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The Great Inflation Train Wreck
2004: The Year of the Monkey

Russ Winter and Jim Willie CB
Feb 25, 2004

[After reading and discussing the thoughts and analysis of Russ Winter for well more than one year on Silicon Investor, I concluded that the community which is interested in world economic conditions should be permitted to share in his work. I am certain readers will share my view, after they read his assessment of the current evidence of widespread and rampant price inflation. -Jim Willie CB]

As this is written in late February, 2004, almost all market and economic observers are asking "What has been the effect of the Great Reflation orchestrated by the Federal Reserve and other central banks?" Most seem to be fixated on the notion that poor US labor markets will allow hyper-easy monetary policies to continue on, "patiently" to quote Alan Greenspan. The authors believe the markets are badly offside with this benign sentiment, and see something altogether else in store. We see material evidence of surprisingly high inflation, bottlenecks, and a worldwide subsistence or sustainability crisis.

First, a brief and to-the-point review will follow of the impacts of the Great Reflation within the United States. Extremely low interest rates have encouraged American households to expand household mortgage and consumer credit by $1,424 billion between Nov 2001 (officially the end of the recession) and year end 2003. During this same period, wages and salaries rose $193 billion. Household debt expansion grew relative to wages by 7.4 to 1. We leave the discussion to others, on whether such a debt expansion or credit bubble in the face of weak wage numbers is sustainable. Suffice it to say, the numbers speak for themselves in terms of the success of the low interest rate and tax cut stimulus on the US economy, at least in terms of job creation. The verdict is poor, and that's being kind. However, the global effect of the massive stimulus is quite another story, and that's our interest here and now. The subject of unintended consequences caused by the Fed's Reflation Initiative is discussed by Jim Willie in a recent work: "Broken Cycle: Permanent Intervention."

The US fiscal and credit policy has arguably been a major factor in the economic transformation of Asia over the last several years. It been reported that in China nearly two million people a month move from the countryside to the city, in effect creating twelve Asian cities the size of Philadelphia every year. Although movement from rural areas to the cities are part and parcel to emerging economies, this recent Asian experience is in a class of its own. So the question begs, why has this happened? We believe it has largely to do with the US credit bubble that has kicked this process into overdrive. Additionally, years of bail outs, rescues, and market interventions have contributed to a pervasive sense of global moral hazard. In China and elsewhere in Asia this manifests itself with the notion that maybe, just maybe, Americans have invented a perpetual wealth machine. Perhaps they think Americans really don't suffer bad years after all, and have actually abolished the economic cycle, which would be a big improvement over life in rural China, or Vietnam. Indeed, perhaps they sense such a free ride, that they pack up and go to work in that stainless steel toenail clipper factory in town. Once there, they will go with the "free ride" until such time as significant and unsustainable strains are put on the global resource supply chain of metals, energy, water and food. We submit that "until such time" has arrived. That time is now!

The Great Reflation & Stimulus (of Asia) has now suddenly created a worldwide spike in resources and input goods prices, as well as bottlenecks in transportation. The result is the real threat of a subsistence crisis (henceforth loosely termed "the train wreck"). One reason for the spike in resources is the fact the most commodities and resources are priced in US dollars, and it's no secret that the US Dollar is the weakest major currency in the planet. The reaction of the markets is straightforward and clear, we think. They wish to be paid in real terms. The recent comments of Saudi energy minister Ali Naimi says it all. "The falling value of the dollar means that oil prices were artificially inflated." His use of the word "artificially" may either be an expressed leap of faith, or perhaps diplomatic politeness? Regardless, his point is made:

"don't pay us with funny money."

The second component of the train wreck is the voracious appetite for input goods and resources that comes from selling to western markets and from building an Asian metropolis like Philadelphia every month. The new Chinese urban dweller is typically not going to a shanty town either. Standards of living are improving in Asia, and that translates into even more resource consumption. China became the world's largest consumer of copper in 2002, and now accounts for 20% of world consumption and 80% of world growth. Copper inventories as of this writing (2/18) are at 313,000 MT, the lowest in eight years. See current primary and scrap metal prices.

