DONALD COXE October 25 2004


DONALD COXE October 25 2004




How the booming Chinese economy helps Canada—and hurts the U.S.

THE WASHINGTON meeting of G7 finance ministers earlier this month wasn’t a reprise of the 1999 Battle in Seattle. It’s not that anti-globalists have become disciples of Adam Smith, it’s that since 9/11, there’s been no tolerance of mob violence along the Potomac.

But leftist opposition to free trade is still growing. The Democrats, once the party of free trade, have switched roles with the Republicans, once the

party of protectionism. Under intense pressure from the AFL-CIO, six Democratic congressmen from Chicago voted in July against the free trade treaty with Australia, allegedly because that country isn’t sufficiently pro-union and pro-environmental protection. The real reason, however, is that the words “free trade” have become so obscene among the far left that ratifying any treaty that includes those words is the equivalent of asking the Vatican to sign an agreement promoting abortion.

Nevertheless, like other G7 economies, the American economy is being reshaped by Asia. If the 19th century was Europe’s, the 20th America’s, then this century will be defined by China, with help from India, Russia and the Mideast. Stock markets have already begun to reflect this power shift. That is why Canada and Australia, suppliers of raw materials to these nations, have been

the top-performing stock markets in the industrialized world for the past five years.

Why should the most commodity-oriented of the major stock markets be the best performers? From 1982 to 2001, global commodity prices (and shares of companies producing commodities such as mines, oils, forest products and agriculture) endured a sustained decline compared with prices of finished goods, services and real estate. This is what I call a “triple waterfall.” It follows a mania in which “new era” propaganda leads to massive speculation and overinvestment in productive capacity. That leads to a three-stage plunge (interrupted by brief “sucker rallies” in which beaten-up investors delude themselves that the good times have returned and throw even more money into the doomed sector of the market)

over decades that devastates an asset class. One important result of that 20-year-long commodity price crash was that the industrialized world came to assume that cheap fuel, cheap food, cheap metals and cheap forest products were its birthright.

Now, with the dawn of a new millennium, a classic second triple waterfall is beginning. Nasdaq is already in the third stage of a three-step collapse after the massive overinvestment in technology from the new economy mania. One good result: tech companies, desperate to stay alive amid shrinking demand, drove their product prices down even faster than in the ’90s, thereby accelerating the already rapid pace of productivity improvements in the industrial world and reinforcing global deflationary forces.

Almost unnoticed amid the tech carnage was a change in the direction of commodity prices. Led by oil, raw materials prices stopped falling and started rising. Big time. China had quietly moved from backstage to centre stage in the global economy. Its voracious appetite for energy and metals soon drained global commodity inventories, setting the stage for what will be the greatest commodity bull market in history.

China didn’t do it alone, of course: the global economic recovery meant raw material demand rose worldwide. But China had such astonishing growth in its demands, and in its financial resources to bid up prices, that it took charge of the process. Imagine an art auction in which one billionaire buyer is determined to stock a new gallery in just a day. He wouldn’t be the only bidder, but he’d outbid everyone else and the auction would break all records.

But China hasn’t just been buying commodities, it’s also been buying U.S. government bonds. Its trade surplus with the U.S. is roughly US$12 billion a month, and it has been reinvesting much of that in Washington’s debt.

Why? Because China is determined to hold the value of its currency, the renminbi, against the greenback. Japan, which also runs a huge trade surplus with China and the U.S., has been equally eager to buy Treasury bonds to hold down the value of the yen. Together, those nations (with some help from Taiwan, South Korea and Russia) have bought more than US$450 billion in bonds in just two years.

Now, here’s where the Asian story gets

really interesting. With Washington running a gigantic fiscal deficit, the U.S. in economic recovery and commodity prices soaring, American and global interest rates should have been climbing sharply. But those sustained gigantic Asian bond purchases have held rates down. One result: a housing boom

POWERED by its

perceived high commodity content, the loonie is assaulting the Canadian inferiority complex

(and, in some communities, a bubble), fed by the lowest mortgage rates in a generation. Without that growth in household wealth, the stock market plunge would have forced American families to slash consumption and boost savings—and the recovery would have been aborted.

China has become the price setter for the commodities it needs to buy and, at the same time, the global price setter for

all the manufactured goods it chooses to export. (That’s why the shares of so many leading American industrial companies in the S&P 500 have gone nowhere this year—they have no pricing power.) Together with its Asian associates, China has also become the most important factor in the price setting for U.S. bonds, which means, indirectly, the pricing of American homes. Those two widely watched signs of U.S. inflationenergy and house prices—are rising because of China, not because of money printing by the Fed or other domestically generated forces.

In all past economic cycles, rising commodity inflation led by oil prices meant rising consumer price inflation and rising interest rates that constrained house price increases and eventually choked off the economic recovery. This time, there is a bizarre coexistence among inflation in commodities, inflation in house prices and stable interest rates. Meanwhile, it’s hard for most economists to believe this can last. Either the two inflationary forces cool out or interest rates will have to rise sharply.

What do stocks do in such a conflicted environment?

The bull market in commodity stocks continues: such interlisted Canadian heavyweights as Suncor Energy, Imperial Oil, EnCana, Canadian Natural Resources, Potash Corp., Cameco and Inco have been among the top-performing stocks in the U.S. market this year. Powered by its perceived high commodity content, the loonie continues to assault the Canadian inferiority complex by threatening to break through US80 cents—great news for snowbirds, but painful news for Canadian exporters who stubbornly refuse to hedge their exposure to a global winner in the currency exchanges.

Investors should get used to the idea that this economic recovery is unique ... then get used to the idea that it won’t stay unique as the Asian millennium unfolds. i?il

Chicago-based Donald Coxe is Global Portfolio Strategist, BMO Financial Group.