Surging Commodity Prices Could Crush the Stock Market Recovery

By: MoneyWeek

Stock markets around the world had another rip-roaring day yesterday.

The S&P 500 traded above 1,000 for the first time since November. The FTSE 100 hit its highest point since October.

Everyone cheered the return of banking profits and banking bonuses, as money flooded out of “safe haven” assets and into riskier plays such as commodities and emerging markets.

We’ve seen this before. And it didn’t have a happy ending last time...

Why we are so bearish about the recovery rally

Why are we so bearish about the current rally? It’s a question that was put to me in an email yesterday and it’s a good one. So let me explain.

The global economy was always going to rebound at some point. This recession has already been massive, although it may not feel like that to anyone who has managed to hold on to their job. In the US, it’s easily been the worst since the Great Depression. But even the Depression wasn’t a bottomless pit – you had recovery and relapse all the way through that.

However, we haven’t fixed any of the problems that led to the financial pile-up in the first place. Our route out of trouble has been exactly the same as it’s always been. Pour more cheap money on the problem and reward the banks for failure. Quantitative easing, or money printing, or whatever you want to call it, is just a turbo-charged version of the “Greenspan put”.

Let’s remind ourselves of why this collapse happened in the first place. It’s really not complicated, though many would have you think it is. Banks were allowed to operate with impunity in a consequence-free environment. On the one hand, they weren’t effectively regulated. That would be fine, but for one thing. There was an implicit promise that they couldn’t fail either. Alan Greenspan had already amply demonstrated throughout his time as head of the Federal Reserve that he would do anything in his power to bail out Wall Street.

It’s exactly like being taken to a casino, given a never-ending supply of chips, and being told that you can keep the profits and the house will take care of the losses. The result was that banks took the biggest bets they could, and with the aid of the credit ratings agencies, made a lot of money by selling their clients high-risk products masquerading as low-risk ones.

None of that has changed. Bank reform is becoming bogged down in the mud of reports and committees on both sides of the Atlantic and meanwhile, the champagne is flowing and the guaranteed bonuses (an oxymoron if ever there was one) are back.

So what, you might say. That’s the way the system works. Banks pay plenty of taxes, and we all benefit from the trickle-down effect, everyone from celebrity chefs to Polish nannies.

The current system doesn't work

That’d be fine – if it did work. Our problem is that it doesn’t work. All cheap money does is blow up fresh bubbles, which then explode and cause terrible damage. The tech bubble was bad, and the property bubble was far, far worse. Remember, at one point last year people were genuinely afraid that cash-points would stop paying out and we’d have riots in the streets. If we don’t deal with this – and it looks like we’re not going to – then it’ll happen again.

Only this time, our economies are even more fragile than they were then.

If banks are too important to be allowed to fail, then we have to split out the function that makes them too important to fail – the retail banking function, basically – and regulate it to within an inch of its life, like the utility companies.

And this isn’t just about the banks. If central banks are going to persist with the notion that they can somehow control the economy, then they’re going to have to start paying attention to asset bubbles too, rather than washing their hands of all responsibility for them as the Greenspan Fed did.

But it’s unlikely that any of this will happen now. As the ‘recovery’ continues, any impetus for reform will vanish. And politicians will be too scared of withdrawing support from the financial sector in case it upsets the apple cart and ruins their chances of getting voted back in. So we’ll stick with the current system until it blows up in our faces again.

Rising commodity prices are bad news for the economy

Already we’re seeing a “recovery” bubble building. I said yesterday that the current markets felt uncomfortably like early 2007, when everything was rising and no one could find any reason for it to stop. In today’s Financial Times, John Authers compares it to a different time period – last summer. “The rally in risky assets is painfully reminiscent of the behaviour that preceded last year’s crash. Then, as now, commodities, emerging market equities and high-yielding currencies validated and supported each other higher.”

Meanwhile, the dollar has been taking a kicking as investors abandon “safe haven” assets. In fact, the greenback has “now given up half of its gains since it hit bottom last July, just as the bubble of commodities and emerging markets was about to burst. Then, as now, the advance of relatively risky assets has been uniform, and undiscriminating.”

Whatever the reason behind rising commodity prices – cheap money, “stimulus” packages, or demand from China and India – they are bad news for a fragile global economy. Higher raw materials prices hit profits and raise costs for consumers just as they need the money most. But they also put pressure on central banks to raise interest rates to combat inflation. With cheap money the main thing keeping the global economy afloat right now, any hint of tightening could bring the rally to a very rapid end indeed.

By John Stepek for Money Morning , the free daily investment email from MoneyWeek magazine .

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