Is Stephen Roach finally on the money???

Keeping in mind that this guy was off all year long, I found his article today to be somewhat thought provoking.

Commodity Bubble

Asset bubbles have dominated financial market experience over the past six years. First equities, then bonds, property, and spread assets. Like clockwork, liquidity-driven investors have migrated from asset to asset, desperately in search of yield. In my opinion, the world is now in the midst of another bubble - this one in commodities. It, too, will burst. The only question is when.

This is not about thresholds - $700 gold, $4 copper, $70 oil, and record prices for a broad array of other base metals. I am not making this case based on the parabolic increases in many key commodity prices that have occurred over the past couple of months. I leave that to the market technicians and traders. But suffice it to say that many key materials prices are tracing out patterns that very much resemble the dot-com mania of late 1999 and early 2000. That speaks to an important aspect of any speculative bubble - that price excesses have now permeated the far reaches of an asset class. To borrow from Yale professor Robert Shiller, who knows something about speculative excesses in markets, the bubble is an outgrowth of amplification mechanisms - both real and psychological - which create an unsustainable condition whereby "...price increases beget further price increases" (see Shiller's Irrational Exuberance, second edition, 2005). Such is the case in commodity markets today.

I make my case, instead, purely from the standpoint of global macro - emphasizing the extraordinary decoupling that has occurred between a broad aggregation of industrial commodity prices and world GDP growth. This shows up loud and clear in an analysis of world economic growth and commodity prices over the past 35 years (see accompanying chart). Over this time frame, there have been five periods of extended gains in global economic activity - the current recovery (2002-06) and four earlier recoveries - two in the 1970s, one in the 1980s, and another in the 1990s. The current rebound, as measured on an annualized world GDP growth basis, has averaged 4.2% - slightly weaker than the 4.4% average annualized gains in the previous four global upturns. In other words, there's nothing all that exceptional about today's world growth climate when compared with earlier periods global vigor.

Yet the current surge in commodity prices has been off the charts when compared with those of the past. This can be seen by an examination of trends in the Journal of Commerce composite gauge of industrial materials prices - for my money, the best of the so-called macro commodity price measures. JOC industrials include four major components - textiles (burlap, cotton, and polyester), metals (steel, copper, aluminum, nickel, zinc, lead, and tin), petroleum products (crude oil, benzene, and ethylene), and a miscellaneous grouping (hides, plywood, rubber, red oak flooring, and tallow). Not included are agricultural products and precious metals - seemingly tangential elements of the commodity complex that can often take on a life of their own.

Over the past four years, the JOC industrial gauge has increased by 53% - a sharper rise than that which occurred in any of the four previous periods of global recovery. Moreover, as seen in "real" terms - scaling the JOC by the cumulative increase in the US headline CPI over the same periods - the current surge in commodity prices stands out as even more extreme. The real JOC is up 42% over the past four years - nearly double the 23% average gains that occurred in the two commodity booms of the 1970s and in sharp contrast with the relatively stable trends during the global growth cycles of the 1980s and 1990s.

This latter result is a big deal, in my view. It is the functional equivalent of the macro smoking gun of a commodity bubble. It was one thing for commodity prices to surge during the Great Inflation of the 1970s. Such outcomes were very much an outgrowth of a generalized inflation that permeated most aspects of the cost and price structure during that period. It's another thing altogether, however, when commodity prices surge in a low-inflation environment as they are doing today - and when that spike actually outstrips those of the classic commodity booms of yesteryear. Perspective is key in this instance: In the midst of a slightly subpar upturn in global growth, a low-inflation world is experiencing the sharpest run-up in commodity prices in modern history. If that's not a bubble, I don't know what one is.

Of course, there are a multitude of counter-explanations as to why this is not a commodity bubble. This is a classic response - borrowing a page right out of the time-honored script of psychological denial that always occurs toward the end of an asset bubble. Shiller stresses that every bubble has its perfectly plausible story - the "new era" that is always used with great passion to justify fundamental support to sharply rising asset prices. From tulips to dot-com, with plenty in between, the believers are convinced they have a credible and sustainable story. That's very much the case with the current commodity bubble. Globalization is its story - and China is its poster child.

