Speaking of extremes, the market seems to be full of them today…
(Don's Note about Copper): It is probably the single best economic indicator. Since it is used in virtually all manufacturing, if it is in demand, the economy is growing, if not the economy is contracting
Copper is one of the most important metals in the world… It's in everything from cars and condos to plumbing and telephone lines. China consumes around 40% of the world's copper… And with growth slowing, demand for China is falling. A slowing European economy is also weighing on copper prices.
As such, copper hit its lowest point since mid-2010 at less than $2.90 per pound. The metal is down more than 15% in 2014 and more than 10% in the last six months alone…
Likewise, iron ore – the core ingredient for steel – has been crushed.
Like copper, iron ore is an important industrial metal. Slowing global demand has sent the commodity down nearly 50% this year… making it the worst-performing major commodity of 2014.
Worse for iron ore, the major producers like BHP Billiton and Rio Tinto are expanding production to "make it up on volume" and force smaller, less-competitive mines to close. Iron ore hit a five-and-a-half-year low last week.
And of course, oil has gotten crushed, down 45% this year to less than $54 per barrel – also a five-and-a-half-year low. We wrote more about oil's decline in the December 10 Digest.
In tomorrow's Digest, we'll show why Extreme Value editor Dan Ferris is super-bullish on commodities today… and how buying today can lead to even larger gains in the future.
Falling commodities and a stronger dollar have also sent emerging markets to extremely low levels. Russia – which, in addition to relying heavily on energy prices, is battling with Ukraine – is getting slammed…
Sanctions based on Russia's involvement in the Ukraine crisis caused Russian companies trouble in securing financing from abroad, sending $100 billion flooding out of the Russian economy, according to Reuters.
But the even bigger problem for Russia is that Brent crude oil – the international benchmark – is down nearly 50% over the past six months. As Global Contrarian editor Kim Iskyan explained in the December issue…
Around 25% of Russia's GDP is from the energy sector. About three-quarters of its export revenues are from oil and gas. The Russian government has talked for years about economic diversification, but the government hasn't created the business and investment conditions to really make it happen.
These events triggered a rapid drop in the ruble, Russia's currency. The ruble was trading in a range of 30-35 rubles to one U.S. dollar at the beginning of the year. It spiked all the way to 80 rubles to the dollar in mid-December.
The rapid drop in value caused the Russian Central Bank (RCB) to take measures to halt the ruble's slide. The RCB raised interest rates to a huge 17% in an effort to stabilize the country's currency. As a result, the dollar-to-ruble ratio sits at around 59.
The ruble's rapid devaluation caused Russian citizens to quickly withdraw money from banks and put their money into safer currencies like the U.S. dollar. That put huge pressure on Russia's banking system, which, due to sanctions, can't roll the debt over and must redeem it as it comes due.
As a result, the RCB was forced to intervene several times to protect the value of the ruble and hold together Russia's banking system. On December 19, Russia's parliament passed a bill to provide $16.5 billion to recapitalize the banking system.
Last Friday, the government was forced to lend $1.9 billion to bail out Russian bank Trust Bank… preventing a full-scale banking collapse (for now). That was three times the amount of money originally requested… And the cost of bailouts is rising. Two other Russian banks are expected to require $5.9 billion in bailout money.
Finance Minister Anton Siluanov said the government will also boost capital to state-owned banks VTB and Gazprombank. According to Sergey Voronenko, a director at ratings agency Standard & Poor's, "Banks need to provide finance to companies that are under sanctions or are unable to go to capital markets." According to Voronenko, banks and large corporations need to refinance or repay $100 billion in foreign debt in 2015.
The interbank lending rate – the short-term rate at which banks lend to each other – is now at 18%. Russian banks are wary of lending to each other out of fear that they won't get their money back… further intensifying banks' dependence on government handouts.
According to Kim…
After one bank fails, the risk increases that others will, too. When banks stop trusting each other, the interbank lending system freezes. It's like the oil in the engine of the entire banking sector. When it breaks down, it sparks more defaults.
Then the central bank has to step in with more money to ward off a total banking system meltdown. This is what happened during the last two big financial crises in Russia in 1998 and in 2008… So something similar will likely unfold this time.
So far, the Russian central bank has used $110 billion in foreign currency reserves to help stabilize the ruble. The currency's weakness will lead to higher costs of imports and higher levels of inflation in Russia. Russia's Ministry of Economy expects inflation to reach as high as 10% next year.
The Russian government said gross domestic product (GDP) shrank 0.05% in November and forecasts a 4% drop in GDP next year… a huge contraction. We can see this fear reflected in Russian stock prices. Russia's stock market is down 45% this year and nearly 70% since 2008. As Kim explained…
Russian shares are now extremely cheap – trading at a price-to-earnings (P/E) ratio of 4.6, compared with the market's five-year P/E average of 6.1. Right now, Russian shares are trading at a 60% discount to emerging markets.
Russian stocks are undoubtedly cheap… But we believe the trouble in Russia is just getting started. As Russian economist Dmitry Polevoy told Reuters…
With the current oil price, we expect things to get worse. There is no cause for optimism… The damage to the banking system and consumer sentiment will take a long time to repair.
Don's Note: Russia must remain stable or the destabilizing effect on that side of the world is huge. Another point is how Russia might get some quick cash. One of their major exports is weapons, and they sell a lot of those. But as this crisis for them deepens, it begs the question as to whether they might be willing to sell some of their most prized weaponry...Things with plutonium for example...
