Ignore Inflection

Points at Your Peril

Chart from Feb 2011 Strategic Investment

Paul Richardson
Copyright © 2011
The graph on the cover points out that ever since China joined the World
Trade Organization in 2001 they have been the driving force in
commodity prices. I want to point out in this ethnocentric time of
handwringing over even the tiniest percent of federal and state budget
cuts that need to be made to bring our government spending in line with
revenues that we must get our house in order. If not, we are giving
China and other nations much more control of our future prospects than
should be comfortable or even tolerable.
Some data relating the changes from 2001 to now bring things into
focus.
2001 Now
Dollar Peak value
Gold $275/oz $1400/oz
Chinese imports Up 7X since 2001
Oil $16.45/barrel Approx $100/barrel
Reserves as % of China = 49.6%
annual GDP US = 0.88%

Thus, the title of Ignore Inflections Points at Your Peril for this piece.
Inflection points are the most difficult things for people to deal with.
That is, when long term events cause a change in the direction of
external factors impacting our lives we tend to want to extrapolate the
old “normal” trends. Since we once were the unchallenged economic
power in the world we got into some bad habits of borrowing against our
future to fund “nice” programs now.
The last few years, especially the last two, have shown that we have not
adjusted our spending for the reduced forward prospects that are reality
now. In fact if we can’t bring our spending into balance with reality it
will accelerate the reduction in our future prospects. For example, this
year we have federal budget in place that spends over 70% more than
our projected income. That brings into perspective the ridiculous
statements from politicians that even the current $4 Billion cut in the
two week continuing resolution is too painful. The pain we will feel if
we don’t get our act together will make the current $4 Billion seem like
a tiny pin prick in comparison.
Let’s look at some reality. China is facing the need to build their
infrastructure at an incredible pace to enable them to keep the “natives
from getting too restless.” They are building massively to try to bring
the prosperity in coastal China to the interior where about half the
population of 1.3 billion people still live at a much lower standard.
Bloomberg estimates that it takes 90 kg of copper to outfit one family
apartment. No wonder copper prices have risen so much.
Food prices are the biggest concern to developing nations and have
caused massive food riots, most recently in 2008. And as the emerging
markets develop, the increased wealth naturally makes people want
more meat in their diets which puts more pressure on grain prices.
Chinese hog herd is now 440 million more than seven times the size of
ours. That has caused the Chinese to increase corn imports by eight-
fold.

Our Federal Reserve’s Quantitative Easing programs have weakened the

dollar and since food is priced in the commodity markets in dollars the
price of food has risen more dramatically than explained by demand or
crop failure concerns. This has been the stimulus for the current turmoil
in the Middle East and elsewhere. The World Bank said that “Arab
countries are very vulnerable to fluctuations in international commodity
markets because they are heavily dependent on imported food. Arab
countries are the largest importers of cereal in the world – and most
import at least 50% of the food calories they consume.” The population
of the Arab world was 73 Million in 1950. Now it has more than
quadrupled to 350 Million. The World Bank expects that number to
double by 2050. This looks like they will be using their oil domestically
and not be able or willing to export large quantities to the developed
world.
While a majority of you have followed the anthropogenic global
warming preachers to full belief and won’t believe it, I want to assert
again that the sun is the controlling factor in climate and that it seems
likely that the crop failures and “strange” weather of late are most likely
related to the early stages of a period of reduced solar activity. If I am
right the impact on food scarcity of a repeat of the late 17th century and
18th century “Little Ice Age” will be dramatic and devastating. In times
like that the self inflicted scarcity of oil and gas to fuel greenhouses, etc.
in a quest for more food production could be catastrophic. The price for
following the (in my opinion) false prophets of carbon dioxide doom
would be high indeed.

The current deficit debate is of incredibly high importance because we

have already given the Chinese huge leverage over us economically.
The delusion of our politicians lecturing the Chinese about currency
exchange rates and the firm belief that the Chinese “need” us as
consumers of their industrial output is dangerous. The Chinese
leadership “need” to continue to bring their people into more modern
living standards and they can do that perhaps most cheaply by using
their bond holdings to sell just enough at the right time to create a
recession here which lowers demand (and prices) for the commodities
they need for their people projects.
From China is bigger than you may think, Financial Times Blog of
Gavyn Davies former Chairman of the BBC, 2001-2004
The above chart shows the relative size of our economy versus China on
a Purchasing Power Parity (PPP) basis. This casts doubts on the “China
needs us” argument. As to the leverage point consider that in July 2008
when oil reached a peak of $147.27 per barrel, the Chinese began selling
rather than buying tens of billions of dollars of Freddie and Fannie
mortgage bonds. This helped trigger a “wholesale run” on the highly
leveraged Wall Street banking system. Because Wall Street was
dangerously undercapitalized it could not survive the collapse.
When the Bush Administration caught on to the Chinese dumping of
mortgage paper, they quickly tried to calm the market with an explicit
federal guarantee of Fannie and Freddie which backfired. The attention
it inspired caused the reality of billions perhaps trillions of mortgage
paper used for collateral for margin and other loans to become apparent.
Thus previously viewed AAA paper became toxic overnight and the
loans throughout the system where the paper was used for collateral
collapsed along with them. The Chinese benefited greatly because the
price of oil fell from an average of $136 per barrel to $33.87 on Dec 21,
2008. Copper plunged similarly from a July high of $4.08 to a
December low of $1.26. This process did reduce the value of Chinese
holdings in US bonds but the savings in commodity purchases they
needed desperately to make was many times larger. Since China
attacked the Yen “carry trade” (borrowing in yen at zero interest rates
and buying other country’s bonds yielding higher rates for a net sizable
gain after employing leverage) at the same time it appears they intended
to “take us down” a peg or two. This seems to be a coordinated process
not just “playing the markets.” Can you blame the Chinese for acting in
their self interest when we left ourselves open to this vulnernability?
The message I am trying to convey is that we have been massively
deluding ourselves about our “wealth and power.” We need to start
paying attention to what works and makes our economy go. It is not
government control of more and more of our economy. It has always
been allowing free people to work for their own benefit as Adam Smith
wrote about in The Wealth of Nations. Every socialist system has
eventually failed as Margaret Thatcher said when the money runs out.

Only by embracing our founding principles can we make the future as

bright as we desire it to be.