The Rising Liquidity Wave

STOCKS - Going forwards, I expect the liquidity environment to remain supportive of asset prices resulting in another good year. If my assessment is correct, emerging-market equities and commodities should (once again) be the biggest beneficiaries in 2007. Even the US stock-market may surprise to the upside.

Figure 1: Dow Jones rallies after mid-term election year

Source: Chart of the Day

This is a pre-election year (US elections are scheduled for November 2008) and history has shown that during pre-election years, American stocks have done well. Moreover, each mid-term election year in the US since 1950 has provided investors with an opportunity to profit from a significant rally (Figure 1). The current rally began in June 2006 (prior to the mid-term elections) and if historical patterns remain intact, the Dow Jones should advance strongly over the coming year.

The US economy is currently undergoing a mid-cycle slowdown and the chances of a full-blown recession are slim. Over the coming months, I expect US housing to deteriorate further but a crash is highly unlikely. In other words, I anticipate a soft-landing in the US economy. For sure, the world's largest economy has severe problems (record-high indebtedness and sky-high deficits), however other nations want to sell their merchandise to the US and are willing to finance its deficits. As long as this continues, the US economy should be able to live on borrowed time.

I am of the opinion that despite a slowing US economy, growth in other parts of the world may remain unharmed. Asia is advancing at a blistering pace, Latin America has turned around and Eastern Europe is developing rapidly. In fact, the "developing" world is expected to outperform the industrialised nations in the future (Figure 2). Accordingly, our managed-accounts are invested in the fastest-growing regions of the world. At present, my preferred stock-markets are Brazil, China, Mexico and Russia. Furthermore, I may add that assets in the US will continue to disappoint for as far as the eye can see.

Figure 2: World economic-growth trends

Source: Morgan Stanley

COMMODITIES - Over the coming year, I expect commodities to resume their bull-market and make headlines all over the world. Despite all the negative news surrounding natural resources, the fundamental factors have not changed. In fact, the recent consolidation has made commodities even more attractive. Global demand for "things" is rising, supplies are tight and monetary-inflation continues worldwide.

As China and India continue to urbanise, it is estimated that more than 150 million surplus workers from rural areas will move to cities by 2020. It is interesting to note that roughly 60% of China's population and 70% of Indians still live in rural areas. These numbers are shockingly high when compared to a more developed Asian nation such as Korea, where over 80% of the population live in cities!

Back in 1980, over 80% of the China's population resided in rural areas (versus 60% today) and this number is expected to decline further to 40% by 2030. India is lagging in this department as its rural population has not fallen much over the past 30 years, but the downtrend is expected to accelerate in the years ahead.

I am sure you will agree that people in cities generally earn more money when compared to rural areas. For example, the per-capita income of rural households in China is US$510 whilst it is US$1,400 in the case of urban households.

Once the millions of Asians move to urban centres and become wealthier over the coming years, they will demand a better quality of life and all the "creature-comforts" you can possibly imagine. These people will want bigger homes, washing machines, televisions, refrigerators, motorcycles, cars and so forth. Now, unless you are a central banker and have the ability to create something out of thin air, it is safe to assume that the demand for all these goods will require an immense quantity of raw materials such as cement, steel, copper, rubber, zinc and energy.

Now that we have established the case for a sustainable rise in the demand for natural resources, let us examine the supply dynamics. Throughout the 1980's and 1990's, prices of commodities were caught in a vicious bear-market. The devastation was so severe that the majority of the commodity-producers did not invest in spare capacity. After all, there was no incentive to spend more money and increase supply when prices were falling sharply! So, when the demand for commodities suddenly began to rise 4-5 years ago, nobody was prepared for it. Even today, despite the surge in the prices of raw materials, spare capacity and stock-piles are extremely low.

Figure 4 shows the price and inventory levels (shaded area on the chart) for both copper and zinc. Since December 2002, both these base-metals have risen sharply to all-time highs, yet their inventory levels are close to or at record-lows.

Figure 4: Base-metal inventories extremely depleted!

Source: Raymond James

These days there is a lot of noise about the copper "bubble". It is my observation that asset-bubbles are usually accompanied by an over-supply of the item in question and build-up of its inventories. Yet, if you take note of the copper inventories on the London Metals Exchange (Figure 4), you will quickly realise that the "bubble-talk" is totally absurd! On the contrary, supply-shocks in the near future may cause inventories to diminish further as Bolivia plans to "industrialise" a river that supplies water to Chile's Atacama Desert, thereby threatening the world's largest copper-mining district.

I suspect copper (like many other commodities) is simply consolidating within its ongoing bull-market and its price in real (inflation-adjusted) terms is still way below its all-time high recorded in the 1970's. Over the coming days, copper may decline somewhat more but once the correction is over, I anticipate copper to resume its uptrend in the latter part of 2007. Utilise any weakness in the near-future as an opportunity and consider investing in copper-mining companies that have huge reserves and cash-flows.

Furthermore, it seems to me that the multi-month consolidation in precious metals is now almost complete and we are likely to see upward moves over the coming weeks. Both gold and silver have built a huge base and they have recently shown strength in the face of a strong US dollar - impressive action. It is my belief that this maybe the final opportunity for investors to buy precious metals and quality mining stocks at these depressed levels - it always pays to buy when the sentiment is negative.

Finally, as the central banks continue to debase their currencies through monetary inflation, precious metals and other tangible assets should appreciate significantly over the coming years.