The Great Correlation

Posted by Joel Bowman - The Daily Reckoning

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Commodity_correlation

Paper is out; stuff is in. That’s what the markets are telling us right now. The dollar, that esoteric, floating abstraction upon which the financial world erects its sandcastle economies, plumbed a new seasonal low this week, with the dollar index flirting dangerously with its support level of 77. “Stuff,” as measured by the CRB Commodity Index, meanwhile, soared to within reach of the psychological 300-point milestone.

Indeed, everywhere we look, stuff is on the march.

Gold opened to another record above $1,365 on Thursday, then retraced a bit to around $1,345 as of this writing. Oil shot through $84 a barrel this week and copper busted the $3.75 mark, reaching ever closer to the 2008 high of $4.08. Not to be outdone, silver climbed to a fresh 30- year high, topping $23 per ounce by Friday morning.

The message from Mr. Market, in anticipation of the Fed’s QEII program (second round of quantitative easing – fancy jargon for “money printing”) is clear: Increasingly, investors are coming to prefer the sober, welcoming embrace of physical materials to the unrelenting, drunken currency abuse perpetrated by the world’s central bankers.

In actual fact, there’s not a whole lot that hasn’t been rallying in dollar terms lately…except, of course, the reputation of those responsible for destroying its credibility.

While the dollar index plummeted 12.4% from early June to the end of September – even as headlines persisted about a shaky euro – everything else has benefited. Our mates over at The 5 sketched up this neat little chart, which really puts the story in perspective:

Commodity_correlation

One particularly notable – and worrying – component of the skyward global commodity trend can be found in the agricultural sector. The story here is part weak dollar and part supply-demand dynamic. Unlike metals or energy, however, the agricultural component of the commodity complex is not typically a “dollar diversification” tool for the emerging market’s growing middle classes, or for the 1.2 billion (according to UN data) hungry souls around the world. For them, food is a necessity, not an investment strategy. The demand for dietary staples, therefore, does not enjoy the same price elasticity as does, say, an iPod or a spiffy new electric can opener. And, as the global population swells to 9 billion by mid-century, you can bet this is a trend with marathon legs.

Partly due to this reality, farm commodities – or “ags” – have staged a remarkable rally this year.

Wheat, for its part, is climbing back toward its 2008 crises levels. Prices have risen some 75% since June as the Black Sea region suffers through the most severe heat wave in nearly half a century. The affected area ordinarily produces roughly one quarter of the entire global output. Consequently, experts forecast Russia’s harvest will come in around 60 million tonnes this year, well shy of the 75 million tonnes consumed domestically. Moscow has since implemented a ban on grain exports until late 2011.

Chris Weafer, chief economist at Uralsib Financial, recently told The Financial Times that, even allowing for the country’s emergency stockpile of 9.5 million tonnes, “We think Russia faces shortfall of 17 million tonnes and will have to import next year.”

Of course, supply shocks have been around as long as Mother Nature herself. Extreme weather patterns probably spawned the Biblical concept of the “seven fat years followed by seven lean years.” Droughts in Australia, floods in Pakistan, heat waves around the Black Sea and cold snaps across the south all collude to hinder global production, and have done, in one form or another, for millennia. But now, more than ever, global population growth and the emergence of the middle classes in developing markets are trimming that critical margin for error.

As Javier Blas reports in the FT, “…the most important underlying trend is the rise of emerging markets, where there are not only a growing number of mouths to feed, but where people with rising incomes want to eat higher-quality food – notably chicken, pork and beef. That in turn increases global demand for grain for animal feed.”

Corn, for example, is up more than 40% since June as global stock levels, with a “stock to usage ratio” of a paltry 12%, dipped to their lowest levels in almost four decades. Unfavorable weather patterns in the US kicked the rally off, but it was the revelation that China, feeding the fastest growing middle class on the planet, imported a record 432,000 tonnes in August that really kicked it into overdrive. This trend is all the more alarming, at least from a geopolitical perspective, when one considers that the US diverts a little over one third of its entire crop production to ethanol for fuel, a boondoggle that led one wry commentator to declare the program a blatant act of “unsustainable, government-sponsored food burning.”

To be sure, the hand of the state is always a dead weight on production, but when it comes to food, the matter quickly transforms from one of mere-to-moderate inconvenience to one of severe-to- apocalyptic life and death.

Moreover, if analysts like John Clemmow of UBS are correct, what’s on tap in the months to come could dwarf even the epic food crises of ’08.

“Clemmow maintains that despite riots and rationing at the time, there was no rice shortage in 2008,” relayed The 5 earlier this week. “The shortage two years ago was the result of governments panicking over supplies.”

But “Unlike in 2008,” says Clemmow, “there is now a possibility that with export bans in place, production problems in Pakistan and the strong suspicion that China and the Philippines will be importing in large quantities, we could be in for a fundamental squeeze.”

“Rice is the new iron ore,” Clemmow concludes, “and corn the new gold.”

As the food crises of 2008 illustrated all-too-clearly, the world’s dietary consumption habits seems to be approaching an important inflexion point, where a hungry emerging population literally eats into the market’s ability to absorb supply shocks. It would be foolish, and immoral, to blame the hungry for demanding their daily bread…and equally blind to assume they’ll ever be satisfied without it.

Regards,

Joel Bowman
For The Daily Reckoning

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