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The Global Economy, Baltic Dry Index, Gold and China

April 18th, 2011 · Greg Atkinson · 16 Comments

We are almost through a third of 2011 and the mood across global markets appears to be decidedly downbeat.  The bullish voices of late 2010 have now faded and even the Reserve Bank of Australia and Federal Treasurer are sounding cautious. But don’t be fooled by the talk that recent events have caused the global economy to face headwinds because the reality is that 2011 was always going to be a tough year.

Over the last few years I have stressed that the actions of the G20 nations in response to the global financial crisis amounted to little more than going on a spending spree to try and prop up demand.  This of course works for a while, but it is a dangerous strategy because it relies on consumers and businesses picking up the slack once government economic stimulus spending stops.

We are now at the point where most, if not all, of the G20 nations are starting to either ease back on government spending or make fairly drastic budget cuts in order to get debt levels under control.  The big problem  is that it doesn’t look like the average consumer is overly keen to shop until they drop and companies are finding business conditions are still challenging.

Even worse is that inflation is starting to become a problem for many countries and has the BRICS economies particularly worried as reported recently by Bloomberg in this article:  Commodity Price Swings Seen Threatening World Recovery, Needing Regulation

This article is interesting because it also touches upon a theme I have been talking about for some years and that is that an over reliance on commodities exports for any economy can have some serious negative consequences.  I think this theme was captured quite well in above Bloomberg article via this passage:

“Deputy Prime Minister Sergei Ivanov said that oil prices over $100 a barrel are discouraging Russia from diversifying its economy. Ivanov said the current price was unsustainable and that Russia’s budget will fall into a deficit when it drops.

“When the gold rain is pouring on your head, you are not motivated to diversify,” Ivanov said in an April 7 interview in Miami. “I wouldn’t say I hate high oil and gas prices, but I am not happy with them.”

So even the nations which are doing well from high commodities prices are worried because they see the twins dangers posed by high inflation and lack of diversification. (well apart from Australian that is)

Higher commodities prices are not necessarily a good thing despite all the hype from mining companies because at some point they start to have a negative impact on demand.  They also tend to push up inflation which is something the BRICS seem very concerned about despite many experts over the last few years talking about deflation being one of the biggest threats the world economy would face.

Another concern I have is the weakness of the Baltic Dry Index (BDI) which tracks the prices for moving raw materials by sea (including coal, iron ore and grain) via 26 shipping routes.  Some people will tell you that the BDI is no longer worth watching for a variety of reasons, however my view is if you are interested in the state of the global economy then I don’t see why you would not monitor this very important indicator.

It’s true there is a lot of extra capacity (i.e. new ships) still being delivered but what has also been happening is that a lot of capacity has been taken out of the system as ships are scrapped, laid up or ship speeds are decreased.

But don’t forget that we are suppose to be in the midst of a global commodities boom so the demand for ships to carry oil, grain and iron ore should be booming right? Well according to the BDI this is not quite the case as we can see in the chart below.

Baltic Dry Index BDI versus BHP Billition 5 year chart

bdi-vs-bhp-5-year-chart-apr-11

(Source: Bloomberg)

Up until late 2009 or early 2010 you can see that there was a correlation between the Baltic Dry Index (BDI) and the share price of the global mining company BHP Billiton Limited.  This makes sense since a booming commodities market tends to push up the share price of mining companies and the shipping rates for raw materials moved along the shipping routes covered by the BDI.

But this relationship or correlation has broken down over the last few years as the BHP share price has basically trended upwards while the BDI has been struggling and now appears to be stuck at multi-year lows.

At this point you can either give up on the Baltic Dry Index and say it no longer has any meaning or you can join me and say this doesn’t look right.  Yes there is probably more ships than needed around at the moment but as I explained earlier much of this extra capacity has been taken out of the system so why is the BDI still so weak?

Could it be that commodities prices and hence stocks like BHP have run up too far? Could it be that commodities prices now are disconnected from the medium to long term supply and demand fundamentals? Could it be that rather than the BDI being the problem alone that we should actually be looking at commodities prices more closely?

I appreciate that no economic or trade indicator is 100% accurate and so I accept that the Baltic Dry Index is probably being dragged down due to some over capacity issues in the shipping sector, however I believe more is at play here than a simple over-capacity issue and I remain cautious about the outlook for commodities prices.

Now onto a favourite topic of mine – gold prices.

As people who read my articles often will know I am not a big fan of investing in gold simply because I believe many market commentators simply get carried away talking about gold in US dollar terms and don’t put things into perspective for Australian investors.

ASX Exchange Traded Fund GOLD 5 year chart

etf-gold-5-year-chart-apr-11

Once again I am using the Exchange Traded Fund (ETF) GOLD to track how gold prices are fairing in Australian Dollars since I see no point for Australian investors to track them in US dollars. In case you have not realised just about everything is going up against the US dollar as the economy there struggles.