Prices are rising widely on the LME (London Metal Exchange), COMEX, and NYMEX, which freely trade in copper, aluminum, nickel, tin, lead, zinc, iron, steel, specialty steel, stainless steel, nickel alloy, chrome, titanium, ferrochrome, cobalt, molybdenum, antimony, manganese, titanium, tungsten, vanadium, and wolframite.

Even more alarming is the rate of decline in supply, prompting Pierre Lassonde of Newmont to state, "at this rate there won't be a pound of copper above ground on the planet in May." China is one of the largest consumers of alumina, zinc, lead, and nickel as well. Lead has the lowest inventories since June, 1991. Nickel is a particularly vulnerable metal commodity today. Used primarily in stainless steel production, one week's inventory (15,000 tonnes) above ground is now available. Stainless steel production in 2003 was up 8%, as was nickel consumption. China has added one million tonnes of stainless steel capacity for 2004, which requires an incremental 40,000 tonnes of nickel. The anticipated 2004 shortage of nickel is estimated by Inco at 75,000 tonnes, or 10% of annual demand. There are two major nickel mines expected to come on stream, Voisey Bay, and Goro, but not until 2H2006. China itself is not well endowed with resources, particularly the aforementioned. Moreover, what they do have is difficult to exploit, generally low grade, and located in remote areas suffering from poor infrastructure.

China has also become the fastest growing economy for energy. In Dec 2003, crude oil imports surged 23% y-o-y to 2.5 million barrels per day. Demand in China for crude oil is running 5.43 mb/d. The Energy Information Agency (EIA) indicated that crude oil stocks for the Pacific (eastern Asia) in Nov, 2003 was 155 mb, which is roughly 25 mb below the 1997-2002 average. Petroleum inventories in the US are also exceedingly low at 628.8 mb (on 2/6/2004), some 42 mb below the five year average. The world can now ill afford a geopolitical disruption from the usual cast of characters.

Although China once stockpiled large food and grain inventories, those are largely gone now, sold cheaply over the last few years to neighbors. The USDA release of 2/6/2004 stated the following, "Although grain stocks are still a state secret, MY 2004 ending stocks are forecast to be less than half of MY 2003, and the state held wheat reserve is reportedly extremely low. Grain production fell to its lowest level in a decade in 2003. Demand exceeds production, exports will decline, and imports increase." Other threats to Asian food supply would of course be avian influenza (aka "bird flu") which could wipe out their poultry production.

This brief synopsis gives the reader a glance into current Asian and Chinese demand characteristics. Importantly though, how does this translate in terms of impacts to the global economy, including the US? Primarily by creating shortages, bottlenecks, overheating and high prices (inflation). As the Asians scarf up commodities and goods throughout the world, they have smashed records for global freight costs on almost a weekly basis. The Baltic Dry Index, a barometer of the dry-bulk freight market for commodities such as iron ore, grain, and coal, is now up close to 300% from last spring.

Bloomberg.com: Research

A broker with Clarkson's in London exclaimed, "You only see this once in a lifetime, once in two lifetimes." Tanker rates for oil cargo from the Persian Gulf to the Gulf Coast of the United States are running $3 per barrel, double the average over the last five years. The expectation is that demand will continue to run high for shipping as China will kick off importing large quantities of South American soybeans from March to May.

If shipping weren't expensive and in short supply, this is all occurring against a backdrop of unusually low inventory levels for all kinds of key commodities around the world. The USDA in February revised world coarse grain ending stocks down to 100.47 million metric tonnes, the lowest level in a quarter century. That's about a month of usage (risky) versus a norm of about two months. This has of course resulted in large grain prices gains of late, and would be made all the more critical should important crops come up short, given the vagaries of nature.

