Phew! Thank goodness that whole thing about toxic assets is over. Now we can get back to passively investing in stocks that only ever go up.

There is a serious case of denial coming from institutional investors and the financial media about what's ahead. Sure, it's tempting to think that because things have been so bad they won't get any worse. But what exactly emerged yesterday that changed the situation banks and investors face?

Not much, that we can tell. But that's because this is not a subjective crisis. Whether the situation has really improved does not depend on how you perceive a bank's balance sheet or a company's earnings. It depends on whether that balance sheet is actually healthy and the company can actually grow earnings.

But let's not quibble. The job of the Bear is to lure investors back in so he can smack them back down later. Frankly, the bear was gorging himself a bit anyway and getting a bit lazy.

Stocks were down on average about twenty percent in major Western markets. Consumer confidence levels were low and getting lower. The Bear needs fresh meat. And he can only get that if he can attract more investors back to the market. In you go!

The major economic news released yesterday is at odds with the way the market behaved. We're talking about the news from China that exports dropped 25.7% in February. Imports were down 24.1%.

If China makes and the world takes, China is making less because the world is taking less. And of course, China takes from Australia to make for the rest of the world. If China is making less, it will take fewer Australian resources.

There is a raft of data that need sorting, though. First, fixed asset investment in China actually grew by 25%. Fixed asset investment could be roads, bridges, and buildings-the sort of investment that needs copper, nickel, zinc, coal and iron ore. Or it could be commercial real estate-the kind of shovel-ready government busy work that doesn't lead to any bottoming in commodity prices ore sustained resource demand from China.

Also comes the news from Japan on thermal coal negotiations between Chinese utilities and major coal sellers Rio Tinto and Xstrata. It now looks like thermal coal prices for 2009-2001 are going to come in around US$70-72 per tonne, according to Matthew Stevens in today's Australian.

That's a 44% decline from last year's price of around $125 per tonne. But it's still higher than the spot price of US$60. And it's still 25% higher than the price for 2007-2008. So, as big as the percentage decline is, it's coming off a large base.

That doesn't make coal stocks an instant buy. But here is a clear difference between the extractive resource industries and the financial industries. Prices are responding to changes in demand. Resource producers are not being bailed out or directly subsidised by the government. There is a lot more transparency about what's going on the industry.

What's missing, to use a word analysts love, is visibility. No one can see that far ahead for the economy. This makes reliable price forecasts for commodities difficult to make, which makes earnings estimates hard to make, which makes valuations difficult to make.

Our suggestion? Keep it simple. Focus on companies with cash, little debt, and world class ore bodies (poly metallic for metals miners).

It's a bit nauseating to be told over and over the problem is confidence. We suspect this is a political tactic. Blame the credit bubble and resultant insolvency of the financial system on confidence! Then, give the people a dose of free money, which may numb the pain of the approaching second freight train to hit them.

That freight train is the credit market not responding to increased central bank liquidity in the desired fashion. "Libor's creep shows credit markets at risk of seizure," reports Bloomberg. "The cost of borrowing in dollars is rising as the global recession deepens and central bank efforts to prop up the financial system fail to prevent a growing number of banks from requiring government bailouts."

It is still a bear market in trust within the financial system. Central Banks are more than willing to lend to banks. But banks are hoarding reserves. The only upside of this is that banks haven't relent expanded reserves into the real economy. That would be the engine of inflation.

The downside is that increased bank reserves don't do much to improve the value of the assets on bank balance sheets. To address that, expect G20 finance ministers meeting in London to make a lot of noise about mark-to-market accounting. They want to change the rules so that firms don't have to constantly revalue assets to their current market value.

In any event, the action in the credit markets-Vikram Pandit's ray of sunshine not withstanding-suggest that the financial system is just as vulnerable to trillions more in losses and failures now as it was six months ago. Not a single thing has changed in the last few days to alter that fact.

Nonetheless, the market may rally anyway. The G20's political leaders meet in London in early March. This could be a world-historic event, but not for any positive reasons. We are pretty sure the leaders of the G20 nations are not going to gather together to ratify and sign an agreement that solves all the problems.

