1970’s revisited? Running out of gas?

The global market place is sending a series of contradictory messages. On the one hand, commodity prices have risen amazingly but Wall Street is looking bewildered and running out of gas. While Wall Street is pleased with reported profits, investors are also conscious that high fuel prices are hurting consumers and business.

When all the evidence is surveyed, it seems to be consistent with a rather startling conclusion: namely, the global economy is being gripped by the greatest surge in commodity prices since the 1970’s. But, there is a difference. In the ‘70’s it was OPEC that made the running, and while oil is now reaching $38 a barrel, there is a tremendous surge in demand for metals and "softs’, notably grain.

The central feature of the global economy is surging commodity prices, which have grown at their fastest rate for 20 years. While China’s insatiable appetite is the main driver, in several categories very low stockpiles or inventory is influential. Another driver is freight rates especially in the Pacific which have practically tripled in the last year. The process has great implications for inflation.

Oil prices are inflicting pain. In the USA, light crude has surpassed $38, partly as a result of terrorism but also because winter stocks were at a 30-year low. International demand is high. The International energy Agency has raised is projections of demand almost entirely because China’s needs have leapt by 230,000 barrels a day. China has just surpassed Japan as the world’s second largest oil importer. The US is feeling the pinch as oil is priced in $US, and it has risen in 2004 by 19% but only by 2% in euro. US airlines are trying to impose surcharges.

The trend has attracted gloomy headlines. The increase expense of motoring is creating a feeling that this is ‘the end of civilization as we know it". One new book, "Oil Factor" claims oil will soar above $100 a barrel "by the end of the decade, and possibly sooner". The Economist remarks this depends "on the dubious assumption of imminent oil scarcity". The Economist misses a point; another assumption is that the USA may be dragged into galloping inflation reminiscent of the 1970’s oil shocks.

Certainly, US prices are heating up. These rises are mostly in the pipeline and showing in Producers and Wholesale prices. Core crude goods have risen by 23.9% in the year. Some critics believe the Federal Reserve’s policy of keeping interest rates at their lowest level for 45 years is focussing too much on the past when it should be thinking of a rate increase to head off inflation. Some have voiced their nightmare: rapid inflation in a weak economy. As inflation is still around 1.7%, these fears may be premature yet the scene may be set for a problem in two years time.

The recessionary effects of high fuel costs are more proximate. The "misery index’ is higher because of higher transport, housing and heating costs. These act as a tax on consumers and negate the effects of the Bush tax cuts as higher oil prices has taken an estimated $US 400 billion out of consumer hands. It is diminishing discretionary spending throughout the economy.

There could be incipient signs of what in the 1970’s was called stagflation: a combination of inflation and a stagnant economy. Evidence for this comes straight from the Federal Reserve which is changing its rhetoric. Formerly it said output was "expanding briskly", now output is growing at "a solid pace’. A Merrill Lynch survey confirms a change of pace; only 48% of investors now expect 2004 to see an expansion of output, compared to 74% in January. Wall Streets indices have retreated recently, with the Nasdaq 10% off its high.

The precious metals market is making a strong signal about inflation and the weakness of equities. Gold is at a 15-year high at $417, platinum has reached a 24-year high of $900 and silver has almost doubled in value.

Of course, the equity markets discomfiture may be a short-lived phenomenon; perhaps the market is dwelling too much on the losses in Iraq, the Madrid bombings, the Gaza assassination and the oil price. Nevertheless, it is possible that a new trend is being established. Ever since late 2002, when interest rates were slashed, US investors have been great risk-takers, trying to grow their money. This has driven up equities worldwide and boosted property in many localities. Junk bonds have also rallied.

Recently there appears to be a pulling back, some symptoms of risk satiation. Stock is slipping and funds are pouring into dull government stock. The Economist has also observed these developments, and argues that it is possible that the virtuous cycle of rising growth and appetite for risk may turn into a vicious cycle of falling growth and an aversion to risk. It is as if the Japanese disease is contagious. Germany also has declining growth, a hollowing out of industry, and a falling equity market.

However, there is no gloom is Asia and Australasia! Chinese demand is extra-ordinary, and is forcing up prices for many commodities such as copper. So much is this the case that the world now faces an aluminium shortage for two years. China is responsible for 19% of world output but needs much more. Merrill Lynch predicts exceptional prices for 5 years until China builds more smelters. Steel is also "a crazy situation".

Chinese grain output meanwhile has declined by 70 million tons in the last few years (an amount equivalent to Canada’s production). This coincides with the lowest global stocks for 25 years. Experts are predicting a doubling of grain prices in the short term.

China’s demand is driving up shipping freights. Spot prices have doubled in six months. Chinese imports of iron ore rose from 112 million tons in 2002 to 148 million in 2003. Freight rose from $us 12 to $32 per ton. Freight for alumina from Australia has risen from $12 to $35 per ton. This incidentally has considerable implications for New Zealand’s bulk exports of logs, coal, iron sands etc.

These freight costs will eventually be passed to the consumer. So, while New Zealand will benefit from extra demand and higher prices for its commodities, costs will rise and imported goods will be more expensive. A commodity boom is wonderfully stimulating in the short-term, but it does imply inflationary pressures requiring deft adjustments.

Dr. Neville Bennett
Christchurch, New Zealand
March 29, 2004

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