Economic Outlook - what's the impact on commodities?

GLOBAL RESOURCESINVESTMENT CONFERENCE

STATIONERS’ HALL, CITY OF LONDON ● TUESDAY-WEDNESDAY, 27-28 SEP 2011

www.ObjectiveCapitalConferences.com

Opening Keynote: Economic outlook – what's the impact on commodities? Chris Watling – Longview Economics

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Twitter: Chris@LongviewLinkedIn Group: Longview Economics – all welcome Website: www.longvieweconomics.com

304/07/23Twitter: Chris@LongviewLinkedIn Group: Longview Economics – all welcome Website: www.longvieweconomics.com


3

Macro & Markets

Chris Watling, CEO, Longview Economics September 2011



404/07/23

Contents

1. Macro Outlook– Euro crisis– Structural growth headwinds– Whiffs of Western Stagflation– Slowing EM economies– Risks in China’s property and infrastructure bubble

2. Western Indebtedness & structural deleveraging3. Commodities outlook

– Next 12 months– Next 5 - 10 years


504/07/23

Rising Sovereign Risk – Italy; Belgium; Spain amongst others

Spain Italy Belgium

Source: Reuters EcoWin

Sep

08

Dec

09

Mar Jun Sep Dec

10

Mar Jun Sep Dec

11

Mar Jun Sep

CD

S (

Bas

is p

oint

)

0

50

100

150

200

250

300

350

400

450

500

Cost of Insuring against Default in Various Euro zone sovereign bonds (CDSs bps)

Ireland, 5 Year Portugal, 5 Year Greece, 10 Year


Sep

08

Dec

09

Mar Jun Sep Dec

10

Mar Jun Sep Dec

11

Mar Jun Sep

CD

S (

Bas

is p

oint

)

0

500

1000

1500

2000

2500

3000

3500

4000

4500

Cost of Insuring against Default in Various Euro zone sovereign bonds (CDSs bps)

Spain, Italy & Belgium Ireland, Portugal & Greece



604/07/23

Euro Crisis - Possible outcomes/Policy Options1. A disorderly default (i.e. with markets forcing that default) – this would be the worst of all outcomes with particularly

severe global economic outcomes. In particular this would likely lead to bankruptcy of many parts of the European financial system, a major tightening of credit conditions and with that a major European (& probably global) recession/a depression.

2. Unsterilised ECB intervention – i.e. The ECB ‘electronically’ prints money and buys the sovereign bonds of the troubled euro zone economies. This, however, compromises the ECB’s monetary independence and risks its own solvency (i.e. as it would then grow the size of its balance sheet with assets of questionable quality). Its independence is compromised because monetary policy would be operating in the sphere of fiscal policy;

3. Full political/fiscal union – i.e. some form of communal guarantee of all euro zone debt by all euro zone countries (e.g. a Eurobond). There appears, however, to be little appetite in Northern Europe (i.e. the fiscally strong Euro zone countries) for this outcome. Opinion polls in Germany highlight a growing preference, for example, amongst a growing segment of the population to leave the Euro – rather than become more deeply intertwined. The recent election success of the ‘True Finns’ party in Finland, who campaigned on a platform of ‘no more bailouts’, highlights the lack of Finnish enthusiasm for deeper European fiscal integration.

4. A European bailout led by and primarily (or at least significantly) funded by the emerging market world. Many of the BRIC economies, Middle Eastern economies and other emerging market economies have significant reserves at their disposal. With the right attached conditionality, it would be in the interest of the emerging economies to use these funds to invest in propping up the Euro area in some way (e.g. by committing to and becoming a major buyer of Euro zone debt in Italy, for example, or by buying EFSF debt).

5. Leveraging the EFSF – perhaps in conjunction with the ECB – thereby increasing up the €440 billion current firepower up to €1.5 – 2 trillion.



704/07/23

Structural western economic growth headwinds

See Longview Letter no 56 July 29th 2011 for full update: “The ‘Old’ or ‘New’ Normal”

US real house price index (rebased to 100 @ 1 Jan 1975)


1975 1980 1985 1990 1995 2000 2005 2010

US

real

house

pri

ce

index

90

100

110

120

130

140

150

160

170

Peak '79

Trough '82

Trough '75

Peak '89

Trough '95

Peak '06

+16% rise

14% fall

+16% rise

+58% rise

8% fall

Trend?