On the other hand, all their quarrels and divergent national interests will be on full display for investors and savers the world over. Investors are going to realise this problem is bigger than even big government's ability to contain it. What happens after that should be interesting...

Dan Denning
for The Daily Reckoning Australia

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Far East Asian economies built to export consumer goods to America and Europe are just now feeling the brunt of the consumer strike unfolding in the developed world. Savings rates are up. Credit card use is down. Exporters have too many goods and too few buyers.

"Adding to the country's [South Korea's] difficulties," the Journal reports, "is that exports to China have fallen more quickly than the overall rate in recent months. A sizable portion of South Korea's exports to China are partly completed televisions, cell phones and cars, which are finished in Chinese factories and exported to other countries."

There is trouble in Singapore, too. The Times of London reports that, "Singapore - the world's busiest port by tonnage handled and the home of some of the world's largest shipping companies - is already feeling the pain of an alarming slump in global trade." The port is becoming a giant parking lot for empty freighters with no commerce to conduct.

Rob Parenteau, who's taken over the Richebacher Letter in the States, says that Asia is in danger of becoming the next Detroit. Or if we were to put in the form of a question, what if an entire region's economy ramped up to produce goods for people who couldn't afford to buy them any longer? You'd probably get a harbour full of ships waiting off shore, as the image from Google Maps shows below.

All those tiny dots are ships waiting to load goods and take them to a retail outlet near you. They could be waiting awhile. According to the Times, "With the credit crunch still affecting trade finance and the demand for Asian manufactured goods in acute decline, hundreds of container and dry-bulk ships now sit unneeded and at anchor outside Singapore. The stagnation, say brokers, is matched onshore.

By the looks of the picture below-admittedly we don't know how recently it was taken-things are looking pretty crowded on shore. Too many goods, too few buyers.

There is no shortage of productive capacity, that's for sure. But that could be problem, especially for China. All those goods with no place to call home came from factories. Many of those factories were (and still are) in China. And the Chinese working in those factories-many of whom moved off the farm and into the city-are not especially happy with the current state of affairs.

And we are not talking a small number of people here. We are talking an entire Australia of workers who migrated to find urban factory work. Many have now returned from the Chinese New Year Holiday, only to find out they don't have a job.

There is this from today's Asian Wall Street Journal: Chen Xiwen, who heads the Chinese Communist Party's office on rural policy, said Monday that about 20 million migrant workers -- nearly a sixth of the total -- lost their jobs in recent months. That number, the first official estimate, underscores the government's challenge in maintaining employment and avoiding unrest.

"For those migrant workers who have lost their jobs, what are they going to do for income when they return to their village? How are they going to manage? This is a new factor affecting social stability this year," Mr. Chen said at a news conference in Beijing.

You can say that again. The Far Eastern Economic Review calls it, "The Coming Crack Up of the China Model." More on the origins of that phrase "Crack Up" in a moment. But what is the China model? It's the model that keeps the Chinese currency artificially cheep against the U.S. dollar in order to give Chinese manufacturers-already armed with a distinct advantage in low-cost labour-a global competitive edge.

It worked, at least in the sense that Chinese manufacturing boomed in the last ten years. But the model also failed to produce substantial real wage growth for Chinese workers. This wage growth, and the expansion of consumer credit, would allow domestic demand to generate more economic growth in China that exports alone.

What's more, if and when China ever allowed its currency to appreciate against the U.S. dollar, it would instantly increase domestic purchasing power. It would also instantly wipe out a good deal of the value of China's massive U.S. Treasury bonds and dollar-denominated reserves. This is what's known as a "pickle."

Take a huge contraction in global trade. Add one part corruption. And two parts growing income inequality. Mix together vigorously and what do you get? Political instability.

"Violent unrest rocks China as crisis hits," again reports the Times. "In the southern province of Guangdong, three jobless men detonated a bomb in a business travellers' hotel in the commercial city of Foshan to extort money from the management. On January 15 there were pitched battles at a textile factory in the nearby city of Dongguan between striking workers and security guards."

