by Tom Sawford

A week, so it is said, is a long time in politics.  The same could easily be said for economic news and the messages we have been receiving from prominent investors.

Jim Rogers told us at our successful Investor Forum to sell bonds and  the US dollar, and to buy commodities whilst learning to speak Mandarin on the way!  The Q4 update from GaveKal Research, delivered in the splendid surroundings of the Merchant Tailors’ Hall in the City was rather different.  Although they would all probably all agree on the need to learn Mandarin.

Anatole Kaletsky started proceedings on a very positive note; if you have been bullish the GaveKal view is you have not been bullish enough.  Whilst some may argue that equities are overvalued and that “earnings are unsustainable as they are top of the cycle valuations”, Kaletsky argues that at a pe of around 14, global equities are still at historically low valuations.  For the UK specifically, he stated that UK corporate profits are not above trend and have further to go. 

GaveKal have become synonymous with a positive view of current global economic conditions and have gone out on a limb to argue that “it is different this time”.  Revolutions in technology, capital flows, and globalisation have permitted the emergence of a new business model: the Platform Company.  In their book, “A Brave New World” the Gave brothers and Kaletsky argue that global economic leaders are now Platform Companies; those that keep the value adding functions of design and marketing, but ruthlessly outsource production to emerging markets, releasing capital from production assets, and maximising margins – “You guys take the jobs, we’ll take the profits”.  Examples of these companies include Apple and GE.  It is this type of economic activity that is enabling the continued rise in corporate profitability and may explain the dramatic rise in corporate cashflows.

Their European economic forecast was not at all positive.  Economic union has led to ‘specialisation’ in economies with Germany continuing to focus on manufacturing design, whilst many of the southern states, or the “Club Med” region have become dependent upon leisure and property speculation.  Kaletsky argued that the proposed consumption tax rises due for both Germany and Italy will result in a slump if historic precedents such as Japan in 1997 are repeated.

Charles Gave presented the GaveKal assessment of the global forces at work leading with the idea that capitalism is retuning to its deflationary roots, perhaps mirroring the deflationary boom of the 19th Century.  This is a fundamentally different view to that of Jim Rogers.  Charles Gave believes that the data shows that even the US along with other central banks has been reducing liquidity for at least two years.  According to data from Reuters Ecowin, US monetary base is growing at just over 2.5% or less than the growth rate of US GDP.

China will continue to contribute to the deflationary trend.  A startling fact is that China is now a net exporter of machine tools to other emerging Asian economies.  There is an industrial revolution occurring in economies that can now industrialise with cheap Chinese made machinery; we are now on the verge of a new (or is that a further?) deflation in goods.  The position of China represents that of the US in the 19th Century.

This effect and the structural adjustments by the US economy to the platform/service model will prevent the US suffering a recession in 2007.  Charles believes that “recession in the (economically) stable world we are describing is becoming a very unlikely event … To have a recession you need the cost of money to be obnoxious; short rates are low and are not high enough to cause a recession.”  If the Fed can stop raising rates and even start lowering them in 2007, GaveKal may well be right.

They admit to being “confused” by the Japanese monetary policy.  With the Japanese economy continuing to fail, Yen rates are likely to remain as they are, which implies that the Yen carry trade is set to continue.  If so, the argument goes, western institutions will continue to borrow Yen at low rates and reinvest in high return projects elsewhere.  The good times would appear to be set to continue, with hard asset inflation, in particular real estate, set to boom.

This set-up Louis-Vincent Gave to contend that the recapitalisation of Chinese banks that we have seen over the last months (they have raised over $70bn in 2006) had one key purpose.  That being to create a consumer finance and mortgage market in China.  With a property owning class you reduce the risk of revolution, or so the Central Committee theory may go.  Louis believes that “a wall of money will hit the Chinese economy in 2007” creating a real estate boom that will be explosive.  So much so that it may well be talked about and written about in 200 years time just like the South Sea Island bubble or the Tulip Mania.

The apparently good news for commodity investors is that this will be supported by a widespread infrastructure boom all over Asia.  However, GaveKal are fundamentally negative on commodities citing long term returns deflated by US CPI as being “dismal”.  In fact their approach seems to imply that nobody ever makes money out of commodities with “commodity prices falling 70% in real terms between 1900-2000”.  That is not to say that short term returns may not be very positive, acknowledging the returns seen by investors between 2001-2006.  They argue that new supply comes on stream to lead to sharp falls in prices.  In the open forum session, Minesite argued that this is a fundamental point; we know the mining industry faces the triple challenges of discovery; energy costs and a people shortage.  None of which seem to be getting any better.  One could argue that if Platform Companies make the world a different place this time round, then perhaps the same could be said for commodities.  Maybe it is time for GaveKal to take another look at their fundamental assumptions?

Investors will take on board information which fits with their fundamental view of the world.  We have seen the positive and upbeat view on commodities from Jim Rogers, who argued that many commodities have yet to achieve historic highs.  His basic view is that the commodity boom will continue based upon supply and demand.  Whilst GaveKal may have differing views on the price for commodities they certainly do believe there will be increased demand from healthy global growth which will include an extraordinary real estate and infrastructure boom spreading out from China.

There will be many other effects upon commodities, real estate and equities on 2007.  ‘Events’ and geo-political circumstances may affect returns.  The US may deflate more rapidly and hit a recession.  Inflation may continue to rise resulting in spiralling interest rate rises which will only add to the woes of the US.  The only commodity “that really matters” is oil and this appears to be now in something of a surplus with forecasts of lower oil prices already being lined up.  The consensus view appears to be that barring accidents growth is set to continue, and may well be strong.  For commodity investors and mining companies 2007 would appear to be set-up for an excellent year.

Louis-Vincent Gave has agreed to an interview with Commodity Watch radio which will be broadcast in early 2007.

GaveKal Research provides economic advice to high net worth individuals and institutional clients worldwide

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