Structural Growth Headwinds i) Downtrend in US/UK Real House Prices. In real terms, US house prices are still above trend and are expected to continue to trend lower.…a resumption of normal housing activity has not begun.

ii) Structural Deleveraging. While there is evidence of some modest growth in consumer credit since September last year, the overarching theme with respect to debt is one of deleveraging. Because the deleveraging was ‘cut short’ during the recession

iii) Future & current Fiscal Austerity: Loose fiscal policy and the use of the government’s balance sheet to ‘bailout’ companies, financial institutions, households (e.g. cash for clunkers, housing stimulus) and the economy (extending the Bush tax cuts, fiscal stimulus packages etc) during the crisis has created major fiscal imbalances.

iv) Jobless Recovery: With most sectors of the economy facing headwinds, job creation which responds to actual and perceived demand growth, is anaemic.


804/07/23

Structural deleveraging


804/07/23

Source: Longview Economics, Federal Reserve flow of funds, Reuters EcoWin

1945 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Fin

an

cia

l s

ec

tor

de

bt

as

% o

f G

DP

0

10

20

30

40

50

60

70

80

90

100

110

120

130

accelerating rate of financial sector indebtedness (in recent decades) in particular since the Asian crisis in 1997

122% of GDP peak q109

1997 @ 62%

1952 2.7% of GDP

1950s - heavily regulated banking & financial system - banks stuck to core intermediary business - taking in deposits and lending them onwards

Beginning of financial deregulation 1970s & early 80s

now 95.1%

US financial sector debt as % of GDP



904/07/23

BRIC – Leading Economic Indicators – Mostly turning/trending lower…

China, Leading Index Brazil India Russia


04 05 06 07 08 09 10 11

Inde

x

75

100

125

150

175

200

225

250

275

Inde

x

90

100

110

120

130

140

150

160

170

China - Trending up but at a slower pace...

Brazil & India - trending over......

trending down...

Russia - rolling over?

BRIC economies – Leading economic indicators (index)



1004/07/23

Various (Western) Leading Economic Indicators

Euro zone LEIs (source: OECD)

US LEIs (source: OECD)

US LEIs (source: Conference Board)


70 75 80 85 90 95 00 05 10

Y-o-

Y %

-15

-10

-5

0

5

10

15

20

US vs. Euro zone LEIs (Y-o-Y %)

Euro zone LEIs are now in/very close to recession warning territory



1104/07/23

Market overly optimistic on China….….

South Korea Singapore Japan China Taiwan


1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Inv

es

tme

nt

sh

are

as

% o

f G

DP

5

10

15

20

25

30

35

40

45

50

'97 Asian crisis

'90 Jpn peak

Investment Share as % of GDP – Various Asian economies



1204/07/23 1212

Chinese Overbuild?

“Perhaps Rome cannot be built in a day. But at China’s current rates of construction, it would take roughly two weeks. It took the Asian hyper-economy (i.e. China) roughly a decade to build the equivalent of Europe’s entire housing stock (excluding Turkey), and there are few signs that the seemingly insatiable appetite of Chinese consumers for bigger and better housing will slow substantially.” From attached EIU report – published last week.


1304/07/23

(Slowly) building global inflationary pressures

-30.0%

-20.0%

-10.0%

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

70.0%

80.0%

Jan-

05

Mar

-05

May

-05

Jul-0

5

Sep

-05

Nov

-05

Jan-

06

Mar

-06

May

-06

Jul-0

6

Sep

-06

Nov

-06

Jan-

07

Mar

-07

May

-07

Jul-0

7

Sep

-07

Nov

-07

Jan-

08

Mar

-08

May

-08

Jul-0

8

Sep

-08

Nov

-08

Jan-

09

Mar

-09

May

-09

Jul-0

9

Sep

-09

Nov

-09

Jan-

10

Mar

-10

May

-10

Jul-1

0

Sep

-10

Nov

-10

Jan-

11

Mar

-11

May

-11

Jul-1

1

Infla

tion

perv

asiv

enes

s (%

)

UK US EZ


1304/07/23

UK, US & Euro zone Longview Inflation Pervasiveness models

07/04/2314www.longvieweconomics.com

07/04/23

Indebtedness of the Western Economies


1504/07/23

Why BUY Commodities?1. The alternatives…..




1604/07/23

The (biggest) Bear case – US & Europe follow Japanese Path…..

European STOXX 600 (from 1 Jan 1990 - rebased to 100)

Japan, Nikkei, 225 (from 1 Jan 1979 - rebased to 100)

US S&P500 (from 1 Jan 1990 - rebased to 100)

Source: Reuters EcoWin, Longview Economics

0 1000 2000 3000 4000 5000 6000 7000 8000 9000

Inde

x

0

100

200

300

400

500

600

700

European STOXX & S&P500 (10 years prior to their secular bull market peak in 2000)

vs...