"On January 16, about 100 auxiliary security officers, known in Chinese as Bao An, staged a street protest after they were sacked by a state-owned firm in Shenzhen, a boom town adjoining Hong Kong. About 1,000 teachers confronted police on the streets of Yangjiang on January 5, demanding their wages from the local authorities."

"In one sample week in late December, 2,000 workers at a Singapore-owned firm in Shanghai held a wage protest and thousands of farmers staged 12 days of mass demonstrations over economic problems outside the city. All along the coast, angry workers besieged labour offices and government buildings after dozens of factories closed their doors without paying wages and their owners went back to Hong Kong, Taiwan or South Korea."

In the West, a dysfunctional financial system with many major banks insolvent. In the East, a dysfunctional economic model whose breakdown is leading to mass unemployment and social instability. And here in Australia?

Well, yesterday the government said the fall in revenues from the global black swan dive will lead to a $115 billion decline in government tax takings (what the government likes to call revenue). That's a pretty big hole in the budget. It suggests that we've entered an era of regular government budget deficits and, if the RBA holds to form, lower interest rates.

These lower rates, and not just in Australia mind you, represent the coming devaluation of paper money against real goods. We wrote about this in the January issue of Diggers and Drillers. And in today's essay section, you can read about what the devaluation means for one particular tangible good, namely gold. The Swarm Trader Gabriel Andre shows you the inter-market relationship between the Aussie dollar, the U.S. dollar, and gold. Check the essay section below.

The phrase "crack-up boom" first appears, as far as we can tell, on page 427 of Human Action, by the great Austrian economist Ludwig von Mises. Mises was writing about how changing expectations for purchasing power eventually affect people's real-world economic decisions. Once people see trillions in new money coming down the pipeline, they flee for higher, firmer ground.

"Once public opinion is convinced that the increase in the quantity of money will continue and never come to an end," he writes, "and that consequently the prices of all commodities and services will not cease to rise, everybody becomes eager to buy as much as possible and to restrict his cash holding to a minimum size."

"For under these circumstances the regular costs incurred by holding cash are increased by the losses caused by the progressive fall in purchasing power. The advantage of holding cash must be paid for by sacrifices which are deemed unreasonably burdensome. This phenomenon was, in the great European inflations of the 'twenties, called flight into real goods (Flucht in die Sachwerte) or crack-up boom (Katastrophenhausse)."

It may seem odd to ring the alarm about an inflationary crack-up boom at just the time when policy makers are publicly fretting about deflation. But deflation as such is not the bogeyman. You can have deflation when you have a constant money supply coupled with increases in productivity. Prices fall.

The deflation in asset markets, on the other hand, is what policy makers are worried about. But as Doug Noland points out in a must read update at PrudentBear.com, the "deflation" in financial assets is itself a result of a system of Wall Street Finance that is now in tatters and failed to produce anything of real economic value.

"The financial sector is a black hole right now," Doug writes. "With myriad assets Bubbles having burst, there is an enormous amount of debt today insufficiently backed by asset values. At the same time, there is a tremendous amount of debt backed by households, businesses, municipalities and our federal government. In terminology I have used in the past, the Credit Bubble has left both the Financial Sphere and the Economic Sphere grossly inflated. Total system debt has been severely impaired."

"There is very real risk at this point that policymaking is about to set course for bankrupting the country," Doug continues. "The pundits are out there suggesting trillion dollar economic stimulus; trillions for the banks; hundreds of billions to support the securitization markets; and hundreds of billions more for households, businesses, and municipalities. There is a current need for 'Trillions' and future needs for 'Trillions' more. Once the Trillions start to flow there will be no easy way to end them."

We have on our hands a financial system that has used cheap credit and leverage to erect a systemically destabilising class of financial assets backed by debt. Our policy makers are trying to safe that system through a policy of deliberate inflation. And in the meantime, they are blaming "extreme capitalism," when the real culprit is perverted capitalism with its theory of unsound fiat money.

But we won't get into that again today. How about some reader mail? We only have time for one, because it is so long. But as soon as we read it last night, we knew we had to reprint it.

I need to say to you the following about your ideas as expressed in today's article re Rudd's opinions about the capitalist system.

