By Bear Feller.

As Christmas edges closer, the silly season is in full swing. Not only has your usually punctilious writer neglected his usual Tuesday afternoon deadline, but colleagues have been doing bizarre things at end-of-year parties, television has been getting steadily worse and the markets have been even further removed than usual from reality.
Two cases in point are copper prices and the Australian dollar, two interlinked phenomena for more reasons of financial speculation than economic fundamentals. Increasingly too, their individual price levels are dictated by speculation, not fundamentals, which is nothing new for readers of this column, but frightening nonetheless. And add to the news of AUD/USD parity and fresh record copper prices on the London Metals Exchange  that a single LME trader, perhaps employed by investment bank JP Morgan, reportedly holds 80-90% of all the copper sitting in that exchange’s warehouses! According to the New York Times, that’s copper worth some $3 billion in current prices and approximately half the world’s entire exchange-listed supply.

But before we envoke the memory of Nelson Bunker Hunt and Silver Thursday, back in March 1980, I should point out that the situation in copper is not exceptional. The NYT article continues to state that a single trader holds as much as 90% of the LME’s aluminium stockpiles and that individual traders also hold between 50% and 80% of warehoused metals in the nickel, zinc and aluminium alloy markets. In tin, meanwhile, a single firm owns between 40% and 50% of stockpiles.

Then there’s that (in)famous story of “Choc Finger” the moniker given to London hedge fund manager Anthony Ward when he took delivery of 240,100 tonnes of cocoa, approximately 15% of global stocks and a quarter of estimated European stocks at the time. Though while this may all seem faintly amusing for chocolate-gorging Westerners at Christmastide, it’s a crime verging on East India Company proportions when one considers how vital cocoa is to the economies of West Africa, where 75% of supply is grown. And it is particularly galling when one considers that the Ivory Coast, cocoa’s biggest producer, is being effectively destabilised by such corporate mercantilism and now faces risk of civil war.
Indeed, this northern winter, I fear, will not just be remembered for snowfalls on the Heathrow Airport and freezing days in the usually mild city of Hong Kong, but for widespread commodity price discontent. Not only are food prices getting out of control in China and elsewhere, as we all by now are too aware, but factors are building for particularly expensive fuel prices too. The West Texas Intermediate is already trading above $90 a barrel and with freezing winters in the East and West that trend is set to continue.
More worrying, however, are two black swans that are vigorously beating their wings. Returning to the Dark Continent, discord is fomenting in Sudan, which awaits a referendum on Southern secession on January 9. As part of the 2005 Naivasha peace accord between Khartoum and the Sudan People’s Liberation Movement of the South, this ballot has been a long time coming, but as observers of the situation are well aware, threats of violence from the North, backed by an increasingly bellicose Chinese military-industrial machine, were never taken so seriously until now. And considering that Sudan now produces 500,000 barrels of crude per day, most of it in the South and in border lands like Abyei, you can expect plenty of collateral damage on the markets.
You can also expect plenty of spill-over and power vacuum issues, if and when conflict re-erupts in the region. Not only is Sudan’s west – the Darfur region – on continual tenterhooks, with only a hybrid UN-African Union peacekeeping force standing between uneasy peace and certain anarchy, but Sudan faces growing Islamism in its under-developed eastern regions and has long been feared as a terrorism safe-haven, exporting its horrors all across the oil-rich region. Sudan’s neighbourhood isn’t exactly the most glamorous either. Counting Eritrea, Ethiopia, Uganda, Congo, Libya and the Central African Republic alongside its borders, another civil conflict within Sydan poses quantum risk of contagious instability in an already contagiously unstable region. No wonder analysts including Jamestown Foundation’s brilliant Andrew McGregor call it the “Triangle of Death”.  

Further to the north, politics are also making life uncertain for another key geo-petro chokepoint. Last night it was announced that seven candidates who ran against President Alexander Lukashenko in Belarus’s recent elections face up to 15 years’ prison following violent protests in the former Soviet state. Repression and dictatorship in this poor man of Europe is nothing new, but this latest crackdown by the always-unpredictable Lukashenko, referred to informally as bats’ka, or “daddy”, comes at a time when Belarus has already enough problems on its plate, having angered Russia with signs of EU rapprochement and pursued a series of increasingly erratic policies. Over in Russia, meanwhile, Putin and Medvedev are in a race to prove who is tougher on petro-diplomacy with their troublesome former satellites. 

