Alignment To War: Asian Commodity Demand Versus The US Printing Press
FNArena News - September 19 2006
By Greg Peel
Marc Faber has a PhD in economics and a famously contrarian view of the world. He is the author of the popular "Gloom, Boom & Doom" report and became a best-selling author in 2002 with his book "Tomorrow's Gold".
At the invitation of fund manager US Global Investors, Faber last Friday spoke live on the internet to the topic "Investing in a world of rapidly changing geopolitical and economic trends". This is a summary of that presentation.
Taiwan is more vital to the delicate game of geopolitics than most would realise.
While never particularly amiable, relations between China and Japan have deteriorated in recent years and a lot of that has to do with Taiwan. The US has a policy of supporting the independence of Taiwan (a sort of quasi-independent Chinese state inhabited by those who escaped the Maoist revolution) while China has long wished to rope the renegade back in. Japan has aligned itself with the US.
The US is the world's largest consumer of oil, with China second. As the US is 40% self-sufficient in oil production, China is actually the world's largest net consumer.
Japan has no oil. 75% of Japanese oil imports come from the Middle East (compared to the US with 20%). The Middle East also supplies the bulk of Chinese oil imports. Tankers which leave the Persian Gulf en route to China and Japan sail through the Straits of Malacca, between Malaysia and Indonesia, and up through the South China Sea – right past Taiwan.
Says Faber: who controls Taiwan controls Chinese/Japanese oil.
China and the US create a fragile dichotomy. While once clear enemies on an ideological basis, China's capitalist evolution has meant relationships have become more co-operative, but not particularly less strained. While China has become the factory for the manufacture of US goods, it has also become the largest foreign investor in US financial assets. While US businesses are happy to invest in China, US Congressmen are calling for protectionist policies.
The US is bordered by two friendly nations – Canada and Mexico. Both are significant suppliers of oil and other commodities to their neighbour. China is bordered by 14 nations of various levels of influence and ideology. They include Russia, India and North Korea.
China enjoys a friendly relationship with Russia. They have formed an alliance with each other known as the Shanghai Co-operation Organization (SCO), which includes members Uzbekistan, Kirgizstan, Tajikistan, and oil and uranium-rich Kazakhstan. Aside from these members, the SCO includes "observing members", being Mongolia, India, Pakistan and Iran. If these countries became full members, the SCO would represent 45% of the world's population.
Faber notes it is US foreign policy that has pushed China closer to Russia. The SCO has set a timetable for the US to withdraw its central Asian military bases.
Central Asia boasts significant amounts of oil and gas. Under its alliances, China can contemplate direct overland access through to Iran, which currently supplies 15% of Chinese oil imports. Already India is building an oil pipeline from Iran, through Pakistan (with Pakistan's co-operation).
From Iran it is a hop, skip and a jump to Sudan – another exporter of oil to China. Faber notes Africa today is similar to China pre-industrialisation – little industry, but vast resources and population.
To date the US and the rest of the West has been interested only in exploiting African oil and other resources. The US has also been globally criticised for pricing vital, patented drugs out of the reach of the average African. In the meantime China has been creating alliances in Africa – building infrastructure and commencing agricultural projects.
You can see where Faber is heading with this. Slowly but surely the world's most populous nation is setting up ties with the rest of the non-Western world.
[What Faber didn't include here is South America. The oil and gas-rich northern part of the continent has been undergoing a transformation towards self-rule and nationalisation of industry. Led by Venezuela's charismatic president Hugo Chavez, Bolivia and Peru have fallen into line and Ecuador has been teetering. Mexico remains loyal to the US, for now. This alliance is mentored by Cuba's Fidel Castro.
China has been very busy organising export alliances in South America. One goal is to bring Venezuelan oil across the continent to the Pacific, for easier sea-access to China. The US has declared Chavez an enemy.