Your ideological opinions are not superior or inferior to any other ideologue. They are simply different.

The world needs different opinions and ideas to become a better place. The capitalist ideas have prevailed over a very long time and the result is many minor failures as well as catastrophic failures the likes of those in the 1929/30 and the one we are experiencing today. As well as many positive other outcomes.

If one considers the economy to be a an airplane in flight that fails every about 60 years or so one would attempt to address such failures and to prevent them at any cost. What Rudd is telling us is exactly that. We need to refine the capitalist system to prevent catastrophic consequences. This will be at some cost and the balance between gains and losses is our challenge. There is no sense in having responsibility without accountability. Accountability is about risk prevention.

The dog eat dog mentality of extreme capitalism is more dangerous and immoral than any Marxist ideal that any one can present. It is a fact that extremism is anti progressive and antihumanistic. Extreme capitalism is no better in any way than extreme socialism, but, a blend of both worlds is the best for humanity.

The gaff you have presented in your article are extreme ideological here say garbage without any relevance to logic or wisdom.

How can an audience take you seriously when such a blatant disregard for sound judgement is presented by you.

So get your act together stay with commentary on financial issues that are moral and within the law. You are not qualified to make commentary on ideological connections that are too far removed from human principles of fairness, social responsibility, the greatest good for the greatest number and meaningful support for diversity of ideas.

I have read the book suggested "Mobs messiahs and the market". The book presents ideas of a distorted mind which has no basis on the scientific rationality and no sense of balance between human contributions and human failures. One should read about the fundamental mind set of a paranoid person first before reading this book in order to calibrate its worthiness in a world that is moving away from extremism. Extreme capitalism and extreme communism is evil. The world has known this for a long time hence the reason why The US has retained socialist policies to balance extreme capitalist ideals, hence why it is exercising socialist approaches to save capitalism.

Tell a self retiree that Capitalism should not be recalibrated after loosing 30% of their capital due to the behaviour of the bankers and other CEOs. Justify if you can why these financial gurus should not be brought to account for their cavalier style financial activities. If any one created a product that failed catastrophically they would be crucified by the legal system, yet capitalists are immune from accountability for financial disasters that were based on dishonesty.

Greed should never be allowed to dictate terms to humanity.

You may want to take stock of what Aristotle said about the extreme capitalist, I quote; These are the people who are slaves of greed and left unchecked to themselves they will injure themselves and everyone around them. After 2000 years we are witnessing this prediction many times over yet you advocate no need for recalibration of the system. What level of social intelligence is in play her I ask. Only individuals who are at the bottom of the Maslow hierarchy would think in such primitive ways that are far removed from the domain of wisdom.

A discussing article with out any basis in fact and wisdom.

Leo.

Discussing?

Discuss!

The above letter could go in a textbook for how to put the most logical fallacies in the shortest space possible. It really is remarkable, and in its own way, delightful. Appeal to authority...ad hominen attacks...false equivalence...it is a cornucopia of rhetorical devices. Really, our former rhetoric teacher would have been in raptures over what a "teaching moment," this is. All we can say is that if you really believe most of what you've written, you should probably unsubscribe to the DR immediately.

And by the way, we never said people shouldn't be punished if they've broken the law. Feel free to dispute what we've written. But at least read what we've said and criticize it accurately before ascending to the heights of "logic and wisdom." We're not saying we're automatically right. But of course our ideas are different. And we'd humbly argue they're better! That's what brains are for, to make judgements with.

How about one more letter?

Hi,

I know this is not a "write-back show" but i must get a little off my chest. it is hard to sit through your political bias and then be expected to hand over money to such one eyed, money hungry columnists with little fact behind the ranting and raving ( i would rather listen to sam kekovich get paid to talk about lamb). Don't get me wrong, i would normally consider myself on the right side of middle

I myself are a very tired of the Obama bandwagon but let's remember his predecessor on the other side of the political fence had little grasp of directing a nation and too in my opinion Mr Rudd's predecessor comes into this category as a back seat leader with no forsight. If only Mr Costello were the captain of Oz. For you to say that its bad for the ruling government to want to control what our influential young populus watch on TV or to question the merit of owning a car capable of doing 320km/hr, then you should be signing up as a student and reading some university texts on the definition of irresponsible.