Nikkie 10 year prior to its secular bull market peak in 1989...

X Axis = No of Trading days

Europe, US & Japan – rebased to 100 10 years prior to the end of their secular BULL market*

*i.e. 1979 for Japan, 1990 for US & Europe



1704/07/23

Attractive Valuation or Value Trap?

Equity Risk Premium (US equities) US Cyclically adjusted PER (Shiller)

S&P500 PE ratio calculated by the Shiller method (i.e. based on 10 year rolling historical earnings)

Long term average

Source: Shiller, Reuters EcoWin

1890 1905 1920 1935 1950 1965 1980 1995 2010

PE

ra

tio (

cy

clic

all

y a

dju

ste

d)

0

5

10

15

20

25

30

35

40

45

2000 peak

5x

6x

6.6x

currently @ 20x - above long term average levels

1982

1932

1920

1929 Peak

1965 peak

1901 peak

1937 peak

9.0x

1949

Source: Longview Economics, Reuters EcoWin

1996 2000 2002 2004 2006 2008 2010

Eq

uity

Ris

k P

rem

ium

(%

pp

)

-1

0

1

2

3

4

5

6

7

8

9

Main recent lower bound (i.e. since '02)

Equities expensive rel. to bonds

Equities cheap rel. to bonds

Main recent upper bound (i.e. until recently)

Negative ERP - i.e. suggesting that bonds are riskier than equities

4.9% ERP at '03 lows

ERP currently 8.9% - all time high

7.8% record highs Nov '08


07/04/23

S&P500 & DJIA inflation adjusted indices (1896 to 2010)

Western Equities – in a Secular Bear Market

S&P500 (real terms, rebased to 100 in Jan 1940)

Dow Jones Industrial Average (Real terms, Rebased to 100 Jan 1940)


1890 1905 1920 1935 1950 1965 1980 1995 2010

Inde

x (re

base

d to

100

Jan

194

0)

25

50

100

200

400

800

1600

Criss-crossed areas = commodity super cycles

Secular bullSecular bull

Secular bull

Secular Bear

Secular Bear

Secular BearSecular Bear


1904/07/23

The Alternatives: Government bonds - attractive?

Yield (at month end) Annual average yield


1875 1890 1905 1935 1965 1980 1995 2010

Ger

man

bon

d yi

eld

(%)

1

2

3

4

5

6

7

8

9

10

11

12

German bond yields - up over 11% peak in 1981

lowest yield ever...

1870 - 1st data point

1925

German 10 year government bond yields (1870 – 2011)


2004/07/23

Why BUY Commodities?2. The Demand drivers


07/04/23

Demand Drivers:Developing (& industrialising) Asia: A 3 billion elephant

Asia (Population rank in size relative to RoW)

GDP ($bn 2008)

GDP per capita (US$2010)

population(bn; % of ASIAN total)

Long term Real growth rates

Asia (23) (a) $7,239bn 4,070 3.60 (100.0%)

China (1st) $3,206bn 3,999 1.33 (36.9%) 9.1% (1997-2007)

India (2nd) $1,200bn 1,124 1.13 (31.4%) 9.7% (1997-2007)

Indonesia (4th) $433bn 2,858 0.23 (6.4%) 5.9% (2001-2010)

Pakistan (6th) $143bn 1,067 0.164 (4.6%) 4.8% (2000-2009)

Bangladesh (7th) $68.4bn 624 0.147(4.1%) 7.4 % (1997-2007)

Vietnam (12th) $68.6bn 1,168 0.086 (2.4%) 10.0% (1997-2007)

a: excludes HK, Japan, Singapore, South Korea & Taiwan

NB USA = 3rd 304mn pop; Brazil =5th 191mn; Russia = 8th 142mn; Nigeria = 9th 137mn; Japan = 10th 128mn; Mexico = 11th 110mn

Largest non developed Asian economies


2204/07/23 2204/07/23

Forecasts for Next 40 years



04/07/23

China’s Coming Car growth

0100200300400500600700800900

- 10,000 20,000 30,000 40,000 50,000

Real GDP per head

Motor

vehic

les pe

r 100

0 peo

ple

JapanChinaFranceSpainUSMexicoSouth KoreaItalyNorwayChileGermanyNetherlandsUKCanadaRussiaBrazilIndia

Industrialisation & vehicles per 1000 people

Source: Longview Economics, Reuters EcoWin

The number of vehicles per 1,000 people in China is relatively low (32) - NB India (15), Brazil (198), Canada (597) & US (820)

If China industrialises with the same vehicle intensity of GDP growth as other emerging markets the number of vehicles per 1,000 people in 2030 should still be at low levels (at 170 vehicles)



