Written by Michael Waring

At issue in the current market is whether commodity prices are in a bubble. According to Jim Lennon of Macquarie Bank, investment into commodities indices has jumped from less than $10 billion in 1998 to about $142 billion in 2007. He believes a further $30 billion was added in the first two months of this year and that by year-end, total index fund investment could reach $190 billion. Other observers’ have even higher estimates.  This inflow of capital has led to a massive increase in the number of commodity-based products in the past year alone. No doubt investors have thrown money into raw materials with the expectation that prices will continue to increase and, to diversify away from falling equity markets as well as a declining US dollar (speculators looking for a dollar hedge?).

In our view, there is certainly a case to be made that investors, hedge funds and others have contributed to the run-up in commodity prices. And yes, the investment could leave just as quickly as it arrived. It would seem reasonable to us that a 20-25% near-term decline in commodity prices is a possibility that should not be ignored.

However, when we look at the basic fundamentals of supply and demand, we believe there is another, longer-term argument to be made.

On the demand side, we would note the continued voracious uptake of commodities by emerging economies. This demand is driven by a rising standard of living and a dire need to build infrastructure, which by its nature, is very commodity intensive. While emerging market GDP growth rates will cool from the blistering pace set in 2007, they are set to remain healthy in our view for the foreseeable future.  For example, we expect China’s GDP growth rate to ‘slow’ to 9.0% in 2008, down from 11.2% in 2007.  Still robust number in anyone’s books.

We would also note that the type of investment in these emerging economies is very long term in nature; power plants, electrical distribution networks, railroads, highways, mass transit, these are projects that are not dependent on the outlook of the economy over the next few quarters. For growth to continue in these economies, this infrastructure build-out must proceed.

Likewise in the developed economies, there has been a serious lack of reinvestment to upgrade infrastructure for many decades. Roads and bridges are in disrepair, power networks are strained, mass transit is stretched, and much of what we take for granted is in fact, quite antiquated. It is our view that developed economies will have to invest hundreds of billions of dollars over the next ten years to rehabilitate this aging infrastructure. We believe this need is so great that authorities will have no choice. And again, this speaks to increased demand for raw materials from cement to steel, zinc and nickel.

This combination of new infrastructure build in emerging economies and rehabilitation in developed markets has never occurred before in history. As a result, we expect to see continued strong demand for raw materials for the foreseeable future at levels that are unprecedented in recent history.

On the supply side, we believe that the raw materials sector is very challenged in terms of bringing new resources to market. Low commodity prices for decades (until recently), has resulted in a serious lack of reinvestment in the underlying infrastructure to support the industry. From tires for mining trucks, fabrication facilities and port shipping capacity, this is a sector that is struggling to keep up with demand. These are structural issues that cannot be addressed in the short-term. A massive amount of capital will be required and lead times are long. Resource projects are suffering from delays and deferments as a result.

In a similar vein, we observe a growing shortage of skilled labour in the sector from geologists and engineers to experienced tradesmen. The senior technical individuals are largely a product of the 1970’s and are now close to retirement. Supply of trained, skilled labour is a challenge that is set to intensify in our view.

Due to this lack of support infrastructure and skilled personnel, the raw materials sector is currently experiencing massive cost input inflation. Project costs are rapidly escalating out-of-control and deferment is a common outcome. Higher input costs require higher commodity prices if projects are to proceed. Short of a massive global recession, we see nothing on the horizon that will lead to a reset in these input costs.

We also note that, again, as a result of decades of low commodity prices, there is a shortage of new high-grade resources to exploit. Low commodity prices led to a decline in exploration, which is now surfacing as a major challenge for the industry. This occurring at a time when many existing reserves are very mature and their production is in decline.

We would also point out that because of the currently high commodity prices, governments around the world are resetting royalty and tax rates. Project economics are becoming less attractive as a result and the world is becoming a smaller place for mineral and oil exploration.

And finally, we note that heightened environmental concern is resulting in much longer lead times for many projects to get permitted. We suspect that this issue will only intensify in the future especially with respect to projects that require water resources.

The end result of all these challenges faced by the raw materials sector is lack of a supply response that one would have expected given current prices. We have not seen the supply wall of copper, nor nickel, coal, zinc etc. that one would have expected a few years ago, given current prices.

So where does all this leave us? In a bubble perhaps, with downside risk a constant reality. Yet in our view, commodity prices must remain elevated if new resource projects are to proceed. A significant drop in prices will simply result in projects being cancelled or deferred. And this will only exacerbate an already tight supply situation and ultimately lead to even higher commodity prices in the longer-term.

The senior global mining companies have recognized the seismic shift that is occurring as witnessed by the consolidation that has recently taken place. The disappearance of Inco, Falconbridge and Alcan is a siren call that investors ignore at their peril. We expect further consolidation in the commodity sector going forward.

It is our view that the game has changed. Control of many commodity markets (nickel, aluminum, copper, coal etc.) is shifting to the emerging markets. What investors assumed for decades is no longer relevant. A new paradigm has emerged and with it, a host of new investment opportunities.

At Galileo, we are bullish on emerging producers, especially gold, platinum, coal and international oil. We are also excited by infrastructure related plays in emerging markets, most noticeably in China. We believe that the long-term growth opportunities are exceedingly attractive and investors should have exposure to our selected holdings.

We attempted to see through the short-term noise and focus on the longer-term macro trends that we see set in place. As long-term investors, our unitholders deserve no less. Our advice, as always, is to stay the course. Fundamentals will prevail, near term corrections aside.