Luke M.

For the record, we are biased against all politicians as a matter of principle. Markets work better than governments. But markets are just one institution that makes up a peaceful civil society. But by all means, let us know what university texts you think we ough to be reading.

Dan Denning
for The Daily Reckoning Australia

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So profitable in fact, that it could soon be Australia's single largest export industry.

That's why, since last November I have been recommending two companies to subscribers of Australian Small Cap Investigator that I am certain will profit from a new wave of investment in this industry.

The industry is liquefied natural gas (LNG).

It's hard to imagine that in a country as rich with resources as Australia, liquefied natural gas production is still a relatively new industry. Overseas, the production of LNG has been going on for years. Here in Australia you can count on one hand the number of LNG terminals that we have.

There are just the two. One is based in Karratha to service the North West Shelf off Western Australia. The other is a ConocoPhillips facility in Darwin.

But the investment I've tipped to ASI readers isn't in either of those areas. That's because all the new investment in LNG is happening in Queensland. And it is thanks to the investment that explorers have been making in coal seam gas (CSG). There are at least four new LNG terminals proposed for construction at the Queensland port town of Gladstone.

The first new entrant to produce is likely to be one of the eventual winners in this new industry. The company I like the most is scheduled to be the first to get its LNG terminal ready for business. In addition, its LNG plant will be operational at least three years in advance of the competition. That's a significant head start, or first-mover advantage if you will.

So, why is now the time to be getting into LNG? And why am I recommending it in ASI and not our resources newsletter Diggers & Drillers.

On-shore and unconventional LNG product (coal-seam-gas) is virtually an untapped market in Australia. The opportunity for large-volume, high-dollar exports is enormous. It falls clearly into the category of a high growth play, even though it's what you might call a traditional "extractive" industry.

Australian companies haven't entirely sorted out the economics of the LNG market, on both the cost and revenue side. But it's the revenue side that makes it so appealing for small cap punters. According to industry sources, if the LNG industry develops successfully in Australia it could generate $20 billion in total exports by 2017.

Let me put that in perspective. By the time the production of this product peaks in Australia it could quite easily be our most lucrative money-winning industry in the coming years. Right now, coal and iron ore between them churn out nearly $30 billion a year in exports. Those exports are the profit lifeblood of household Australian names like BHP, Rio Tinto, Fortescue, and Macarthur Coal.

You're talking an industry that could be bigger than the ones that built BHP and Rio. That's why I believe the single most exciting industry for smaller companies is energy.

But don't just take my word for it. Robin West, chairman of consultancy firm PFC Energy, told the Financial Times last year that "Australia's gas reserves are potentially the biggest OECD gas reserves left in the world and are not subject to the same political constraints as non-OECD reserves."

And because of the expected growth in demand for gas, along with the maturing of many overseas gas fields, international companies are eager to get a slice of the action here in Australia. Not wanting to miss out, domestic companies are also keen to exploit it.

You only have to look at some of the recent corporate transactions in this area. You'll remember the USD$5 billion investment by US energy giant ConocoPhillips in a CSG joint venture with Origin Energy. And UK based BG Group's $5.6 billion takeover offer for Queensland Gas.

That is why Australia has the potential to become a major and important global supplier of LNG, and that's why I have recommended ASI subscribers invest in two of the best small cap LNG companies Australia has to offer.

Kris Sayce

for The Daily Reckoning Australia

Editor's Note: Kris Sayce is the editor of the Australia Small Cap Investigator. For more on his research into LNG stocks, go here.

• LNG – The Energy Play for 2009
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• Queensland Govt Chooses Coal Seam Methane Over Resource Boom
• Australia Presents Investors With Great Portfolio of Energy Choices

By the way, by new low, we mean could the indices take out the March 2003 lows? For example, in the week of March 10th, 2003, the All Ords settled at 2,716. It would a nearly 23% fall to there from today's trading level.