2404/07/23

China’s share of world energy reserves

1.2 1.0

6.3

0.52.4

1.30.2 0.6

3.6

13.9

0.9

19.0

7.1

23.4

28.9

0.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0

China Brazil Russia India USA

% o

f wor

ld to

tal p

rove

n re

serv

es

Oil Gas Coal

Energy resources: Share of proven world reserves (%) – key countries



2504/07/23

China’s Strategic Overseas Investments (2005 – 2011)

Summary by Sector

Outward Chinese Investment

Sector Total Invested (2005 - 2011) Share of total (%)

US$bn

Agriculture 7.0 2.7%

Energy 114.6 43.6%

Finance 34.3 13.1%

Industry 5.1 2.0%

Metals 69.4 26.4%

Power 8.1 3.1%

Real Estate 11.2 4.2%

Technology 4.5 1.7%

Transport 8.4 3.2%

Total 262.7Source: Heritage Foundation, China Global Investment Tracker



04/07/23

China - Expanding Trade RelationshipsChina’s global reach has expanded significantly in the last decade

Share of selected countries'/regions' trade (imports plus exports) with China

2000 2009last 12

months* 2000 2009last 12

months* 2000 2009last 12

months*G20 Other Significant trading partners Other Significant trading partnersSouth Korea 9% 20% 23% Mongolia 33% 48% 61% Africa 3% 12% 14%Australia 7% 20% 21% Kyrgyz Republic 8% 64% 57% Ghana 3% 13% 14%Japan 10% 20% 21% North Korea 17% 42% 46% Bangladesh 5% 10% 13%United States 6% 14% 15% Sudan 27% 39% 45% Iraq 5% 8% 13%Brazil 2% 13% 14% Angola 18% 30% 37% Thailand 5% 12% 12%South Africa 3% 14% 14% Tajikistan 1% 19% 33% Zimbabwe 2% 7% 11%Indonesia 5% 12% 13% Myanmar 13% 24% 29% Middle East 4% 10% 11%Saudi Arabia 3% 12% 13% Congo 5% 20% 25% Singapore 5% 10% 11%India 2% 9% 11% Kazakhstan 6% 21% 24% Sri Lanka 2% 10% 10%Argentina 4% 9% 11% Uzbekistan 1% 15% 18% CIS and Mongolia 4% 10% 10%Russia 5% 9% 9% Nepal 5% 12% 18% Venezuela 0% 7% 8%Canada 2% 7% 7% Malaysia 3% 13% 17% Syrian Arab Republic 2% 7% 7%Turkey 2% 6% 7% Iran 5% 15% 17% Nigeria 1% 7% 7%UK 2% 6% 6% Zambia 1% 8% 17% Somalia 0% 5% 5%Germany 2% 6% 6% Philippines 2% 8% 15% Spain 2% 4% 4%Italy 2% 4% 5% Turkmenistan 1% 11% 15% Qatar 3% 3% 4%EU-25 2% 4% 5% Pakistan 4% 10% 15% Azerbaijan 1% 3% 3%Mexico 1% 8% 5% APEC 7% 14% 14% Afghanistan 4% 3% 2%France 2% 3% 4% * from Dec 2009 to Nov 2010. Calculated as each country's total exports to China + total imports from China / the country's total exports + total imports

Source: Longview Economics, Reuters Ecowin



2704/07/23

China’s Tentacles (EurAsia, Africa & beyond)


2804/07/2304/07/23

Long term Risk: GeopoliticsResource Bottlenecks – Potential Conflict Flashpoints

Global trade chokepoints/bottlenecks


2904/07/23

Conclusion

• Euro zone recession – likely• US recession – close call (probably not)• Euro crisis – all outcomes possible – depends on

European policy makers’ decisions (& with that their electorates)

• Emerging market economies – slowing BUT good long term growth outlook

• Commodities – benefit from: i) inflation hedge; ii) Emerging market demand growth; iii) supply challenges


3004/07/23

• Disclosures: This report has been prepared for information purposes only and is not a solicitation, or an offer, to buy or sell any security. It does not purport to be a complete description of the securities, markets or developments referred to in the material. The information on which the report is based has been obtained from sources which we believe to be reliable, but we have not independently verified such information and we do not guarantee that it is accurate or complete. All expressions of opinion are subject to change without notice. This report has been prepared solely for the person to whom it is addressed and must not be relied upon by any other person for any purpose whatsoever. We accept no responsibility whatsoever for any investment or asset allocation decision taken on the back of any or all of the information and/or advice in this report.

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Economic Outlook - what's the impact on commodities?

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