Corn (CBOT): Daily Commodity Futures Price Chart: May, 2004
Soybeans (CBOT): Daily Commodity Futures Price Chart: May, 2004
Wheat (CBOT): Daily Commodity Futures Price Chart: May, 2004

As of this writing there is growing concern about drought in the hard red winter area of the US:
Commodity Weather Forecasts: U.S. Palmer Drought Index

Low inventories run the gamut in food now. The USDA semiannual report on cattle supply came in at 94.882 million head as of Jan 1, 2004, the lowest level since 1959. Year end US soybean stocks were just reported to be the lowest in twenty seven years.

Should the US be complacent about food and energy prices? We think not. American consumers have enjoyed a multi-decade benefit of lower real prices and bountiful crops. Chart 1 illustrates this. See the Details.

Notice the steady decline in spending on nondurable goods (food and energy). Note that spending on durable goods has stayed steady, the same. Also note how money once spent on the nondurable food and energy goods sector has been diverted into supporting the service based economy (chart 4). Finally note the story in chart 3, which shows the couple percent drop in money spent on energy goods, the benefits of the cheap fuel interlude of the 1980' and 1990's. The next stage of the US version of the energy train wreck may be gasoline.

StockTalk: The Epic American Credit and Bond Bubble Laboratory (#8145/8245)

We feel that the other major element of the 2004 train wreck will be food inflation (conveniently excluded and dismissed by the Federal Reserve). Good cropland cannot be turned on like a switch either. In one high potential region, the cerrado of Brazil, it usually takes a half decade of land development to lower soil PH levels sufficiently to grow crops like soybeans. Additionally, these resource regions lack good storage and transportation systems.

FOCUS: Miners Face Delivery Cost Pressures Amid Boom

The big communist era stockpiles (and dumping) are gone. Plus modern farming is energy intensive, a special problem right now.

So referring back to our charts, we can see that prior to the train wreck now underway, US consumers spent 3 or 4% on energy goods, and 14% on food. In dollar terms that is about $300 billion on energy and $900 billion on food. Now calculate a shift or diversion to 5% on energy, and 16% on food, and an extra $200 billion in consumer spending is needed for subsistence items. Although farm value constitutes 19% of food dollar costs, other input items are also seeing price inflation: packaging making up 8% of food dollar costs, transportation and energy making up another 8%. Taken from the December PPI and Bureau of Labor reports, the energy components y-o-y of the CPI:

For PPI food inflation, the seasonally adjusted annualized rate for three months:

What would a subsistence crisis look like? Perhaps much like January, 2004 retail sales numbers, which saw more spending diversions.

So the train wreck scenario can be described as a demand pull inflationary event driven by runaway demand from Asia into crude goods and commodities held in short supply. This in turn is now leading to serious cost push inflation into intermediate and finished goods. An additional speculative element, even a hoarding component has been emerging and shown itself. Like other carry trades engendered by one percent fund funds rates, commodity trades are "no brainers" for practically any monkey on the planet. Simply borrow cheap in US dollars and pile into commodities and goods in short supply. This has been a winning trade on both the dollar short trade and the commodity long trade.

Ludwig von Mises described this behavior as the "crack-up boom" and said, "Once public opinion is convinced that the increase in the quantity of money will continue and never come to an end, and that consequently the prices of all commodities will not cease to rise, everybody becomes eager to buy as much as possible and restrict his cash holdings to minimum size. The advantages of holding cash must be paid for by sacrifices which are deemed unreasonably burdensome. This was present in the great inflations of the twenties, and was called the flight into real goods (Flucht in die Sachwerte). If the credit expansion is not stopped in time, the boom turns to crack-up boom: the flight into real values begins, and the whole monetary system founders."

To the author the current inflationary outbreak has a certain crack-up boom feel and smell to it. For those who are paying attention, it certainly has been rapid. Given that the US Fed and Wall Street have chosen to fiddle as the evidence gushes forward, the reader will need to depend on other more reliable sources outside the Land of Oz (aka The Fed) to gauge this inflation. We would suggest going real time into the trenches with purchasing managers as an excellent starting point.