This is not an exercise in fear mongering, by the way. For most of this week, we've been focussed on a scenario where an increase in the global money supply causes widespread consumer price inflation and at least some inflation in commodity prices. But we need to take a closer look at another possibility today-a staggering earnings depression in resource stocks.

And be warned, it is not pretty. The only good news is that there are at least two businesses we can think of that will do well in an otherwise abysmal situation. More on them further below.

Here is the problem in brief: we know that financial earnings will suck for the fourth quarter. While Aussie financials may be relatively better off than their U.S. and European counterparts, their ability to increase earnings (especially when they are so reluctant to loan to begin with) is suspect. Either way, with Bernanke talking about another effort to re-capitalise banks, it doesn't appear the supply of credit to the real economy is going to increase any time soon-at least not via traditional bank lending.

Next is the real economy. Last night we learned that industrial production in the Eurozone's 15-member bloc fell by 7.7% year-over-year. Couple this with falling industrial production data from China, Japan and North America and you have nearly irrefutable evidence that the first-half slowdown in the global economy is going to be a lot more severe than any of the official estimates by the likes of the IMF, the World Bank, and the Fed.

None of this is good for Aussie commodity demand. Even though commodity prices are already down by large amounts, we now have the possibility of an ugly earnings shock for Aussie resource producers in the first and second quarters of this year. Whether this is already priced into resource shares is a question we'll deal with in a moment.

But it would be wise to not underestimate the possibility of a massive, earnings-crushing double whammy for resources. First, is rapidly contracting global industrial production. This could lead to an unpleasant (and not priced-in) decline in Australia's export earnings. Financial earnings have already been decimated by the credit crisis. Now that the crisis is storming into the real economy, are resource earnings next?

According to the RBA, "Australia's export earnings make up around 20 per cent of total domestic income on average, and thus have a significant influence on economic activity." Two of the biggest contributors to those earnings over the last few years were coal and iron ore. Both saw huge increases in annual contract prices as pre-Olympic Chinese steel production soared.

But now the reverse is happening. The Chinese are working down stockpiles and inventories. And waiting. But waiting for what? They are not just waiting for a resumption in global growth, at which point they will resume production and demand for Aussie raw materials. No. They are waiting for March and April

March and April are the looming deadlines for the annual contract price negotiations for bulk commodities like coal and iron ore. Right now, spot prices are well under contract prices-a reversal from last year when Indian iron ore traded at a premium in the spot market to Australian contract ore. Indian spot ores traded as low as $65/tonne late last year. That's well below the $90/tonne price negotiated for 2008, and a lot further below the spot price of $200/tonne achieved earlier in 2008.

So what can you expect? Contract prices are going to come down, probably by as much as 40%. The steel producers could ask for an even bigger price cut, but that would ultimately affect the number of viable projects in the Aussie and Brazilian markets (and sow the seeds for a shortage and higher prices in 2010).

Before then, though, you can be sure the decline in contract prices is going to combine with a plunging global economy to punish Australian export earnings. Putting aside the effect this will have on national income (along with job losses to accommodate the lower demand for raw materials), you now have a situation where the earnings recession could lead the Aussie market could take out the 2003 lows.

Just to repeat: the proximate cause of a 22% decline from today's levels on the All Ords would be a brutal double smack down of much lower global industrial production in the real economy (lower resource demand) and a huge reduction in contract prices for Australia's two main export earners (coal and iron ore).

But what would all this mean for resource shares? That is the question. Well, as hard as it is to believe, we reckon it would lead to new lows. Despite their gut-wrenching falls from last year, there could be even worse ahead. Perhaps that is why today's Australian Financial Review leads with the story that "$60bn projects under threat."

The Fin reports that falling resource prices and the lack of access to credit could shelve $60 billion in new Aussie resource projects. And that's on top of the $11 billion in projects that have already been deferred or cancelled altogether. ABARE still reckons there are 85 advanced projects valued t $67 billion that will proceed. But what about the 347 less advanced projects, valued at $220 billion? Who is going to fund those in this climate?

