Saturday, March 10, 2012

Canada: A Storm Brewing In China?

I was speaking with someone about commodities last night so I can't help but sound the alarm again. As I read the Fairfax Annual Letter to Shareholders this morning, I was reminded of the following quotes from Prem Watsa, CEO of Fairfax (FFH).  I have collected them over the past couple years:

Where do you see speculation in the markets today?

Clearly in the commodity markets. The price of gold and oil and whatever commodity you want to look at—corn, wheat, agricultural commodities, mining commodities—have all gone up in parabolic curves. Say you are a gold producer with gold at US$1,500 an ounce. You cannot hedge today. No gold company will hedge that gold production. They could guarantee a huge amount of profits, but they won’t do that because they think it will be going higher. You would have been wrong if you tried to hedge at US$900, US$1,000, US$1,100, US$1,200, and US$1,300, so people will not hedge. They will not hedge oil. I can think of only one company that hedges its oil. And very few will hedge the price of copper at US$4 per pound despite that fact is has rarely been at this price. The cost of production is very low, so you can make a lot of money if you hedge your copper price. But almost no one will hedge today, and that is an indication of speculation.

Speculation in China

We met people in China, even ordinary people, who owned three and four apartments. I would say to them, “If you sell one apartment, you’ll have a million dollars, free and clear. And you’ll still have three more apartments.” All of these prices have gone up fourfold in four years. You know what the person says? She says, “I can’t do that because I sold one two years ago and it doubled after that. So I am never doing that again.”

And you see the same thing in commodities today?

There is a ton of speculation in commodities. There is over-inventorying. Whenever the price goes up, people buy more than they need because they think it will continue to go up. So there are inventories. I can’t prove that to you, but experience will suggest that there are inventories all over the place—of copper and zinc and nickel and gold. Everyone is buying gold, and in fact, ETFs have been created with something like 30–40 percent of gold in the form of paper.

So what is the tipping point?

This is the beauty. You never can tell when the music will stop. I can’t tell, but you know it will end. In this case, it might end because the economy weakens and China goes into a little bit of a hiccup. Commodity price speculation will end as certainly as you and I are having this interview today. It will end, and for people who have speculated, it will end badly.

From the 2010 Annual Report

Meanwhile we have concerns over potential bubbles in emerging markets. Consider, for instance, what we learned on a recent trip to China: many house (apartment) prices in Beijing and Shanghai had gone up almost four times – in the past four to five years!; many individuals own multiple apartments as investments with the certain belief that real estate prices can only go up; and maids are taking holidays so that they can buy apartments also. “Buy two and sell one after it doubles to get one for free” goes the refrain! In his essay in Vanity Fair, “When Irish Eyes Are Crying”, Michael Lewis says, “Real estate bubbles never end with soft landings. A bubble is inflated by nothing firmer than expectations. The moment people cease to believe that house prices will rise forever, they will notice what a terrible long term investment real estate has become and flee the market, and the market will crash.” We agree!!

Infrastructure and construction spending in China accounts for more than 40% of GDP – a number rarely seen in the past in any economy. In fact, this demand has resulted in commodity prices going up in a parabolic curve. Combine the increase in commodity prices, substantially from Chinese demand, with hedge funds and others again trying to allocate money to these very illiquid markets, and you can understand why some of these commodities have exploded in price, as shown in the table below.

                            2000  2008   2010
Oil – $/barrel         27      45       91
Copper – $/lb.      0.83   1.39     4.35
Nickel – $/lb.       3.09   5.31   11.23
Wheat – $/bu       2.80   6.11     7.94
Corn – $/bu         2.25   4.07    6.29
Cotton – $/lb.      0.62   0.49    1.45
Gold – $/oz.        274     870  1,405

Even onions and chilis went up 64% and 38% respectively in 2010!! We shy away from parabolic curves, so we continue to maintain our equity hedges!

From the 2011 Annual Report (just released yesterday: Click Here)

As for China, late in 2011 the Chinese bubble in real estate burst. Developers have reduced prices by 25%+ to sell apartments in Shanghai – causing riots by angry buyers who paid full price. Expect apartment prices in China to come down significantly in the next few years. This may result in a hard landing in China, again with major consequences for the world economy. As the table below shows, the parabolic increase in commodity prices has stalled in 2011 and many commodities like copper have begun to decline:
                              2010   2011
Oil – $/barrel            91       99
Copper – $/lb.        4.35     3.45
Nickel – $/lb.        11.23    8.49
Wheat – $/bushel    7.94    6.53
Corn – $/bushel      6.29     6.47
Cotton – $/lb.         1.45     0.92
Gold – $/oz.          1,405   1,531

Cotton is down 37% and may be a harbinger of what is to come!

Of course if commodities, particularly oil and metals, come down, Canada will not be spared. Canada has benefitted greatly from the commodity boom and our housing sector, particularly in Toronto and Vancouver, has gone up very significantly. As George Athanassakos, Chair of the Ben Graham Centre for Value Investing at the RichardnIvey School of Business, said in his recent article in the Globe and Mail, this time is not different for Canada’s housing bubble. There are more condos in construction in Toronto than in the 12 major cities in the U.S. combined, including New York and Los Angeles!! Caveat emptor if you own many houses or condos in Canada.

If you choose to invest in commoditities, I wouldn't be ignorant of the facts above. 

Once again Mr. Watsa has called another bubble.  If you think he's a one hit wonder I would recommend checking the record.  I have a document of every market call he's ever made (since 1986) and quite frankly if you ignore him you do so at your own peril.  If you would like a copy of that document, send me an email (click on contact tab above).


Disclosure: Long FFH

1 comment:

  1. China is unfortunately well on the way to a "hard landing", with global reprucussions.