China

We recently arrived back from one of our many annual trips to China and we feel confronted with a number of cross-currents.

Despite our earlier thoughts that inflation rates would cool, the opposite happened. Inflation in February shot up to 8.7% on an annualized basis in part due to the extreme winter weather experienced during the month. Almost all of this inflationary surge is the result of rising food costs, most noticeably meat, eggs and cooking oil. The so-called core inflation rate is still well under control and we note China’s consumer price index rose by 8.3% in March, down from February’s 8.7%. We think February will represent the peak inflation point for the year due to the winter storm. 

We also think this jump in food inflation is transitory in nature but nonetheless the authorities in Beijing are very concerned and we will likely see further interest rate hikes (perhaps 2-3) during 2008. This will be a drag on the valuation of Chinese equities over the next several months. In our view, it is not a deep-seated structural problem but nonetheless one that needs to be addressed in the short-term.

The extreme weather in February also caused a loss in industrial output. The heavy snow affected many companies and a large number of thermal electricity plants suffered a reduction in output due to coal shortages. Production has only recently returned to normalized levels. And yet, first quarter GDP growth has come in at a surprisingly high 10.6% vs. 11.4% in the fourth quarter of 2007. Little slowdown there!

At the same time, China is now experiencing a drop in exports to the U.S. This should come as no surprise given the continued deterioration in the U.S. economy. However, the impact of slower export growth will be mitigated by three factors; first, the diversification of Chinese export markets away from the United States (see our last letter for details). Second, Chinese exports remain very price competitive in the global market place, especially on lower end products. Third, we believe that the role of net exports as a contributor to Chinese GDP growth has diminished in recent years as the domestic economy has grown (Chinese retail sales growth were up 20.6% in the first quarter).

We expect that 2007 will represent the high-water mark in terms of China’s recent GDP growth. For the full year, we suspect GDP growth to ‘slow’ to a still very healthy 9.0% from 11.2% in 2007. However, given the current high inflation rate, we welcome this slowdown and actually think that it could not be coming at a better time. China’s economy needs to cool after last year’s blistering growth.

Because of all these cross currents, Chinese shares may underperform in the near term. Yet, longer-term, we want to stress that we remain bullish as ever on the growth outlook in China and the investment opportunities that we have identified. China possesses a very vibrant economy and China’s population is determined to achieve a better life. China is in a long-term growth revolution, a once in a lifetime investment opportunity.

And make no mistake: China will continue to increase its consumption of basic materials for the foreseeable future. The basic infrastructure needs are simply too pressing.

Outlook

At this point, we do not believe there is much we can add to the discussion regarding the financial crisis that has so gripped markets worldwide.  There are commentators eminently more qualified than us that can offer thoughts and observations.  However, while there are many more negative surprises in store, we are coming round to the view that the bailout of Bear Sterns may be the seminole event that will come to represent the point of maximum uncertainty for the market.  Collectively, we went to the edge of the abyss, didn’t like the view, and took a step back.  More bad news to come for sure, but our suspicion at this point is that the negative surprises will be contained with the help of the central bankers.

Whether the U.S. economy is in recession or not seems like a mute point to us.  On the heels of disappointing earnings from Alcoa, General Electric and Wachovia, performance of corporate America looks set to not meet expectations over the next 1 – 2 quarters.  We had surmised as much in our last letter and the evidence is now beginning to accumulate. Our guess is that the bulk of the disappointments will be in the financial sector and that global non-financial companies may report in-line with analysts’ estimates.

Gaging the extent and duration of this downturn is now the key factor for investors.  Since this is always difficult to determine, we are avoiding investment in companies that are exposed to the gyrations of the U.S. domestic economy.  While we recognize that global earnings multiples will contract in the face of a U.S. recession, we have positioned our portfolios to hold companies that we deem to be special situations; companies where we believe the underlying business prospects are on solid footing regardless of U.S.GDP performance.

As in our last letter, we continue to favour the following investment themes:

Platinum - Supply challenges in South Africa and growing auto-catalyst demand.

Gold - Safe haven from inflation risks and lack of new supply.

Oil & Gas - Select global companies with meaningful exploration prospects, notably South America.

Coal - Both thermal and metallurgical coal based on strong demand from emerging economies and limited new supply.

Alternative Energy - Driven by concerns regarding climate change and a new U.S. president in November that will be more sympathetic to the sector than George Bush.

Agriculture - Burgeoning fertilizer demand due to higher agriculture commodity prices and pressure to raise yields.

China - Select China exposure notably agriculture, renewable energy, pollution control (water) and infrastructure.

Our near term view is that equity markets are stuck in a trading range. And until the confidence problems in credit markets abate, it is difficult to see how equity markets can move meaningfully higher.

Disclaimer:
This report is intended for clients of Galileo Global Equity Advisors Inc. Galileo Global Equity Advisors Inc. invests on behalf of its clients in the issuers mentioned in this report. Employees of Galileo Global Equity Advisors Inc. may own shares. This document is not intended to sell or promote securities.

Copyright:
All content included on this site, such as text, graphics, logos, button icons, images, and software, is the property of Galileo Global Equity Advisors Inc. or its content suppliers and protected by Canada and international copyright laws. The compilation of all content on this site is the exclusive property of Galileo Global Equity Advisors Inc. and protected by Canadian and international copyright laws.