Stocks for the Lifeboat

You could put gold and oil in your financial lifeboat, even if both are a bit bulky and hard to store. Oil made a 14-month high after closing up 1.4% to $82.82 in New York. Bad weather, tigther inventories, and a weaker U.S. dollar all contributed.

Meanwhile gold jumped by almost $18 to $1,135.90 and make a three-week high of its own. Trading volume is light in the early part of the New Year. But investment demand for hedges to the falling U.S. dollar are in vogue.

The dollar index was up 4% in December. But all that goodwill towards the greenback seems to have vanished in January. It matters for Aussie investors because of the traditional link between the USD and commodity prices. But some analysts say the old relationship between the two is over.

“A stronger dollar won’t spell the end for the commodities rally,” the Wall Street Journal reports, “because the world’s economies are getting back on their feet, meaning that demand is likely to trump the impact of currency moves.” Actually the Journal didn’t say it. A few analysts did.

“The supposed tie between a weak dollar and stronger commodity prices has been severed and…it may become the order of the day that commodity prices rise no matter what the dollar does,” says Dennis Gartman. “That is, we can see commodity prices rising when the dollar falls and we can see commodity prices rising when the dollar rises as well.”

Commodities rising no matter what the dollar does? Hmm. That sounds good to be true. But it is true that the value of the USD is only one driver of commodity prices. Others include basics like supply, demand, and commodity-intensive growth in developing economies. Gartman must believe all those factors line up squarely behind higher commodity prices this year.

If he’s right it would be bullish for Aussie resource stocks. In fact just yesterday Pilbara iron ore darling Fortescue Metals led the pack on the ASX with a 13% gain. This is entirely a play on higher contract prices for iron ore. Those weren’t traditionally that volatile until about five years ago…when annual Chinese steel production began a hockey-stick like rise.

You’d take a punt on the ore juniors now if you were convinced that a) that China was charging ahead this year and b) that global industrial growth will generate higher demandfor steel (in excess of high production figures). Buying Aussie ore juniors now is a call option on a bullish global economy, as far as we can see.

How about the other side of the trade, though? We read over a report from last year by Pivot Capital Management called “China’s Investment Boom: the Great Leap into the Unknown.” The report basically concludes that China already has industrial overcapacity and that it’s resource-intensive phase of growth has already exceeded historical comparisons (to the US, Japan, and Korea.”

All of that argues for much lower resource demand from China. In fact Pivot says, “The coming slowdown in China has the potential to be a similar watershed event for world markets as the reversal of the U.S. subprime and housing boom. The ramifications will be far-reaching across most asset classes, and will present major opportunities to exploit.”

We won’t remake Pivot’s entire case here. But this conclusion is worth presenting: In our view investors have underestimated both the maturity of the Chinese growth cycle as well as the degree to which recent growth is a direct extension of the global credit bubble. This bubble had two major manifestations.”

Other investors have referred to these two manifestations as “Chimerica-China + America”. “The first, which started unraveling globally in early 2007, was evident in excesses in real estate, consumption, and private equity. The second manifestation, which has yet to fully deflate, was a boom in capital expenditure, led primarily by China.”

Now it would be presumptuous to say that all Chinese capital spending was somehow derivative of American consumer demand. China has other trading partners and markets, although without America things might not be so flash. But it is without doubt true that Chinese capital spending is a direct consequence of the global credit bubble.

The upside of a capital spending boom is you get factories, roads, bridges, and the physical infrastructure required to run a productive economy. The downside-if that spending boom is orchestrated for the sake of keeping employment up or for the sake of “busy work” to get money into the economy-is that investment decisions are not made by the market (real demand from people with money) but by bureaucrats.

So we’ll see what kind of boom China has bought itself this year. Pivot believes China’s capital spending activity (and thus demand for raw commodities) has already peaked. It says, “China is already a country with ample manufacturing capacity and increasingly well-developed infrastructure, which does not support the notion of significant pent-up investment needs in China.”

Iron ore bulls beware.

Everything happens at the margin. That is the old axiom of economics. What we’ve been trying to show this week is that the world’s economy is at the margin. But it’s the border between an older and failing economic arrangement based on cheap energy and credit…and whatever lies over the border.

Trouble is, no one knows what lies over the border. It’s easier to hunker down in the world you know that prepare for a world full of unknowns. But easier is not always better. So we’re stocking up our lifeboat with one item at a time, preparing to set sail. Not that it will be an easy cruise.

Life on the frontier is chaotic and competitive. Any time you have lots of motion, you get friction. And friction produces heat and light and sometimes destruction (socially and economically too, not just physically).

But good things can happen in heat too. Think of bacon frying in a greasy pan. What’s not to like about that? So the task for 2010 is to turn market friction into a nice big greasy plate of bacon. More on that tomorrow.

Dan Denning
for Markets and Money

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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