Please review the following Purchasing Magazine Online links:

ISPI gains 2.5% on major metals price push

And another round of sheet metal increases for April:

UPDATE - Nucor, ISG raise prices on sheet steel

OSB leads new explosion in lumber pricetags

Market mavens agree that aluminum ingot is inflating

Steel mavens forecast spike in sheet prices

Industrial leadtimes are skyrocketing

Diesel prices explode at pumps nationwide

LDPE is inflating

Cobalt tops January's movers and shakers list

Heating oil costs expected to go up

Look out for price hikes in chemical industry

Shipping rates are up

Trucking rates to rise

Another excellent source for tracking input goods inflation is the weekly commodity update put out by EDC.

Weekly Commodity Update from Feb 16, 2004

The charts speak for themselves. Note the big price surge in 2X4 lumber, and oriented strand board over just the last five weeks:

Strand Board:
1-9-2004: 310
2-13-2004: 486 (this product was below 200 last spring)

2 X 4 lumber:
1-9-2004: 337.5
2-13-2004: 394.50

And finally, overlay charts showing three component indexes of commodity and input inflation:

CRB Commodity Price Indices

The JOC-ECRI industrial price index shows petroleum and metals especially going parabolic of late:

JoC Online: Industrial Price Index

Apparently the Fed would have one believe this is all benign, and that other factors such as wages and labor are all that matter. To us, slack wages simply spells a further "squeeze" on heavily indebted Americans, not low inflation. And unfortunately, in the real outside of the Land of Oz, the impact of these shortages and bottlenecks are becoming acute. We recently spotted a news account from the Korean Times that describes our train wreck theory perfectly:

StockTalk: The Epic American Credit and Bond Bubble Laboratory

This 1/6/2004 steel shortage article out of the Middle East really caught our eye too.

And how have the increases in input prices played back in the USA? Inflationary, given the evidence. It looks like those Chinese-made stainless steel toenail clippers, might be getting more expensive, or soon to be in short supply?

Import prices:

Nov 2003 +0.5%
Dec 2003 +0.5%
Jan 2004 +1.3%

Even using the familiar trick of excluding "volatile" energy, import prices for the last three months rose 1.1%, equal to 4.4% annualized. Even export prices demonstrated the new inflationary footprint, rising 1.2%, equal to 4.8% annualized.

China may have to pass costs on as well, given their own emerging inflation.

StockTalk: The Epic American Credit and Bond Bubble Laboratory (#8006/8245)

Perhaps a timely yuan currency repeg might make at least those expensive imported commodities more affordable in US dollar terms? Can China afford to absorb the new costs of exporting to America? A rather unnoticed change in Chinese tax law makes that even more difficult now than otherwise. Effective Jan 1, 2004 rebates on tax payments that Chinese businesses could claim for products sold outside of China were cut. For instance, on microwaves, small appliances, and air conditioners, the tax rebate will drop from 17% to 13%. We will be watching closely for Chinese price increases to protect their already thin margins.

How about US based firms selling at home? That question is up in the air, and a critical piece of the picture. Early evidence is mixed. We believe most of the crude and intermediate goods producers are passing on these new inflationary costs. At the finished goods level, we are still looking for strong evidence. The February Empire Sate surveyed showed that prices paid were strongly on the increase: 39%, versus decrease of only 5%. Prices received were punky: increased 15%, versus decreased 11%. This would suggest that at this stage a great cost squeeze is on finished goods outfits and possibly retailers. Perhaps these pressures will encourage US based firms to speed up the outsourcing of the one input cost they truly control, labor. Certainly that topic could be the grist of further articles from the authors or others?

Russ Winter and Jim Willie CB
February 24, 2004

Russ Winter is a money manager and private investor. He lives in Oregon.

Jim Willie CB is a statistical analyst in marketing research and retail forecasting. He holds a Ph.D. in Statistics. His career has stretched over 22 years. He aspires to one day join the financial editor world, unencumbered by the limitations of economic credentials.

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