WEEKLY ECONOMIC ANALYSIS: May 15th, 2009

Provided by TEAM Financial Services

"Don’t look back. Something might be gaining on you."
- Satchel Paige 

Items for Discussion

One of the themes we have discussed in the commentary over the past year has been our long term bullishness on commodity prices, with agricultural commodities being near the top of our list for the next few years. This bullishness is based on our assessment of global supply and demand fundamentals, but we are very worried about these fundamentals and what impact higher prices may have. 

Global inventories for many major agricultural products are at multi-decade lows. The world has “enjoyed” a period over the past few years of relatively minor supply disruptions courtesy of Mother Nature. The last time the world reached similar supply/demand fundamentals was in the early and mid 1970’s. Grain and soft commodities experienced rolling parabolic moves higher, with most taking a turn at moving higher by several hundred percent in a relatively short period – 12 to 24 months. So far, we are suffering similar supply and demand fundamentals, only this time prices have not yet responded significantly. In addition, there is a major difference between that period and the present. Namely, the period in the 1970’s occurred with a closed communist China and Soviet Union excluding billions of people from the demand side of the equation. 

Global population continues to expand at around 80,000,000 people per year. Historically, arable land has been developed (i.e. lost of rain forest etc.) to meet the increased food demand. Advances in fertilizer, irrigation and seed technology dramatically increased crop yields per acre or hectare. Unfortunately, these forces appear to be losing ground in their relative ability to increase supplies compared to the combination of population growth and the progression of millions of people out of subsistence living standards in the developing world. One of the first things people do when their income rises is to consume more food in general and introduce more proteins into their diets. This increases demand for agricultural products via direct grain demand, but also via the high demand for grains to raise livestock. 

TEAM is extremely concerned that the world is poised to suffer a combination of a food and water crisis in the next few years. China, in particular, has significant problems in both regards. The country simply does not have the internal resources required to meet the long term demands from their population for food and water. 

Social and political volatility has spiked significantly in the past during periods of significantly higher food prices. Famine and increased poverty is likely for those most vulnerable should prices head much higher. This development would be horrible for the world and it is certainly not something we are hoping to occur. Unfortunately, it is something that we believe is not only possible but probable. 

One agriculture segment we believe is particularly vulnerable to higher prices over the next 12-24 months is livestock. Herds were reduced significantly in 2007 and 2008 when grain/feed prices had risen sharply, while hog and cattle prices remained stagnant or fell. Along with herds being reduced significantly, land which had previously been utilized for livestock was converted to farm land to “follow the money”. 

Livestock inventory is not something that is increased rapidly when pricing incentivizes such a move. Cattle and hogs do not grow as quickly as a crop in corn or wheat. Some agricultural commodities have longer cycles, such as livestock and coffee (coffee trees take several years to reach a point of being productive). This compares to rapid cycle commodities like corn, wheat and soybeans. At present, TEAM believes there is a critical state in livestock prices – like snow building up on a mountain. At some point their will be a “small noise” or catalyst that will start the avalanche of higher prices. We certainly don’t know when it will occur, but if you have a freezer large enough you may want to buy your steaks summer grilling soon!

Market/Economic Climate 

TEAM believes that the stock market finally launched into a correction or retracement of the explosive rally off the March low. If our base case premise is operative, then a decline of significance would take place and last between 3 to 6 weeks, which is a typical rule of thumb for such a decline. As we’ve stated in the past couple of weeks, we’ve increased hedging and defensive measures in client portfolios with the intent of weathering such a move. 

ECRI’s leading economic indicators now suggest that the US economy should begin a cyclical economic recovery sometime this summer – i.e. the economy should emerge from recession. Such a development would not suggest that the many long term structural problems we’ve chronicled over time have been addressed or solved. On the contrary, TEAM believes that the policy actions pursued over the past two years have likely compounded those long term problems and created new ones. 

The trillions of dollars in stimulus being created throughout the world are likely to have at least a temporary impact and get the economy moving. TEAM is anxious to utilize any significant correction/retracement in the stock market to continue our shift to assets we believe are poised to benefit from the recovery – even if it proves to be temporary and fleeting. 

Humor for the Weekend 

This graphic comes via the Big Picture Blog authored by Barry Ritholtz.

Weekly Economic Analysis newsletters are provided by TEAM Financial, and are written by TEAM's Chief Investment Officer, James L. Dailey. Visit TEAM's website if you want to receive weekly economic updates right in your inbox - Click here.