Whither Stephen Roach?

When real short-term interest rates were negative a couple years ago, back when Alan Greenspan was ridiculed for his serial bubble blowing ways on a weekly, sometimes twice-weekly basis, Stephen Roach's commentaries were something to look forward to every Monday and Friday.

They were a voice of reason that too few appreciated or understood.

Now that short-term interest rates are up over five percent and the world is "on the mend", he sounds pretty much just like any other economist, albeit one with a growing reputation as a contrary indicator.

His commentary from last Friday, Whither Commodities?, seems to be another example of a dismal scientist who, already knowing the answer to the question being posed, throws together a thousand word essay knowing that none of his dismal peers will question the content.

Are commodities a bubble? Probably.

Has the bubble just popped? Probably.

Do sky-high commodity prices in an era of low inflation qualify as cognitive dissonance to your run-of-the-mill economist?

Definitely.

As noted here a few months back when Caroline Baum of Bloomberg penned a similar piece regarding the prospects for commodities (see my 25 May dispatch, "Dissecting the Duck Diagnosis"), it appears that Mr. Roach of Morgan Stanley is also in need of a few more bits of supporting data for his bursting bubble thesis.

In defense of Mr. Roach, in Friday's commentary he was not near as sure of himself as Ms. Baum was back in May - not nearly as annoying either. Nor did he share Ms. Baum's playful use of analogy to demonstrate the point being made.

What Stephen and Caroline did share, however, was a largely unimportant bit of data regarding copper demand. In Friday's commentary, Stephen said:

I continue to believe that a post-housing bubble shakeout is a distinct negative for US commodity demand. This works through two channels -- the residential construction impacts and property-related wealth effects on personal consumption. The former remains a heavily commodity-intensive activity; for example, the Copper Development Association estimates that 46% of total copper usage is earmarked for building construction -- with about two-thirds of that total going to the residential homebuilding sector. As homebuilding goes, US commodity demand will most assuredly follow.

Back in May, Caroline opined:

Building construction accounts for more than 40 percent of all copper used in the U.S., according to the Copper Development Association, the development, engineering and information services arm of the copper industry. Residential construction is two-thirds of the construction market, according to the CDA. So you could say that copper's fortunes are intimately connected to those of the housing industry.

From the sound of this you'd think that copper demand in relation to the cooling U.S. housing market was some sort of talking point circulated by writers of weekly columns on the economy. What both Stephen and Caroline have provided as critical support of their bursting bubble thesis - waning demand for copper by U.S. homebuilders - ignores the much more important copper demand as shown in the chart below.
It seems that since China started building lots of factories, homes, and office buildings back in the 1990s, they've become quite a bit more important to copper demand than the rest of the world combined. Surely, if one were to look for where weakening demand for copper will most affect prices, and hence validate the bubble thesis that economists seem to so desperately want to confirm, big red China is the place to look.

In Friday's commentary, the incredible demand for raw materials coming from China was cited before identifying a slowing U.S. housing market as one of three critical "legs" to the commodity super-cycle "three legged stool".

The most important "leg" of the stool, according to Mr. Roach, is indeed demand from China. But, as was the case for Ms. Baum, supporting data doesn't seem to be all that important. Mr. Roach admitted his statistics regarding Chinese consumption were shaky, but went ahead anyway.

The August data flow just released out of China points to the first signs of the long-awaited cooling off -- meaningful deceleration in the growth rates of both industrial output (+15.7% y-o-y in August versus +18% in June and July) and fixed investment (+21.5% in August versus +30% in the first seven months of 2006). While one month’s data should never be taken all that seriously in any economy -- especially in China with its notorious data problems -- these signs could well be indicative of a legitimate turn to the downside. If that’s the case and Chinese industrial output growth decelerates further into, say, the 12-13% y-o-y zone, then it is almost a mathematical certainty that this slowdown would produce a major downturn in global commodity demand.

This story has been heard over and over for the last four years, but in the end nothing changes - it's nonstop gangbuster growth all the time in China, constantly revising GDP upward, and repeatedly taking steps to cool the economy.

The China slowdown meme has been heard every year for most of this decade - is this going to finally be the year that this prediction comes true?

But to "inside the box" thinkers, the increasing appeal of commodities as an asset class for both institutional and retail investors must be the most problematic of all props that have been supporting commodity prices in recent years. Ms. Baum had a bit of fun with some erroneous data regarding the gold ETF (GLD) and Mr. Roach similarly is challenged by the thinking of some investors.

Virtually every institutional investor I visit these days now has a commodity department. Even retail investors have jumped into these markets. Assets under management by Commodity Trading Advisors (CTAs) now stand at over $70 billion -- essentially triple the total three years ago and up at about a 40% average annual rate over that period (see Chapter 1 of the IMF’s September 2006 Global Financial Stability Report). Moreover, this most likely is only a small portion of the commodity asset class.

A mere $70 billion under management as compared to $15 trillion invested in equities and $40 trillion in bonds doesn't seem like all that big a deal. Coming off of a very low base, tripling really doesn't mean that much. More to the point of the spottiness of the data is the claim that this total is probably only a small portion of the total investor stake in commodities.

The other, much bigger portion apparently didn't seem worth tracking down, as long as something has tripled then it can be labeled a bubble.

At least Mr. Roach's conclusion contained none of the giddiness that characterized Ms. Baum's .

The multi-year run in commodity prices has been a transforming event in the global economy and world financial markets. It has become conventional wisdom to believe that this super-cycle has years to run on the upside. I am deeply suspicious of this conclusion. History tells us that commodity prices have some of the greatest mean-reverting tendencies of them all. I am not looking for a crash in commodity markets. But as China slows and the US property bubble bursts, a broad and protracted downturn can be expected in most economically-sensitive commodity markets, including oil. Investor involvement in these markets can only compound the downside.

Yes, copper and now nickel probably have some lumps in store, both having doubled in the last year, but oil is below the peak of last year, and gold is far from nominal highs seen in 1980, barely a quarter of the way to the inflation adjusted high of over $2,200. Agricultural products have been largely absent from the commodities party.

This is seemingly another shining example of group-think, akin to the near-universal praise that was heaped on Alan Greenspan as he neared retirement despite the slow-motion economic train wreck that was clearly moving down the tracks and gathering steam as the retiring Fed chairman was being hailed as the greatest central banker ever.

Someone should really step in and have a look at the talking points used by economists to discredit commodities.

Maybe a few new ones are in order.