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The Quadrillion Dollar Question: Deflation or Inflation?

Is it deflation, stagflation, or hyperinflation, in the current global economic crisis? That's the quadrillion-dollar question investors must get right. This article will answer that big question but it is also meant to be a sequel to part one and part two of the serial articles talking about valuations of physical and non-physical assets as well as currencies. Please read the first two parts of the articles if you have not. It's critical to understand valuation of commodities and currencies first, before the big question of inflation versus deflation.

Recently, as the credit crisis unfolds, we saw the worst commodity price plummet in history, while the U.S. dollar index rallied amid the unfolding financial crisis. Many people wonder that the commodity bull market has ended as the global economy enters a recession. Their reasoning is that due to credit squeeze, people cut back on spending, as they could not borrow any more.

Such notion is wrong. While people looked at the weaker demand side, they failed to notice the destruction on the supply side! On the consumer spending side, people are NOT cutting back in TOTAL spending. Actually, people are squeezed to spend every dollar from their monthly income, just to keep heads above water. More and more people are living from paycheck to paycheck, meaning they have to spend every dollar they take in, and have nothing to save. They might be forced to cut spending on some specific items and spending more money on other things. The total spending in dollar terms is up.

Recent commodity price plummet is NOT a fundamental change in the supply/demand relationship. Fundamentals do not change abruptly in just three months.

The real reason is that the global credit crunch squeezes out inventories in the supply chains, causing a temporary and false supply surge, depressing the price. Such price depressing effect is only momentary. It will be corrected violently to the bullish side once the false surge of supply is exhausted and the effect of supply destruction becomes evident.

In any commodity market, besides the supply side and the demand side, there is a long supply chain connecting the supply and the demand. In different parts of the supply chain, there are sizeable stockpiles of the materials. Under normal supply, the stockpiles at different parts of the supply chain will buffer out supply disruptions and ease out price shocks. That's why when a commodity is in adequate and abundant supply, the price will be flat.

However, stockpiling materials requires operational capitals. Oftentimes money tied up in inventories is credit provided by banks, in the form of so-called commercial papers. Things work fine if the credit market is healthy and adequately funded.

Unfortunately, in a credit crunch, borrowing money is expensive or virtually impossible even for good businesses. Faced with a liquidity squeeze, businesses must raise cash for operational needs or to merely service debts. That means selling off inventories and cut spending in purchase of raw materials and equipment. When producers cut spending in productive activities, the supply destruction is in the pipelines!

Not only corporations are selling, hedge funds invested in commodities are also selling like there is no tomorrow. Every one is liquidating everything to raise cash and stick the money in safes. That is absolutely foolish! While governments around the world are printing astronomical amounts of money out of thin air, people are hoarding the funny papers in their pillows. We are in the making of a Weimar Republic on a planetary scale, and you hoard the fiat money?

When businesses at all levels suddenly sell off their inventories and at the same time halted purchase of new feedstock materials, prices are depressed prompting more sell offs. This leads to the false illusion of supply surplus, while hiding the fact that production of further supply is being suffocated. It's an extremely dangerous situation, as it could lead to a sudden onset of supply disruptions just as every one cheers at cheaper prices, without realizing that the supply chains have been squeezed empty.

My wife told me the best sales always happen right before a store goes out of business! When you go shopping this weekend and enjoy the lowest prices you haven't seen in a long while, you'd better ask the manager when will the next delivery truck arrive, or will it arrive at all! It's Economics 101 - all businesses are for profit. No one can operate at loss sustainable.

What do you expect when the supply chain stockpiles are depleted? There is no longer a buffer to absorb supply disruption and price shock. The market will suddenly discover that the supply has dried up. Therefore, the price will rally violently, in an extreme volatile way. That is what I predict will happen in all commodities in the coming weeks, including oil, food grains, and metals.

The market of platinum and palladium metal [PGM] is probably a good case study. About half of these metals are used in making the catalytic converters on vehicles. To reduce the risk of price volatility and supply disruptions, automakers normally maintain a stockpile of PGM metals worth about 6 months to one year's consumption. Jack Lifton from Resource Investors described a very interesting case when one man's attempt to modify that inventory level caused dramatic reaction in the tightly traded rhodium and platinum market.

I am a big fan of palladium and platinum investment due to these metals' bullish prospects. After the headline news of South African electricity crisis in early January caused the platinum and palladium prices to shoot up, they stayed at the relative high level until the end of June. And then, at the onset of global financial crisis, they plummeted in a free fall fashion, all the while South Africa's PGM production continue to suffer from tight electricity supply. What gives? Who is selling? Every metals analyst is puzzled by the mind-boggling fall of platinum and palladium.

The Big Three U.S. automakers, General Motors (GM), Ford (F) and Chrysler are facing a severe liquidity squeeze. They have been aggressively reducing inventory levels for months. When you are in a liquidity crisis, you sell whatever asset you can sell quickly to raise cash. The most liquid asset, of course, is the platinum and palladium precious metal stockpile.

In the narrow platinum and palladium spot market, when inventories from automakers were sold out, it creates a lot of downward pressure. If industry users are selling, speculative hedge funds will be selling as well. The only buyers therefore must be the value-based long-term investors. A recent Resource Investor article by Nathan Becker also provided an explanation that hedge funds have to sell their precious metal hoardings due to liquidity squeeze.

