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The Inflation Hare

by Dan Denning

–How do you know when inflation is hopping away like a rabbit? When the People’s Bank of China (PBOC) raises one year lending rates by 25 basis points from 5.81% to 6.06%. For the third time since October. That’s how!

–The PBOC has repeatedly raised lending rates, deposit rates, and reserve requirements at banks. Sounds like an inflation problem, doesn’t it? Sounds like a credit bubble, doesn’t it? Sounds like excessive lending leading to a huge boom in fixed asset investment (real estate), doesn’t it? Sounds like the sort of thing that might be bearish for Aussie resource producers, doesn’t it?

–Or not!

–Rio Tinto is due to report its 2010 profit results tomorrow. Word on the street is that Rio’s full year profit will come in around $14 billion, or more than double 2009’s figure of $6.3 billion. That kind of profit makes the Commonwealth Bank’s first-half profit of $3.34 billion look a little pedestrian.

–It’s definitely not 2009 anymore. Back then, the miners were licking their wounds from the GFC and dealing with lower commodity prices. But since then, commodity prices have rebounded. The combined stimulus efforts of China and America have unleashed much higher prices for tangible assets. Resource stocks loved it.

–With Xstrata reporting a profit of $5.12 billion and Oz Minerals even posting nearly $600 million in profits, only BHP can spoil the party when it reports its results a week from today. But remember, these profit results are from last year. Even if the Efficient Market Theory is balderdash, these positive results aren’t a surprise. They should already be priced into stocks.

–What’s not priced in is a China crash. Or at least much lower growth rates as the government in China tries to contain inflation. The repricing of resources and resource stocks on a China crash is the “other shoe” to drop on Australia. But it hasn’t happened yet.

–By the way, the “other, other shoe” to drop is a housing crash. That hasn’t dropped either. That means Australia has both shoes in the air, ready to drop, like Wyle E. Coyote against a clear blue cartoon desert sky.

–But maybe the resource boom will never really crash. At least not for another 15 years—according to David Gruen of the Australian Treasury. Gruen reckons, “The re-emergence of China and India into the global economy is the most important global economic development likely to have an impact on the industrial structure, and hence the demand for skills, in the Australian economy over the next 15 years.”

–If he’s right, then this “one-off” event would sustain a continuous shift in the balance of power for resource pricing away from consumers and toward producers. All the capital spending and exploration in Australia for new projects would be justified. And profits to companies and shareholders would make everyone rich.

–Thank you China!

–But what if he’s not exactly right? There are two ways of looking at the re-emergence of China and India. The first is that two 5,000-year-old civilisations are rapidly catching up with the industrialised West. For the world, this means flatter/falling wages (lower Western standards of living), lower prices for finished goods (more producers), but long-term support for real assets and presumably the companies that find, mine, or refine them.

–If you’re trying to reduce that to an investment strategy, it won’t be easy. Where will the profits be? Two places, we reckon.

–The consistent, plodding kind of profits will probably belong to entrenched incumbents. These should be safe but boring profits for long-term investors who have time on their side. Our colleague Greg Canavan keeps his eye out for the best time to buy the handful of Aussie companies that qualify as cash-generating blue chips that are very hard to compete with.

–The bigger, riskier profits are obviously on offer for junior resource companies, especially the explorers. But finding which commodities have the most favourable dynamics and which companies can find and produce them the cheapest isn’t easy. That’s why we have several people who do nothing but look for those opportunities all day long.

–Of course this whole first way of looking at the China story is exactly the way we were all looking at it in 2007. Before the GFC. But since then, we’ve learned that what’s making these abnormal rates of Chinese GDP growth possible is an abnormal rate of fixed-asset investment. And what made THAT possible is an abnormal credit bubble.

–Or, to follow the logic, China has condensed decades of economic development into a few years with the help of copious amounts of credit. This means China’s story (like Egypt’s) is, at heart, a currency story. But does that mean China’s spectacular growth, like Mubarak’s regime, will be a victim of the collapsing U.S.-dollar empire? Or will China surpass the dollar and keep on trucking?