And more important, what would be the best investment strategy in a situation where there is a final, blow-off contraction in the resource patch? Well, as a thought experiment, one way to avoid another massive fall in the ASX and All Ords is to simply liquidate everything now and keep your head low. Such a strategy acknowledges that the bottom of the cycle in commodities has not yet been reached, and that it is not prudent to hang on for grim death. Rallies would be sold.

However, that is not to say that the bottom of this cycle is going to leave you wandering in the equity desert for 20 years. Earlier this week, we published Dr. Marc Faber's analysis that commodities may be the one asset class for whom the current situation most resembles stocks in 1987-the big correction/crash was an interval in the cycle, not the end of it. What would that mean in this case?

It would mean that the real economic consequences of the credit crunch are going to accelerate in the first two quarters of this year, leading to much lower global trade, industrial production, and export earnings for Aussie producers. Already you see this with plunging freight rates. This economic slowdown, along with the seemingly inevitable contract prices for coal and iron in March of this year, mean a steep drop in Aussie resource stocks in the next four months.

And then?

It's important to remember that commodities are heaving perfectly naturally and cyclically at the moment. "We know that this is a perfect economic storm," says Mitch Hooke, the CEO of the Minerals Council of Australian in today's AFR. "There is going to be some wreckage, there is going to be some damage and there will be a drop in supply. But demand will come back and then outstrip supply, and when that happens there will be a rapid recovery in prices and then production."

He's right, of course. This is basic cyclical economics. Its how things worked in the first stage of the resource bull. The increase in prices and the availability of finance led to surge in publicly listed explorers. Mind you with the exception of the base metals, you did not see a huge increase in new commodity supply come from all these new explorers (that's important later).

But now, the cycle has reasserted itself on the downside. Boom gives way to liquidating bust in the commodity sector, where free market economics still functions (unlike in finance). Slower final demand and tighter credit are pushing non-producers and those resource companies without cash or lines of credit right to the wall. There's nowhere left to go for many of them except out of business or into the hands of larger acquirers.

This too, is part of the cycle. When small would-be miners with quality resource projects and ore bodies lack the financing to produce those ore bodies (and can't live off the production of another working mine) they don't survive, at least not without help from a larger, cashed-up producer. This has an obvious effect (and also represents an opportunity for investors). Supply of commodities and minerals falls as the small firms disappear and the big ones mothball capacity. "Pebbles" get scooped up.

But when will the cycle bottom? This year? Not that we're a big believe in equilibrium, but the fall in supply will eventually get more in line with current demand (which itself may fall for awhile). And so you get a consolidation and contraction for a few quarters. Equity prices would react to all this much sooner, of course.

But what is the general, long-term trend for commodity prices? If we accept Marc Faber's analysis last week, the commodity cycle is not dead. It is merely resting. After a 20-year bear market and a eight year bull market, the cycle must now work through effects of a credit contraction and slower global growth.

Some analysts, like those at UCI say that the long term is good, even if the short term could be very gad. "The secular trend remains upward due to tight supply/demand fundamentals. In medium term, focus will be on global slowdown, easing inflationary pressures, dollar recovery, monetary tightening - all bearish for commodities."

Mind you, even in such a bearish argument for commodities, you might find an exception in gold producers, although not the explorers. The junior gold explorers are fast, like everyone else, running out of finance. Our forecast? Gold production is going to fall this year at the same time gold prices rise.

We've focused so much on the demand side for gold as an inflation-hedge that it's easy to forget gold is a mining business. You have to find it and dig it up. It is hard to increase the mine supply of gold.

True, there are large above-ground hoards of gold held by central banks. But in terms of mine supply, you can probably expect lower production this year, meaning those gold producers without debt might make attractive investments, even in the first six months of this year-and especially if the gold price reacts to the increase in global money supply.

Another exception might be LNG. Our man Kris Sayce at the Australian Small Cap Investigator has been all over this story. In fact, his two LNG share tips from the last two months are each up over 100% already. Kris was able to spot the bull within the bear. LNG is rapidly emerging as a substitute for oil as a transportation fuel (see the Pickens Plan by U.S. billionaire T. Boone Pickens).

LNG is also an infant industry in Australia. But it's already attracting the interest of large foreign firms who want in on an energy source coveted by Asian economies like Korea, Japan, and of course, China. So even amidst the general bearishness in oil prices, a punter could find some nice little earners in the Aussie energy patch.

