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Commodity Correction Nearing An End?

Below is an article from Jim Jubak discussing why we have seen the downside of the commodity correction and why China and the rest of Asia may hold the key to the next leg up in the commodity bull market.

Many thanks to my friend Peter Schmidt, owner of UpClose Printing & Marketing, for this article. UpClose is the printer for my periodic Investment Strategies newsletter, so I can recommend his company if you are looking for someone to designing and printing your forms, brochures, or producing a broader marketing campaign.

Here is Jim’s column:

The key to our wild market: Asia

As developing giants like China and India grapple with high inflation and slowing growth, the world feels their effects. Now is the time to hedge with commodities.

By Jim Jubak

One day I’m ready to pull the trigger and load up on rallying financial stocks such as Citigroup (C, news, msgs), American Express (AXP, news, msgs) and Bank of America (BAC, news, msgs). The next day I’m happy I didn’t, as news from JPMorgan Chase (JPM, news, msgs) and Goldman Sachs (GS, news, msgs) takes the sector back down.

Just when I’m ready to dump my energy and commodity stocks, the sector rallies, and stocks like fertilizer maker Potash of Saskatchewan (POT, news, msgs) climb $7.48 a share, or 4.7%, in a single day.

It’s enough to make your head spin.

To make sense of this market, you’ve got to go back to economic fundamentals and to where so many fundamental stories start these days: Asia. Do that and you’ll understand several things:

  • Why the prices of oil and other commodities have been falling over the past month.
  • Why the drop doesn’t signal the end of the commodity bull market of the past few years.
  • Why growth in Asia, especially in China, is likely to accelerate in the beginning of 2009.
  • Why inflation is a bigger danger today than at the beginning of 2008.
  • Why owning commodities as a hedge against inflation is more important than ever.

At the core of the current wave of volatility are investor worries that growth is slowing in the Asian economies, which have been driving the global economy forward since the U.S. economy dropped into low gear in the fourth quarter of 2007.Investors have been expecting that Asia’s export-driven economies would follow suit. Lower growth in importing economies must lead to a slowdown in exports from Asia, right?

Recent figures suggest the slowdown has finally arrived. Growth in China slowed to an annual rate of 10.1% in the second quarter of 2008 from 11.9% in 2007. Economists are predicting growth will slow even more in the rest of 2008 and in 2009. Goldman Sachs is projecting 10.1% for all of 2008 and 9.5% for 2009. The Economist magazine is somewhat more pessimistic, projecting 9.8% growth in 2008 and a drop to 9% in 2009.

The pattern is similar in other Asian economies, big and small. India, where gross domestic product grew 9.1% in the fiscal year that ended in March, will see growth of 7.1% this fiscal year, according to Morgan Stanley. The government of Vietnam has cut its target growth rate for 2008 to 7.5% from a prior goal of 8.5% to 9%. Indonesia recently cut its target rate to 6.4% to 6.7% from an earlier 6.8%.

But it’s not just growth levels

All the economies of the developed world, including the United States, would kill for growth rates like those, but it’s not the absolute level that matters. A drop from a 9.1% growth rate to a still high 7.1% is enough at the margin to cut demand for the commodities that fuel these economies. And that explains the price drop in commodities from oil to fertilizer to copper.

For example, copper, which was trading near historical highs July 6, dropped in price by almost 18% by Aug. 11. With expectations high that demand and price for these commodities would fall even further, commodity stocks have sold off, too.

Video on MSN Money

Chinese flag © Jeremy Woodhouse/Photodisc/Getty Images
Buy China, not Chinese
Robert Hsu of Absolute Return Capital Advisors thinks that despite China’s big pullback, there are still some good Chinese stocks, but he says investors should buy only in New York and Hong Kong.

The slowdown in economic growth in Asia also pushed down the price of commodities and commodity stocks for another reason: Money flowed out of commodity stocks and into financial stocks, consumer stocks and retail stocks during these weeks on the theory that the slowdown in Asia was just beginning while the slowdown in the United States was far enough advanced that the U.S. economy would come out of its slump as the Asian economies were just starting their slowdown.

Earnings growth would pick up at U.S. companies while earnings were still falling for Asian companies, according to the theory. Shares of Bank of America picked up 56% between July 6 and Aug. 11, for example.

But while the slowdown in growth in Asia is pretty much what Wall Street has been expecting ever since the U.S. economy started to slump, the slowdown doesn’t seem to be happening because growth in the U.S. economy has slumped. Instead, soaring inflation in Asia seems to be at the root of the slowdown, and the damage to Asia’s economies is largely self-inflicted.