–If you read our “Exit the Dragon” report on this subject a year ago, you already know where we’re going. But it’s been a year and still no crashing Dragon. What gives? We’re updating that report for the February issue of the Australian Wealth Gameplan. Stay tuned.

–In the meantime, you’ll note that Gruen’s report showed the decline of Australian manufacturing, in terms of both employment and investment. This is what Greg recently called the hollowing out of Australia’s economy. It’s what happened to America over a 30-year period and what caused the country to become an inveterate borrower as it consumed more than it produced.

–Is Australia different? Well, it’s exporting raw materials in record volumes even as the labour market shifts to selling things (services) instead of making them. But whether this is a long-term wealth strategy….or just a way of becoming another Chinese province…is yet to be seen.

–Your editor is an idiot! Doesn’t he know that nuclear waste is a problem for which there is no solution and therefore nuclear power cannot be seriously contemplated by serious people who are serious?

–That’s the tone of quite a few notes that rolled in after yesterday’s Daily Reckoning. Here’s one:

For a time, some of the philosophies expressed in your Newsletter seemed interesting.  I was starting to worry though, and then, finally Dan Denning dropped this: “The first problem is that Australia doesn’t have any plans to invest in nuclear power. This is a result of a childish and unserious attitude in public policy circles about nuclear power. It’s kind of embarrassing.”

Dan Denning ought to have a good think about who is demonstrating childish and unserious attitudes.  Here’s a challenge for you Dan.  You prove to me that you know of a safe, workable solution to the environment destroying mining problem, a safe, workable solution to the nuclear waste problem, and if you can prove that there is no other, better solution to the energy crisis, then I’ll come buy you a beer.

On the flipside, since you have such a strong opinion on the issue, if you can’t, how about you shout me to a beer, and I’ll explain to you why the world is the way it is, instead of you speaking without  understanding of the circumstance of human civilization, nor a full appreciation of the ramifications of your espoused opinions.


Karsten  🙂

–No deal. :-/

–There is no solution to the problem of nuclear waste, if by “solution” you mean a way of generating nuclear power that doesn’t produce radiocative waste that has to be stored for tens of thousands of years. It is a serious problem. And for a serious movie about it, check out “Into Eternity”, which is up for an Oscar this year.

–The problem of how large urbanised societies and economies get their power without eroding their quality of life and degrading the environment is as serious as it gets. But the answer is not to simply give up and go back to subsistence farming. This viewpoint implies that it kind of sucks, but billions of people are just going to have to die for the Earth to be a bucolic, agrarian paradise.

— Or, a shorter version of this argument is that Malthus was right, he was just early. In the share market we call bad timing “being wrong”. But we’ll cut Malthus some slack since he’s talking about the carrying capacity of the Earth as an eco-system. So how did he get it so wrong with his timing?

–Malthus, like many of the Statist control freaks arguing for limits on population growth, badly underestimated human ingenuity. He saw people merely as mouths to feed, as variables in an equation that also happened to require calories, which had to come from somewhere. He did not see each new human brain as a creative resource unto itself, capable of solving problems in unexpected and unpredictable ways.

–In point of fact, while human population continued to grow arithmetically in the last two hundred years, food production grew even faster. Cheap energy and better technology made this possible. The end of cheap energy will make it harder to sustain the big gains in food production in the last 100 years. But should we just give up now? Should we make like the dinosaurs and cede mastery of the earth to cockroaches and pigeons?

–Nuclear energy may not be the ultimate solution to powering the planet. But it has real benefits. And given the time to develop, people will find ways to solve some of the associated problems. People adapt or they die. Technologies evolve too, given the chance.

–What we find so strange about the opponents of nuclear energy is that at some deep philosophical/emotional/religious level, they are human defeatists. They seem to be ashamed of their species. They view human life as a parasite and think the planet would be better off without us. Of course we’re generalising here, but you know the type.

–People aren’t problems. People as the economist Julian Simon wrote, are the “ultimate resource”.  He meant that having more people on the planet is not a problem. It’s a benefit. It’s more brains solving more problems and coming up with more ideas. He hasn’t been wrong yet.

The Daily Reckoning Australia

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