As described in an excellent overview by website East European Gas Analysis, Belarus has long been used as a pressure point by carbon-rich Russia on the EU, with six major gas pipelines running through the country and a series of regionally important oil refining facilities, chiefly supplied by Russia. Poland, Germany and Lithuania are particularly vulnerable to Belarus’s erstwhile status as a transit hub, which Moscow has switched off several times in recent years. And although Belarus’s oil processing industry is seeking diversification of upstream sources – thanks to deals with fellow authoritarian states Venezuela and Azerbaijan – it is still highly dependent on Russia. As again reported by the Jamestown Foundation, almost all of Belarus’s 22 million tons of processed crude are important from Russia via the Druzhaba pipeline, which runs from Almetyevsk in Tatarstan to branches in Hungary, Slovakia and Poland and thence to Germany, Austria and Italy. Ironically, Druzhaba is also known as the friendship pipeline.

Add into the mix a recent rise in Russian nationalism, thanks in part to riots following the death of football fan Yegor Sviridov after a brawl with Caucasian gang members. As the appropriately named Maksim Kalashnikov of commentary site Forum MSK says, the Russian multicultural federation of republics could be at the “beginning of the end” if present trends are anything to go by. If Russia moves from pan-Eurasian petro state to neo-racist demographic morass expect more stories like this from the Financial Times or this from the Observer and less reliable petroleum supply in Europe and Central Asia.

And where could all this leave us besides a winter of discontent? A summer of stagflation, that’s what: my top “surprise” forecast for a happy 2011. Stagflation, as the economic tomes will tell you, is a relatively recent phenomenon, seen in the 1970s when high supply-side commodity prices led to inflation despite stagnant economic growth, yet a non-monetarist worldview will tell you that it’s not all that unusual. Weimar Germany was a classic case of stagflation, though this might be better described as hyper-stagflation. The recent experience of Australia could be described, also, as stagflation-lite, where depending on your measure of consumer and producer price inflation, costs have been rising much higher than revenue notwithstanding a process of continued deleverage in the business and household sector, especially in the non-mining states of Victoria and New South Wales (see David Llewellyn Smith for more on this recent case of ‘Dutch Disease’). The threat of stagflation too was the ultimate reason for The Bernank’s second round of Quantitative Easing, discussed frequently in this column before.
Unless Europe and America can grow out of their respective balance sheet recessions, stagflation in 2011 seems more and more likely. And unless something is done to combat excessive commodity speculation and fixed asset mal-investment, we’re likely to see the 1930s redux; with all the militaristic consequences.
It is the prospect of stagflation in China, in particular, that keeps me worried and up at night, much to the chagrin of Mrs Bear Feller. China, while not stagnant due to an exceptionally accommodative monetary policy and fiscal project of growth-via-construction-at-all-costs, is facing that ‘flation side of the coin in dangerous proportions. It cannot raise interest rates to combat this, as the always-insightful Michael Pettis has pointed out before, due to the Yuan’s position as a US Dollar-pegged hot money destination. And it cannot stop its construction binge, notwithstanding the scores of empty cities and millions of empty homes it has built, due to not only cadre self-interest, but the uneasy, unwritten post-Tiananmen compact between Communist Party and citizenry where democratic rights are loaned for economic growth.
But, as anyone with half a brain can tell, this isn’t sustainable and as we’ve seen with Greece and now Ireland, abdicating responsible, independent monetary policy in exchange for wonton margin- and maintenance-unaware short-term growth is a recipe for disaster. Lest the Chinese people, who earn per capita little more than $6,000 a year, find that food, fuel and footwear budgets exceed income, China will need to do something or it’ll have a revolution on its hands. The problems of the European Monetary Union, by contrast, look like a stroll in the park compared to the Sino-American mutual monetary squirrel grip.
With geopolitical risks to sub-$100 oil supply, will cost inflation become so great in China that it tips the economy (and ipso facto, the world) into stagflation? Will securitisation and exchange centralisation of essential commodities exacerbate a medium-term economic process into a intraday financial disaster? Will rational price discovery forever be a thing of our economic past, like manorial tenure, rai stones and, for what it’s worth, sound money?

Will 2011 be remembered as the year that the second wheel of the Alan Greenspan jalopy – China – fell off? Will the Chimerican consumption-export-money-supply axis of evil, established during the great moderation, run out of steam? Will money managers reassess the ability of Chinese firms, like sub-prime mortgage writers, to grow manna out of the denuded and desertified soils of an inherently unsustainable economy, and thus let the house of cards fall? And does it even matter? For as suggested by fund manager Mike Mangan in yesterday’s Eureka Report, China’s economy may be merely a tool used to ensure sovereign prestige and thus political survival. As Lenin, who started it all, said: “the capitalists will sell us the rope with which we will hang them.”
Well, if you’ve got a cent invested in the markets it all matters to you and as the New Year unkindly unfolds stagflation could be the economic denouement we’ve all been waiting for.
Season’s greetings.