It’s quite clear from the chart above that gold has had a fairly good run but once again I stress that when you own gold you don’t receive any dividends and you won’t see any profits until you sell.  If you time when you buy and when you sell well then a tidy profit can be made but as I have marked on the chart above, gold prices can move quite quickly and this movement is not always upwards.

The gold bulls will tell you that it has performed better than most other investments over the last few years but let’s have a look a a commonly held Australian stock (BHP) and see how true that is.

ETF GOLD versus BHP Billiton 5 year chart

etf-gold-vs-bhp-5-year-chart-apr-11

Since I tend to be a long term investor I have charted ETF GOLD and BHP over 5 years and as you can see the unrealised capital gain from holding either is pretty much the same. (although gold does have a lead at the moment)  But if you had held BHP shares over the last 5 years you would have been received franked dividends and so in investment terms, I would rate BHP stock above gold over the last 5 years.

If you went back two years to late 2009 then the BHP share price has actually gained much more than GOLD and so I really don’t understand why the Australian financial media and market commentators seemed so obsessed with gold prices…particularly in US dollars.

Finally a few words about China since I have just spent a week in Nanjing.  Nanjing is referred to as a second tier city and these cities have been the focus of much spending and development over the last few years.  As I moved around Nanjing it was clear to see the massive amount of construction that had taken place over the last 5 years or so.

There were new convention centres, a high speed rail link, a modern metro rail system, new office buildings and seemingly endless rows of new apartments.  But what struck me was that not much of this looked fully utilised.  There did not appear to be masses of people using the metro line, many office buildings seemed to have plenty of vacant floors and I got the feeling that the apartment housing supply was way, way ahead of demand.

Of course it could be that city planners have had the wisdom to invest in infrastructure in order to cater for a quickly expanding city and if so, that makes sense.  But it could also be that a lot of construction has been undertaken to meet growth targets or to conform with a master plan handed down from the central government.

Personally I would not be keen in invest in Chinese real estate at the moment and it seems I am not alone according to this recent article: Moody’s gets negative on China property

I am certainly no expert on the Chinese economy, but as I have said before I believe a major slowdown in the economy there is likely to happen sooner rather than later after all how long China can keep spending and growing at it’s current rate?

Maybe the Chinese economic miracle can last for another decade but I fear that we will look back in a few years and realise that we were missing the warning signs that another bubble was forming. It wouldn’t be the first time now would it?


16 responses so far ↓

  • 1 AU Stocks // Apr 19, 2011 at 1:35 pm

    Great article, I agree with most of your views, especially in regards to the Chinese real estate market.

  • 2 Greg Atkinson // Apr 20, 2011 at 9:04 pm

    Thanks AU. This year we will find out I suspect just how strong the Chinese real estate market is.

  • 3 si // Apr 21, 2011 at 4:50 pm

    Not sure if you’ve seen this article on Chinese real estate. If the 64 million vacant units is true, that’s a staggering number even with such a large population.

  • 4 Greg Atkinson // Apr 21, 2011 at 6:05 pm

    Thanks…very interesting. The analyst from Hong Kong pretty much summed up my reading of the situation regarding the property market in China. The tier one cities might be okay, but outside those that it looks like there has been a lot of over building.

    By the way, this is also worth watching: httpv://www.youtube.com/watch?v=POGX8_UDhh4&feature=related

  • 5 si // Apr 21, 2011 at 9:54 pm

    Love the comment about China using capitalism to keep socialist elites in power, and western governments using socialism to keep capitalist elites in power 🙂 but ~30 billion square feet under construction in commercial real estate? Wow!

  • 6 Greg Atkinson // Apr 22, 2011 at 8:40 am

    Yes that was a classic comment. I am probably wrong (it’s not unusual) but I getting increasingly convinced that China is hooked on construction and that is the primary way they are meeting their GDP growth targets.

    If you have not done so can I suggest you read this article: GDP growth does not equal a quality Australian economy

    You can skip over my ramblings in the article and just watch the video clip…it pretty much sums up my views about GDP in that people seem to assume that a growing GDP, not matter how it is achieved, is always a good thing. It isn’t, but a lot of resources are wasted just to prop up GDP growth so that statistics look good.

  • 7 Ned S // Apr 27, 2011 at 11:45 pm

    BOJ seems to be taking a pretty traditional ‘bubble’ type view of it all Greg:

    “We close this hectic morning roundup with a stark report by the Bank of Japan on the subject of the recent surge in global commodity prices. The study, produced last month, delves into the effects of accommodative central bank monetary policy.

    The corollary statement of the study is that “it is safe to say that globally accommodative monetary conditions are a key driver of the rise in commodity prices by stimulating both physical demand for commodities and investment flows into commodity markets. Equally, the financialization of commodities, as demonstrated by the rapid increase in commodity futures investments by financial investors, has amplified the fluctuation of fundamental factors, thereby amplifying the price fluctuations.”

