Global Market Commentary

October 09, 2015

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What Is Going On With the U.S. and World Economy?

There are times when things with which I am very familiar are reported in the financial media with 80% accuracy. And there are other times when things with which I am very familiar are reported in the financial media with 20% accuracy. The latter is currently the case.

Monty Guild

Deflationary tendencies have been lively in the world for several years. The European Central Bank (ECB) and Bank of Japan (BOJ) have begun to take action to reflate their economies. After years of expansionary policies, the U.S. plans to slowly begin to normalize their monetary policy by raising rates slightly.

Today, fear and anxiety dominate in the world of financing commodities. There is a misplaced fear that commodity price declines will lead to bankruptcies that will hurt the banking system.

Commodities have been volatile for millennia, and will be volatile for many centuries to come. Commodities are one of the oldest trading and investing areas, and they are subject to continuing waves of excessive optimism and excessive pessimism. They are — more than any other sector — highly cyclical.

In addition to the volatility caused by sentiment and cyclicality, today, commodity demand and supply are powerfully affected by a secular economic transformation. The global economy was once dominated by number of powerful developed countries with fairly identifiable and predictable demand and supply patterns, but we are now moving towards a world where many developing countries are having a rising influence on the world’s commodity supply and demand variables.

Demand

On the demand side, China and India have been big buyers of commodities in recent years, and they both look as if they will continue to buy commodities for years to come. These two countries (especially China) will also continue to expand their domestic commodity production.

For example, over the last decade China has greatly increased the domestic production of base metals, gold, and energy, while simultaneously expanding their world economic clout.

Supply

On the supply side, commodities are usually difficult, expensive, and time consuming to produce. Opening a new mine for base metals can take up to five years. Recent supply changes include massive increases in oil supply from Russia, Saudi Arabia, and Iran. Russia and Saudi need money to fight wars and fund promised social programs, and Iran is gaining freedom from export embargos. The U.S. has also become a bigger producer, and is more and more energy self-sufficient with each passing year.

Commodity Demand and Supply Are Highly Variable

New substitutes for existing commodities, as well as the buildup and disgorging of security hoards and speculative hoards by nations and speculators, create numerous price fluctuations. Layered on top of all this change are changes in global demand and supply due to economic growth and contractions. We believe that the panic over commodity prices is late and overdone. The horse is long out of the barn (commodity prices have been falling for years), and only now are people panicky about commodities because they believe that some commodity producers will go bankrupt. We are happy to see bankruptcies.

The capitalist system is a profit-and-loss system where inefficient and badly managed companies are weeded out by bankruptcy. It is normal and desirable, because it keeps the weak and inefficient from making further mistakes. Commodity producers’ bankruptcies are not an imminent threat to the world banking system.

Current World Economic Growth Is Not Bad — It Is Fine

The IMF believes that the world will grow at 3 percent in 2015. Three percent is not stellar growth, but it is certainly not bad. Fear of global economic collapse is simply not rational at this juncture.

Some countries are growing very well indeed (see India and China). U.S. economic growth of 2.1 percent in real terms, and inflation an additional 1.8 percent, total 3.9 percent in nominal terms. India has real economic growth of more than 6 percent for the last year, and inflation of 7 percent for a total of 13 percent nominal. China’s official GDP growth figure is 7 percent (more accurately 5 percent according to our best China analysts), with inflation so far this year running at about 1.5 percent, for a total of 6.5 percent in nominal terms. European economic growth is less, and Japan is about the same as Europe. Latin America, and especially its problem children, Venezuela and Brazil, are experiencing negative economic growth.

The world economy is changing, but many investors do not realize that they need to change the metrics that they follow to see what the economy is really doing.

Many market participants look at manufacturing data to get a picture of the economy in U.S. because it’s the world’s biggest economy, in Europe because it is the world’s biggest developed region, and in China because it is the world’s second biggest economy and the world’s biggest manufacturer. So when manufacturing data is slowing in the U.S., Europe, and China, some uninformed and shallow researchers begin to panic. They say not only that U.S., European, and Chinese manufacturing is slowing down, but also that it can slow down even more in coming years.

Of course it is slowing down and it can slow more in coming years. Why? Because China especially, and the developed world as well, are not on a manufacturing trajectory to economic growth. Software, services, consumer spending, and technology are all the drivers of these economies. China is in the midst of an epochal transition from an economy driven by manufacturing to one driven by the domestic consumer.

Metal fabrication to make machines, autos and planes, defense equipment and transportation equipment, still continues — but the new machines are less important to growth, and the software that powers the machines, the services to keep the machines running, software and service upgrades that make the machines more effective, and the consumer who buys the new goods, services, and software, are more important at this phase of the world’s economic development. Accordingly growth is in these areas, and there is no problem with the economy if it shifts partly from metal fabrication to services and software. The changes require investors to decipher which metrics to follow in order to understand the new economy.

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