Dichotomies

This long standing maxim seems to be in full force as the US debt concerns deepen. Not that all news has been good, but even where context would auger future gains it is only negatives the market is seeing at present. Efforts by the great and good to catch up to the reality that a major housing and debt based downturn is underway in the US certainly aren’t helping. Fed Chairman Bernanke reporting to his Congress that the economy will weaken further impacted the markets on Thursday, and IMF head Dominique Strauss-Khan amongst others has declared emerging markets decoupling from the US economy a dead idea. Hmm.

China

has just announced its January trade surplus is some US$15.88 billion, up by 50% over the year earlier period. For the full year 2007 the total surplus was up almost 50% at some $262 billion. This is in spite of obvious slowing in overall US consumer demand for the past four months. Obviously a continued slowing in the US can begin to dent China’s exports, but China has dealt with the same rising costs for resource inputs as the rest of world by becoming more flexible with its cost base to maintain its growth of exports.

We expect the upward adjustment of the Yuan, signalled by last autumn’s noises about adjusting the Yuan’s currency basket, to accelerate further. That helps satisfy a rising hue in the US for better trade terms, and also reduces the cost of resource imports and therefore costs into China. Lower exports cost will, in due course, help spread China’s growth around its domestic economy and up-shift consumption in China. That is what the IMF and the G7, those mature economies that don’t decouple from each other very easily, are actually looking for from China. Good of them to notice it is underway.

So are we saying that the great and good are simply wrong in stating that decoupling is a dead concept? No. Obviously if the entire “developed economy” goes into a deep recession it will hurt everywhere. The heads of developed economies’ various regulatory bodies have no more idea how big the debt bomb actually is then anyone else. They are trying to scare the ultimate lenders, those job sapping “emerging economies” that were storing wealth before Romulus was suckled, into bailing out Wall Street. We have no problem recognizing that as scary, so we continue to be cautious about jumping into the deep end just yet. But the decoupling we talk about is specific to metals.

From pre cycle base levels oil is trading up 900%, nickel some 650%, copper over 500%, and even lowly zinc is up 300%. We are a full six quarters into the US housing crisis (signalled by copper’s drop from $4 per pound in mid’06). European zinc smelters want to increase charges by 75%, citing more concentrates supply to justify this. There is some new mine supply. But China reversing long standing tariff enticements that overpaid for zinc concentrates also helps the cause; a new export tax on finished zinc from China is expected to halve its export of the metal this year. Given metal producers are cash flush for the first time in seventy years, do you think really they will drain that cash by supplying zinc at loss due to short term demand weakness? We don’t.

Mono-line insurers are the current béte noir as we noted in the last Journal. Warren Buffet has offered a profitable (for him) way out and the regulators sound like their patience with Wall St is rapidly evaporating. We’re surprised it’s taken this long. Since they created the mess its only reasonable they cut come cheques to help clean up the mess. If the combination of Omaha vulture capital and Albany strong arming can resolve that crisis the market should stabilize for a while at least.

Anything else we should be paranoid about? Well, as long as you’re asking, there are those Credit Default Swaps and Credit Swaps waiting in the wings. These make a lot of people nervous thanks to sheer scale; the best guess as the current amount of outstanding swaps is close to $50 trillion. How ugly might that get? No one knows – that’s the problem. It’s important to add that these derivatives were designed as hedging instruments so (we hope) most of that big total is swaps that will effectively cancel each other out. That’s the theory. Given how many outstanding swaps seem to exceed debt instruments created in recent years you have to suspect someone is using them to leverage up. Cynics point out with more than a little justification that assumptions about other markets having little “dumb money” involved proved to be highly optimistic. This market is a “gray area’s gray area” so the odds of getting any meaningful answers or market statistics are slim. We just have to hope it doesn’t blow up on us. Stay tuned.

With all the market fears and nasty economic stats floating around January and early February were particularly unforgiving on the base metal side. Two producers on the list, Lundin Mining (LUN-T) and Teck Cominco (TCK.b-T) have both been harshly dealt with by the market after reporting weak fourth quarter results. This was partially due to weaker zinc prices and also to one time changes. As we noted above a receding economic tide would “drop all boats” but the market is marking down producers like these much more than the metals themselves. The next month or two should tell the tale when it comes to base metal prices. There will either be rapid inventory build-ups and price drops or the prices will continue to stay at least level. If they do, we can’t help but think these companies will get rediscovered as it dawns on traders they could sustain high profits and low P/E’s for some time. On that basis we think you should have LUN and TCK on the shopping list (on weakness) if the markets get through the quarter without coming apart further.

Juniors have been on ice since the start of the year. Some discovery stories are trading well but market participants are holding back from anything less liquid until there is more clarity on the direction of the major markets. We’ve maintained for some time that there could be another down leg on the major indices so we can’t blame people for caution.

All that said, continued strength in the precious metals complex should start drawing buyers in again soon. Gold could consolidate short term, but events in the broader markets and increasing assurance that the Fed will cut further continues to underpin prices. The only short term event that might rally the dollar is some sort of legislated fix of the mono-line insurer crisis. If that happens and gold is sold down consider it a good entry. There is little chance of the greenback getting rescued longer term. Credit issues in one form or another will be around for some time to come but one can already sense that traders are getting tired of hearing about it and reacting to it less. It seems like this could go on forever but then the same has been said about many other crises over the past couple of decades. It seems silly to say ”the market has no memory” but it does explain greed overcoming common sense with such tedious regularity. W

The preceding article was sent to HRA Dispatch subscribers on February 17^th 2008

David Coffin and Eric Coffin are the editors of the HRA Journal, HRA Dispatch and HRA Special Delivery publications focused on metals exploration, development and production stocks. They were among the first to draw attention to the current commodities super cycle and have generated one of the best track records in the business thanks to decades of experience and contacts throughout the industry that help them get the story to their readers first. Please visit their website at www.hraadvisory.com for more information.

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