China, India wrestle with inflation

China, for example, has b
een waging a battle against inflation since 2007. The People’s Bank of China raised interest rates five times in 2007 to a one-year lending rate of 7.29%, the highest official rate since 1998. The central bank has also raised reserve requirements, the amount of capital that a bank is required to keep in reserve and can’t lend, to 14.5% of deposits. The 1% increase in reserve requirements announced Dec. 8 was the biggest jump in four years.

Those moves didn’t work to slow inflation until mid-2008. Inflation climbed to an 11-year high of 8.7% in February before dropping to 7.7% in May and then to 6.3% in July. Of course, fighting inflation also slowed the economy. Growth slowed to 10.1% in the second quarter of 2008.

Continued: India

India, the other big developing economy in Asia, has been waging an even more aggressive battle. The Reserve Bank of India, the country’s central bank, raised its key interest rate to a seven-year high of 9% at the end of July. It’s no coincidence that at the same time the bank raised rates, it cut its forecast for economic growth to 8% from 8.5%.

Infrastructure versus subsidies

Inflation would be cutting into growth in Asian economies even if central banks weren’t raising interest rates. Faced with soaring costs for construction materials, bottlenecks that delay projects and drive up costs, and climbing pay for engineers and construction workers, governments in Asia have been canceling big infrastructure projects. Thailand, for example, has cut $9 billion in mass-transit projects in Bangkok from recent budgets. South Korea has shelved a $15 billion cross-country canal. In Malaysia, the government canceled a $2.5 billion project to build a bullet train to Singapore.

Much of the money from canceling or delaying these projects has gone into subsidies for everything from electricity (in Thailand) to food (in Malaysia and South Korea). Subsidies are essential to prevent the poorest part of the populations in these developing economies from facing starvation, but they also feed into national and global inflation in food and energy prices. The subsidies necessary to prevent widespread hardship from rising prices also ensure that consumers are sheltered from the rising prices that would cut into demand.These subsidies testify to how hard it is to fight inflation in these developing economies. Every government in the developing world, following the lead of China, is convinced that investment in infrastructure is essential to future economic growth. So cuts in infrastructure spending are truly painful. But politicians in Asia think they have little choice. Higher prices lead to political protests that can bring down a government. Lower economic growth leads to fewer jobs and higher unemployment that can threaten even a regime as entrenched as the one in Beijing.

Stabilizing currency

So it should be no surprise that China’s government has begun to signal an end to the emphasis on fighting inflation and a shift back toward policies that promote higher growth. The central bank of China appeared to have slowed the rise of the country’s currency in July, as the yuan rose just 0.2% against the dollar. Before July, the currency had been appreciating about 1% or more a month. A more expensive yuan makes Chinese exports cost more to U.S. consumers, and that leads to lower exports and slower growth. The country’s politburo also got into the act at the end of July by issuing a statement that emphasized the importance of growth and omitted previous mentions of worries about inflation.

China’s apparent turnaround on inflation is likely to have wide influence across Asia. It will be hard to hold the line on inflation in Jakarta or Manila or Hanoi when the leaders of the most successful economy in Asia are saying to go for the growth.

Video on MSN Money

Chinese flag © Jeremy Woodhouse/Photodisc/Getty Images
Buy China, not Chinese
Robert Hsu of Absolute Return Capital Advisors thinks that despite China’s big pullback, there are still some good Chinese stocks, but he says investors should buy only in New York and Hong Kong.

We’re seeing the beginning of a shift away from the fight against inflation that has contributed to a slowdown in economic growth in Asia back toward more growth-at-any-cost policies in the region. In the short run, that will act to stabilize prices for most commodities near current levels. And even after recent 20% drops, those levels are well above the prices that Wall Street analysts are projecting for 2008 and 2009. That means, in my opinion, that on the fundamentals we’ve seen most of the decline in the prices of commodities.

Commodities and other hedges

In the long run, the shift away from fighting inflation and toward growth at any cost is going to accelerate global inflation. Note that the battle against inflation in an economy such as China’s has hardly been won. Inflation dropped to 6.3% in July at the consumer level but is running at 10% or better at what’s called the factory gate in China (roughly equivalent to producer prices in the United States).

That means the next wave of inflation will begin from a higher base rate. A move back toward growth in Asia at this time almost guarantees that global inflation will accelerate to dangerous levels in the next few years. In that environment, you want to own commodity stocks and other inflation hedges.

There are two exceptions to my generally positive take on events and price movements in the commodity sector. First, the cancellation of so many infrastructure projects in Asia will hit big engineering companies such as Chicago Bridge & Iron (CBI, news, msgs) and Jacobs Engineering (JEC, news, msgs) hard. The sector is likely to see some of its big backlog of work evaporate or get stretched out.

Second, while oil, the commodity, fits my scenario fairly closely, the structure of the global industry makes the stocks of oil companies a special case. I’ll explain why and what to do about it in my next column, on Aug. 26.