We begin our analysis with a little perspective on how we view the crisis. The pre-crisis global aggregate demand was primarily driven by an over leveraged U.S. consumer, who was spending “fake wealth” created by a housing bubble financed by credit expansion. This was fueled by three years of negative real short-term interest rates in the U.S. and massive accumulation of foreign exchange reserves by global central banks.
China and other countries expanded capacity to supply the U.S. consumer, while some emerging markets experienced rapid growth as commodity suppliers to China. The financial and credit crisis caused aggregate demand to collapse, sending the global economy into a deep recession, with lots of excess capacity and not enough demand.
Policymakers, after doing a good job of stabilizing the financial situation tried to shift aggregate demand back to pre-crisis levels through classic Keynesian government spending and monetary policy. The Federal Reserve, stuck with an impaired banking system and limited demand for credit from households and businesses, drove rates to zero and increased or limited the decline in the money supply, by expanding the monetary base. That is, printing money.
China, on the other hand, which we really don’t have a good handle on, increased demand by expanding its money supply growth by over 30 percent. Rather than the Central bank printing the bulk of the money, China’s banking system created the money through credit expansion and loans.
We just don’t know and have to do more homework as to where the credit went, if China created more excess capacity, and if the loans were allocated efficiently. There does appear to be property bubbles throughout Asia, however. And as they try to reign in rapid money growth and inflation, we will, as Warren Buffett says, see who “ has been swimming naked as the tide goes out.”
It is not our base case, but not certain if the country will have a hard landing, which should send commodities reeling into a cyclical decline. A soft landing and pick-up in the U.S. will allow the secular story of commodities to dominate the cyclical softness. Our sense, the commody markets will oscillate until it becomes more clearer, so we are keeping positions light. This scenario of limited and periodic weakness will likely be interpreted as positive for the U.S. market, in our opinion.
Because of our ignorance, we are watching what we can — the Shanghai and Heng Sang, which are bouncing off and holding support fairly well for now. A hard break of either could signal a hard landing and a difficult year for commodities, in our opinon. In the meantime, the trend for commodities is still moving up and betting on something that may or may not happen has proven not very profitable for us.
Former Fed Chairman, William McChesney Martin, was famous for saying the Fed’s role was “to take away the punch bowl just before the party got going.” The Fed’s punch bowl is now primed with super concentrated “high powered” money, that, if diluted by an unexpected surge of credit expansion, could, many worry, spark a nasty round of inflation. The China punchbowl, which we profess our ignorance, but do know, the Chinese authorities appear to believe has been highly diluted with excess credit expansion and is now flowing over with inflation. Soft handing, or hard landing? We’re not sure and lean soft. Watch the Hang Seng and Shanghai.