A summit has just concluded in Cuba, and as the Sydney Morning Herald reported "Heads of state and government from 56 countries and delegates from 118 countries were due to adopt a voluminous final declaration backing Iran's right to nuclear energy; urging UN reform to give greater weight to poor countries; opposing terrorism and what they see as US interventionism". The draft also condemns Israel's "unlawful" policies in the Palestinian territories and the recent intervention in Lebanon.]
As China, then India, and other developing nations, move to industrialisation, resources are becoming more scarce. Notes Faber: most of the wars throughout history began over scarce resources.
This does not mean Faber is warning of World War III on the horizon. He simply intends to put things into perspective. There is little doubt that global tension has increased significantly of late. How the US deals with this tension becomes very important from an economic point of view.
The last time the prices of oil and gold were at their highs was in 1980. Between 1980 and 2000 the Cold War ended, global tensions eased (if you discount the first Gulf War) and commodity prices fell. The resources sector went into the doldrums.
Since 2001, global tension has reared again, and at the same time China has accelerated its extraordinary economic growth. Commodity prices have skyrocketed. It is usual for commodity prices to skyrocket in times of war, and for military spending to increase, funded by borrowings from capital markets.
When the technology boom collapsed in 2000, the US moved to an ultra-easy monetary policy in order to reinvigorate the economy. 9/11 evoked more of the same determination. Since then the US has tightened monetary policy significantly, but Faber suggests that from such a low base, policy is currently still expansionary.
In response to the oil shocks of 1979-80, then Fed governor Paul Volker responded by squeezing the system. This ushered in a period of high interest rates. Volker was able to do this, notes Faber, because US debt levels were contained. Current governor Bernanke does not have that option open to him.
US debt levels were 120% of GDP in 1980. They are at 300% today. Between 2000 and 2005 the expansion of US debt ran at six times the rate of GDP growth.
The bulk of that debt has gone into buying real estate. Housing prices as a percentage of US GDP are now at all time highs. Households have then extracted money from home values to finance consumption. Despite a drop in the US housing market, such extraction and consumption continues today. Household drawdown of funds for the purpose of investment in real estate, and the stock market, has led to US savings becoming negative and has fuelled the economic boom.
Thus the system has become more vulnerable. The economic recovery post 2000 has not been driven by capital creation and employment gains, but by credit creation and easy monetary policy. Asks Faber: how can this be sustained?
Despite the apparent growing wealth of Americans, median household income has actually fallen by 4% since 1999. The cost of household necessities – for example energy and medical services – has risen substantially.
The US regards itself as the economic engine of the world, yet its share of global exports is falling. While the US has fallen, China's exports have grown astronomically. The US now carries trade deficits with every major region of the world.
In 1987, the ratio of US foreign investment turned negative, such that today foreigners hold US$12.7 trillion worth of US assets while the US holds only US$10.0 trillion of foreign assets. The US current account deficit (CAD) is growing annually, having commenced its significant blow-out post 2000.This has been due to easy monetary policy which has led to strong consumption growth but not strong investment growth.
[Note that the growing US CAD has many economists predicting disaster ahead, while others show little concern. Noted bears such as Faber, and Morgan Stanley's Stephen Roach and Nouriel Roubini believe the growing US CAD spells imminent disaster for the US dollar. Other economists suggest the dollar cannot collapse because no other currency provides an alternative. Yet other strategic thinkers, such as Charles Gave, suggest CAD measurements are deceptive as they do not account for the consequent rise in US profits. As long as the US has assets to sell, says Gave, the CAD can safely blow out much further.]
Production and investment have shifted away from the US, to China and other developing nations. While China may have exported its deflation to the rest of the world, it has also promoted deflation at home. Faber notes it wasn't long ago that the Chinese were buying their first locally-produced car for US$20,000 in real terms. Today the equivalent car (everyday sedan not dissimilar to those which GM produces) costs US$3,700.