    As a Forbes analysis concludes, “The Bank of Japan warns that rather than being an inflation hedge, the influx of investor money into commodities has changed the commodities markets from being an inflation hedge into an underlying cause of the current global inflation surge. The report warns that a possible result of speculative commodity trading is like “a vicious, self-fulfilling cycle, in which growing inflationary pressure drives more financial investors toward commodity index investments for an inflation hedge, which further accelerates inflationary pressures.””

    http://www.kitco.com/ind/nadler/apr262011.html

    Though the one bloke who we’d be expecting to be jumping up and down if commods are in a bubble (Jeremy Grantham), isn’t apparently? :

    http://blogs.wsj.com/source/2011/04/27/is-it-different-this-time-round/?mod=google_news_blog

  • 8 Greg Atkinson // Apr 28, 2011 at 9:50 am

    Ned, it sure sounds like the BOJ see commodities as being in a bubble and I tend to agree. The problem is we just don’t know how big the bubble will get before it starts to deflate or burst.

    We also need to remember that a whole range of synthetic materials and composites etc that are in use to today have replaced or provided substitutes to materials that we used in the early 20th century. If commodities prices stay high then the search for alternatives and substitutes will gather pace. Higher prices eventually cause demand destruction. (even for beer!)

    But at the moment commodities seem to be the next big thing. However my view is that we are now very much into the realm of speculation where hot money is flowing in and supply/demand fundamentals are pushed aside.

    P.S Thanks for the links.

  • 9 Ned S // Apr 28, 2011 at 8:33 pm

    A bit more info on same Greg. Apparently Grantham IS actually bearish at the moment? But not longer term:

    “Record levels of net bullish positions have been spotted in cotton, copper, and, obviously, crude oil. Precisely amid such manifest euphoria for “stuff” there are some, such as Boston-based GMO’s Jeremy Grantham, who warn that the entire niche could experience a cave-in of epic proportions. Mr. Grantham places the odds of such a collapse as high as 80%. But, fear not; following such an “adjustment” the GMO contrarian envisions “the buying opportunity of a lifetime.” Mr. Grantham is a huge commodities bull, by the way.

    Marketwatch’s Brett Arends concedes that crystal-ball gazing is a dangerous and quite imprecise practice, but notes that Mr. Grantham’s bearish short-term clarion call has some valid foundations: “This isn’t purely subjective. Data from the futures market back it up. Speculators, as noted above, are now sitting on huge bullish commodity bets. That frequently precedes a serious correction. A fair number of these speculators are semi-pro hedge fund managers who are back in the game and gambling, once again, with borrowed money. They are frequently paid to take big gambles, and they will have to buy back positions, quickly, if markets turn.” ”

    http://www.kitco.com/ind/nadler/apr272011.html

  • 10 Greg Atkinson // Apr 29, 2011 at 9:04 am

    Ned I reckon I fall into the short term bear and long term bull on commodities as well.

    The big question is how much of the China boom and trading speculation is factored into commodities prices at the moment? I have no idea, but I think even the most bullish investors would agree many commodities are trading at a premium at the moment.

    So when will the traders decide to lock-in some profits? Will the old saying “sell in May and go away” ring true this year?

  • 11 Biker // Jun 3, 2013 at 9:11 pm

    Things Are Looking Bad Outside China, Too (CNBC) http://t.co/U5Y8BtZkZc

    …but “China shields the world’s economy…” :

    http://www.nytimes.com/2013/06/03/world/middleeast/china-reaps-biggest-benefits-of-iraq-oil-boom.html?nl=todaysheadlines&emc=edit_th_20130603&_r=0

  • 12 Greg Atkinson // Mar 10, 2016 at 9:43 am

    I guess nobody disputes that the Chinese economy is slowing these days.

  • 13 Biker // Mar 10, 2016 at 10:34 pm

    …or that interest rates are likely to remain low for some time… OR… OR… OR… OR…. 🙂

  • 14 lachlan // Mar 11, 2016 at 5:31 pm

    I missed that one Biker, but ain’t that lovely, Uncle Sam and Sun Tzu playing nice in the sandpit n all.

  • 15 Biker // Mar 14, 2016 at 6:36 pm

    The Chinese may be concentrating instead on the ruly, ruly important stuff, Lachlan:

    http://www.abc.net.au/news/2016-03-14/china's-alien-hunting-telescope-before-and-after/7245690

  • 16 lachlan // Mar 15, 2016 at 5:38 am

    Goodness gracious m….no actually just meh, more money one has the bigger ones toys get. The Chinese rulers have dreams to follow too eh? I take that with a chuckle and as yet another spectacle… of this…astounding world.

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