I agree with most of what Nathan Becker has to say, but I must point out that he only considered the demand side and failed to recognize the damage that low metal prices may inflict on the supply side. No one can produce metals at heavy loss sustainable. Businesses must scale back production or shut down, if they cannot make a profit. Anglo Platinum (AAUK) is currently producing at an average cost of $1250 per ounce basket PGM metal (60% of Pt, 33% of Pd and 7% Rh) while the current market price of the PGM basket is only $778 per ounce. It's only a matter of time before South African producers must start to reduce production if the prices do not improve to profitable level soon.

Last week's market plummet creates one of the rarest buying opportunities in our times for savvy investors with cash onhand ready to buy. How often do you get to go to an out of business sale and pick up things at prices far below their cost? Nickel is on out of business sale, copper is on out of business sale, grains like wheat, corn and rice are all suddenly on nose bleeding out of business sales. Grab them while you can. It may not be there tomorrow.

Do you think mining companies and farmers can continue to sell you nickel at $5.00 a pound, wheat at $5.53 per bushel, corn at $3.84 per bushel, and expect to continue the business at all selling things well below cost? It's the same out of business sale like your wife told you!

The absolute best out of business sale is palladium, metal of the 21st century, currently at $185/ounce bid. Gold mines are everywhere, silver is mined everywhere. But only four places in the world produce significant amounts of platinum and palladium: Norilsk Nickel (NILSY.PK) in Russia; the Bushweld Complex in South Africa; Stillwater Mining (SWC) in USA; and North American Palladium (PAL) in Canada.

Not one of the four palladium producers is operating at a profit at current prices of nickel, platinum and palladium. They must each or together decide to slash production to boost metal prices, or face eventual bankruptcy. Any of these four have enough leverage power to boost metal prices on their own, and I believe there will be strong will to do that, as no business wishes to operate at a loss if they have a choice.

That is reason enough for investors to purchase physical palladium at current price, as there is a virtual guarantee the price must go up to reflect real cost, regardless of industry demand. A good historic example of when auto industrial demand of PGM metals collapsed, but investment demand still pushed the metals to all time highs, together with gold and silver, is 1980.

Out of the four, Norilsk is in bad shape and is most likely to slash production, due to low nickel price. It now stands at $4.93 per pound versus the high of $25 per pound last year. There are also huge political pressures to shut the mine down to clean up the environmental catastrophe.

But South Africa is in a much worse shape as the Rand dropped nearly 20% in one day versus the U.S. dollar. When a country's currency drops 20% in a day, it's pretty much a broken and bankrupt country. The light of South Africa will go out, so will the light for that country's PGM mining industry. I previously pointed out that ESKOM, SA's electricity company, has to keep borrowing money and burn lowest quality trash to keep operations going. Now the global credit crunch means they have lost the ability to borrow. It's not going to be long before it all blows up.

South Africa blowing up means removal of 85% of the world's platinum and 35% of palladium supply! You cannot have a more bullish story than that, on any other commodities. Stillwater Mining, with its palladium sale protected by a hedge floor price well above current market, is the best to weather out current market and best to leverage the coming bull market in palladium and platinum.

The only other metal that is even close to the bullishness of palladium/platinum is the metal cobalt. There are strong and rapidly increasing industrial demands due to alternative energy applications, and due to the need of more drilling equipment in the oil/gas industry, and due to the metal's strategic importance in military applications. I wish to dedicate one article just to cobalt. But suffice to say for now I consider cobalt a better physical metal to buy than silver and it should appreciate at least 10 fold relative to silver. Like PGM metals, 90% of the world's cobalt supply is concentrated in one country, Congo, which has been at civil war for years and the conflict looks like flaring up again. So, the supply is vulnerable while the demand is strong and growing. That's a perfect making of a bull market.

The best cobalt play I found is a stock called OM Group (OMG) (Oh-My-God). It is currently a very decent buy at a ridiculously low valuation. If you know any other cobalt play, or know places other than BHP Billiton (BHP)'s Cobalt Open Sale that I can buy physical cobalt, tell me!

Now, back to the U.S. dollar. We are creating trillions of dollars out of a vacuum and throwing them into a black hole. Make no mistake; it is inherently hyper-inflational. The whole planet is facing a big dilemma today. Short term it is about liquidity preservation or die. A little bit longer term it is about valuation preservation or die. Hoarding fiat currency while new money is created out of thin air preserves liquidity but loses value. Hoarding physical assets preserves value but reduces your liquidity.

I think we will see a very sudden and abrupt switch from a false U.S. dollar rally caused by everyone hoarding cash, to a hyperinflation scenario where everyone wants to spend the cash as fast as possible. In physics, it's like a high pressure and high temperature phase transition. The credit will go straight from solid ice to rapidly expanding vapor, skipping the liquid phase altogether, blowing everything out. The phase change will come imminently and suddenly, so be prepared for it!

A few side notes: I called for shorting Coca Cola (KO) and Pepsi (PEP), now it looks like I was right. I called for selling coal stocks like Arch Coal Inc. (ACI), Alpha Natural Resources Inc. (ANR), Peabody Energy Corp. (BTU), CONSOL Energy Inc. (CNX), Foundation Coal Holdings Inc. (FCL), Fording Canadian Coal Trust (FDG), and James River Coal Company (JRCC) repeatedly since June 20 and I continue to make such calls as I see the U.S. coal market is now bearish. I can see JRCC drops to near $10 or even below. Continue to watch DryShips Inc. (DRYS), as it is a good indicator of the global economy.