withstand low prices for longer than their financially weaker competitors, who will have to cut production first as pumping becomes uneconomical.

What is the price at which major producers chicken out and slash output? Whatever that price is, it is much lower than the US$125 a barrel Venezuela needs to support its mismanaged economy. The same goes for Ecuador, Algeria, Nigeria, Iraq, Iran and Angola.

Saudi Arabia requires a price of more than US$90 to fund its budget. But it has US$726 billion in foreign currency reserves and is betting it can survive for two years with prices of less than US$40 a barrel.

Furthermore, the price when producers chicken out isn’t necessarily the average cost of production, which for 80 per cent of new US shale oil production this year will be US$50 to US$69 a barrel, according to Daniel Yergin of energy consultant IHS Cambridge Energy Research Associates. Instead, the chicken-out point is the marginal cost of production, or the additional costs after the wells are drilled and the pipes are laid. Another way to think of it: It’s the price at which cash flow for an additional barrel falls to zero.

Last month, Wood Mackenzie, an energy research organization, found that of 2,222 oil fields surveyed worldwide, only 1.6 per cent would have negative cash flow at US$40 a barrel. That suggests there won’t be a lot of chickening out at US$40. Keep in mind that the marginal cost for efficient US shale-oil producers is about US$10 to US$20 a barrel in the Permian Basin in Texas and about the same for oil produced in the Persian Gulf.

Also consider the conundrum financially troubled countries such as Russia and Venezuela find themselves in: They desperately need the revenue from oil exports to service foreign debts and fund imports. Yet, the lower the price, the more oil they need to produce and export to earn the same number of dollars, the currency used to price and trade oil.

With new discoveries, stability in parts of the Middle East and increasing drilling efficiency, global oil output will no doubt rise in the next several years, adding to pressure on prices. US crude oil production is forecast to rise by 300,000 barrels a day during the next year from 9.1 million now.

Sure, the drilling rig count is falling, but it’s the inefficient rigs that are being idled, not the horizontal rigs that are the backbone of the fracking industry. Consider also Iraq’s recent deal with the Kurds, meaning that another 550,000 barrels a day will enter the market.

While supply climbs, demand is weakening. OPEC forecasts demand for its oil at a 14-year low of 28.2 million barrels a day in 2017, 600,000 less than its forecast a year ago and down from current output of 30.7 million. It also cut its 2015 demand forecast to a 12-year low of 29.12 million barrels.

Meanwhile, the International Energy Agency reduced its 2015 global demand forecast for the fourth time in 12 months by 230,000 barrels a day to 93.3 million and sees supply exceeding demand this year by 400,000 barrels a day.

Although the 40 per cent decline in US gasoline prices since April 2014 has led consumers to buy more gas-guzzling SUVs and pick-up trucks, consumers during the past few years have bought the most efficient blend of cars and trucks ever. At the same time, slowing growth in China and the shift away from energy-intensive manufactured exports and infrastructure to consumer services is depressing oil demand. China accounted for two-thirds of the growth in demand for oil in the past decade.

So look for more big declines in crude oil and related energy prices. My next column will cover the winners and losers from low oil prices.