The world has changed – and it will change again

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By Adrian Clayton

The world of today is simply unrecognisable compared to that of the turn of the century

Then, markets spoke of disinflation and Western economies were buoyant and rich. Emerging markets were unpredictable and volatile. The oil price was less than $30 and the oil market oversupplied. Gold was a swear word! Well, today we have to deal with inflation. Developed economies are troubled and indebted. Emerging economies are the buzz and the setting for tremendous wealth accumulation. The oil price is at stratospheric levels and the market is supposedly undersupplied. And gold is now considered a store of wealth.

If this is not a sign of the dynamism present in economics and markets, then nothing is. From it we can easily deduce that assuming that things will remain steady or persistent in financial markets is foolhardy and the current state of affairs should also not be regarded as sustainable. But what has brought on this change?

Without going into too much detail, a cocktail of unfolding events has conspired to create the latest bipolar economic backdrop. A weak dollar has made commodities cheaper for growing, non-dollar-based economies. We have seen a rapid industrialisation of the emerging world and the faltering of overindebted US consumers. Supply constraints have emerged in commodity-based products due to a lack of investment in years past. This is the current template and like the disinflationary world that preceded it, market participants are treating it as if it is permanent. My question is: What could change this status quo going forward?

Again, due to time constraints, this will not be a lengthy analysis and we will only mention the factors that we believe could redirect the global economy onto a different path. Firstly, the most obvious change could occur within currency markets. The woes in the US have kept the dollar weak, with neither the economy nor interest rates acting as an anchor for that currency. The dollar/euro cross-rate is particularly closely monitored by markets and with European interest rates having been maintained at relatively elevated levels, we believe that economic growth in Euroland could be under threat. Ultimately this should translate into a weaker euro. Thus, while most commentators seem to believe that dollar strength requires its source from the US [die betekenis hiervan is onduidelik], we are more inclined to view the euro as leading the charge on this front and it could be more a case of euro weakness than dollar strength. Any serious relative dollar gains have major ramifications for commodity markets and we could see commodity prices coming under pressure.

Secondly, watch out for improving supply measures from commodity producers. What has become evident is that some previously tight markets have been moving to a position of oversupply and many commodity prices have fallen sharply (for example uranium, nickel and zinc).

This has yet to happen in some of the commodities that are ‘headline catchers’ such as platinum, oil and copper. However, it is starting to happen with iron ore as producers begin to ramp up production based on elevated prices. On the soft commodity front, a combination of reduction in arable land and freak weather patterns has created the perfect storm to lower output. For many agricultural commodities, though, good weather alone could radically shift the markets back into balance.

Thirdly, a factor well worth watching is the level of interest rates in Asia when taken in combination with the state of the US economy. Well capable of seriously upsetting the apple cart would be the escalation of interest rates in Asia, designed to dampen inflation, while the US economy simultaneously enters a protracted recessionary phase. This would ratchet commodity prices lower and seriously dampen global economic growth.

Fourthly, we have the market’s ability to self-correct. One of the obvious drivers of commodity demand has been China as it has effectively become the cheap factory for the West. Lower labour costs and excellent productivity levels have justified producing in a market far removed from the actual point of sale. However, what is becoming very clear is that the cost of transport due to the higher oil price is effectively negating some of China’s pricing power. If you don’t believe this, look how well US steel manufacturers have started doing. Just a few years ago they were lobbying for protectionist policies and claiming anti-competitive practices by Asia and Africa. Now these businesses are making money hand over fist and their share prices are testament to this.

If commodity costs, particularly oil, continue to soar, China and many of its Asian partners will increasingly lose their competitive pricing advantage. Obvious responses will be to lower subsidies in the case of oil or possibly more aggressive bargaining with commodity producers. Alternatively, Asian authorities may accept a natural slowdown in markets that adjusts prices lower, but this would mean that they could lose out in markets in which they have built years a competitive advantage over the years.

Evident in this discussion is that we are monitoring various key issues that could change the current form of the economic landscape. Change is inevitable and markets will pre-empt these developments. The key is to be quick on one’s feet.

Source: Adrian Clayton, Alphen Asset Management, July 7, 2008.


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