The basic premise of this new era is that globalization has unleashed a powerful strain of commodity-intensive global growth that caught a supply-constrained world largely by surprise. In other words, it's not global growth per se that is driving the demand side of this commodity cycle to the upside; that's evident from the cyclical comparison noted above, with world GDP growth in the current recovery slightly below earlier norms. Instead, the argument rests more on an increase in the commodity content per unit of world GDP. China - the world's greatest development story - is the most important illustration of this trend. Here's a nation that accounted for only about 4% of world GDP in 2005 but consumed nearly 9% of the world's crude oil, 20% of aluminum, 30-35% of steel, iron ore, and coal, and fully 45% of all the cement in the world. With Chinese economic growth driven by the commodity-intensive activities of urbanization, industrialization, and infrastructure, there is good reason to believe that high and sharply rising commodity prices are here to stay.

This is a great story - in fact, one that I have been telling for quite some time myself. The problem with the story - like most tales of new eras - is that it, too, has its limits. The key here is to realize that China is not going to keep increasing the commodity-intensity of its GDP growth. In fact, in the just-enacted 11th Five-Year Plan, the Chinese leadership announced explicit targets to reduce its energy content per unit of GDP by 20% over the next five years. China's concerns go well beyond oil. Potential bottlenecks of industrial materials, together with sharp increases in input prices such bottlenecks trigger, are viewed as a serious threat to sustainable economic growth. It is not that difficult for China - or any country in the developing world - to improve the commodity efficiency of its economic growth. After all, China currently consumes twice as much oil per unit of GDP as the developed world, on average. Technological change has long focused on reducing the energy and commodity content of manufactured products. In its rush to develop, China has lagged in deploying oil and other commodity-conserving production technologies. The Chinese do not have to develop new technologies to enhance commodity efficiency - they merely need to copy those already in existence elsewhere in the world. Great at copying and courtesy of higher input prices, China's appetite for industrial materials seems likely to diminish in the years ahead.

This is a key reason why China has now embraced a very different macro strategy over the next five years - moving away from a commodity-intensive export and investment growth dynamic toward more of a commodity-saving strain of consumer-led growth (see my 24 April Special Economic Study, "China's Rebalancing Challenge"). Yet the super-cycle theory of ever-rising commodity prices is based on the false premise that China stays the same course it has been on for the past 27 years - suggesting that China is expected to grab an ever-greater share of world commodity consumption. Similarly, the New Paradigm crowd of the late 1990s presumed the US was on a path of ever-accelerating productivity growth. Just as that presumption ultimately turned out to be unfounded, I suspect the coming rebalancing of the Chinese economy will succeed in reducing its commodity-intensity - thereby lowering its global demand for industrial materials. Like Nasdaq, irrationally exuberant commodity markets will also be taken by surprise.

My conclusions are macro. They are not aimed at the event-driven stories that can impact commodity price fluctuations from time to time. Nor am I expressing a view on gold or other precious metals that seem to have some very special characteristics of their own. My focus, instead, is on industrial materials - and their relationship to real economic activity in the global economy. On a global growth-adjusted basis, the current surge in industrial commodity prices far outstrips anything we have seen in modern experience. Parabolic price increases have become the norm, spreading across an increasingly broad spectrum of the asset class with a powerful contagion. To the extent this contagion takes on a life of its own - not uncommon for full-blown asset bubbles - it could also infect precious metals and agricultural products. The psychological signs of excess are equally classic. From China to the "end of oil," perfectly plausible stories of the new era abound. Price increases are begetting more price increases. Yes, it can go on for longer than we think - speculative blow-outs usually do. But history tells us how it will end. Play the commodity bubble of 2006 at your own peril.

https://mywebspace.wisc.edu/dcartwright/web/roach.pdf?uniq=-cdksbw