At US$20,000, roughly one million Chinese could contemplate owning a car. At US$3,700 this figure rises to 50 million. China is now the second largest car market in the world behind the US. In the US, first-time car buyers represent 1% of the market. In China that figure is 84%.
Similar price deflation has occurred for other items the West takes for granted, such as TV sets and mobile phones. While the US boasts the largest economy in the world, Faber suggests the Chinese economy is actually far bigger than anyone realises.
Officially, the current size of the US economy is US$12 trillion and China's US$2 trillion. But if you measure not in monetary terms, but in volume of goods produced, then China represents 60% of the global economy. And the Chinese economy is growing at the rate of 13-15% per annum in industrial production and 20% in capital spending.
China is now the biggest consumer of the world's commodities. Yet Chinese per capita consumption of commodities is much lower than the West's. India's is much lower still. Faber notes India is still probably twenty years behind China.
The history of oil consumption provides a revealing example. Prior to industrialisation, the US consumed one barrel of oil per capita. Today it consumes 27 barrels. Japanese industrialisation in the 1950s took its consumption from one barrel to 17 barrels today. China's current consumption is 1.7 barrels per capita. India's is 0.8.
Today all of Asia (including Japan) consumes 22 million barrels of oil per day. This is consumed by 3.6 billion people. The US also consumes 22 million barrels of oil per day, with a population of 300 million people.
Asian oil consumption will double at some point in the future. Can current oil production (84 million barrels per day) be sufficiently increased to meet that demand? Says Faber: oil prices simply must keep going up.
Commodity prices in general in the 1990s were at their lowest level, in real terms, in the history of capitalism. Commodities price cycles can last 45-60 years, notes Faber. We are only at the beginning of the bull market.
This does not mean there cannot be, and won't be, major price corrections along the way – even in the order of 50%. The price of copper, for example, has risen from US30c/lb to US$4/lb. Faber would not be surprised to see the price of copper reaching US$2/lb in the current correction. Or oil reaching US$50/bbl. History is littered with major corrections in ongoing bull markets.
The price of gold moved from US$30/oz in 1970 to US$175/oz by 1974. In 1976 it fell to US$103/oz before hitting US$850/oz by 1980.
In 1987 the Dow Jones index fell 40%. It is now seven times higher. In 1987 the Hang Seng index fell 50%. It is now ten times higher.
If commodity prices rise, interest rates rise and consumer prices rise, and vice versa. Between 1960 and 1980 the price of oil rose, and interest rates rose. Between 1980 and 1999 the price of oil fell, and interest rates fell. Today the oil price has risen to new highs, but interest rates remain low. What is wrong?
Bond prices are wrong, says Faber. And why are bond prices wrong? Because the US is printing money.
Even if the economic growth of China and India begins to slow, notes Faber, there will not be a pullback in oil consumption. Fed governor Bernanke has stated that declining asset prices strengthen the system. He is the money printer. In fact, he has said that as long as asset prices are declining "you could throw dollar bills out of helicopters".
Faber entreats his audience to buy at least one US Treasury bond to frame and hang on the wall. That way, he says, you can show your kids how the US dollar became worthless.
The US has not experienced a real bear market in equities since 1929-32 when the Dow Jones fell 90% in nominal terms. Between 1964 and 1982 the Dow Jones moved basically sideways in nominal terms, but in real terms it lost 75%. Notes Faber: you can make the Dow go wherever you like by printing money.
So how should an investor respond to Faber's dissertation?
Firstly, he notes, the prices of agricultural commodities have barely moved.
Secondly, the price of gold is now inexpensive compared to other commodities – particularly oil. The gold price may yet go to US$500-550/oz, but there it should be bought. If the Dow Jones continues to rally, as many expect it will, and it does so because the US is printing money, then the price of gold must rally.
Buy gold, says Faber.
Note: Marc Faber's full presentation can be found in streaming audio at www.vcall.com/CustomEvent/NA012124/index.asp?id=108754.