LNG and precious metals are the promising exceptions to the bearish general trend of commodities. It's what our analysts are working on full time at the moment. And there may be others. But we thought it important to at least explore a scenario in which things get much worse for commodities. It's hard to believe that's possible.

However, we simply don't know-and no one does-how markets will react to increasingly large sums of money injected in the global banking system, or what direct Fed purchases of assets might to world's economy. In the long-term, as we've said before, the high saving emerging market nations are going to cease funding U.S. deficits and develop their own economies-focused more on domestic demand export growth.

That scenario-growth of consumption in the emerging world-is commodity intensive and favours Aussie producers. But getting to that that next stage in the global economy is easier said than done. Will it happen this year? Next year? In five years? Nobody knows.

Tomorrow, we'll return to the subjects of banks, the alchemy of turning debt into equity, and what it all means!

Dan Denning
for The Daily Reckoning Australia

• Australia & China: Already Partners in the Commodity Boom
• Dollar’s Demise Has Started a Chain Reaction in Currency and Commodity Markets
• Commodities Tell Us the World Won’t Stop Turning in a Financial Crisis
• Commodity Inflation Causes Consumers to Cut Back on Spending
• The Australian Resource Boom Isn’t Dead Yet

Reserve Bank economists now reckon that the recent coking and thermal coal deals inked between Aussie sellers and overseas buyers will haul in another $30 billion to the economy this year. That is not the kind of news the RBA wants to hear while it's busy putting out inflationary bush fires in the economy. But facts are facts.

Thirty billions dollars in coal and iron ore earnings, where will it go? To producers? To investors? To mining service companies like Walter Diversified Services (ASX:WDS)?

While you think on that, let's talk about "terms of trade" for a moment. "Terms of trade" is one of those terms of the trade that gets throw around by economists all the time. But what does it mean?

The simple definition is this: it's the ratio between export prices to import prices. If you get more for what you sell and pay less for what you buy, your terms of trade improve. And guess what people? Thanks to this particular moment in history, Australia gets a lot more for what it sells and pays a lot less for what it buys (except for crude oil).

The chart below is taken from a 2005 Reserve Bank research paper called "Long-Term Patterns in Australia's Terms of Trade," by Christian Gillitzer and Jonathan Kearns.

But we'll save you the trouble and tell you what it means in laymen's terms. The chart shows that the terms of trade exploded in the 1950s as Aussie exports of wheat and wool increased export earnings. Today's terms of trade ratio, by the way, is around 130, where those two dots on the right margin are. Will the index go to 1950s levels? And if it does, what will it mean for domestic spending in Australia?

In a speech given in February of last year, RBA assistant governor Malcolm Edey showed how an improvement in the terms of trade can lead to a rise in national income and, gulp, domestic demand. Think inflation.

"One of the consequences of the strong global economy, and particularly the growth of Chinese industrial demand," he said, "has been sustained upward pressure on a range of commodity prices. Over the past three years this has lifted Australia's terms of trade by around 30 per cent, the largest cumulative increase that we have experienced since the early 1970s."

"It is not hard to appreciate that this provides a significant boost to incomes and spending. With exports representing about a fifth of GDP, each 10 per cent increase in the terms of trade adds about 2 per cent to the value of national income," he concluded.

Whose income, though? This is the key question. Will the rise in export earnings lead to more spending (and if so, by who?). The answer will help determine if and how big future interest rate rises are.

According to today's Age, "While senior Reserve Bank and Treasury officials forecast last month that Australia was heading for a boost of 10% to 15% in the terms of trade in 2008-09, the Posco deal suggests the rise could be more like 20% to 25%. Next year could see the terms of trade - the ratio of export prices to import prices - overtake the record levels of the Korean War boom in 1951."

That's interesting. Yesterday we mentioned that the current rise in Chinese steel production (and growth in Aussie exports of iron ore and steel) happened during the great post-war expansion in Korea and Japan, when both countries effectively industrialised and built up their manufacturing bases.

Base metals demand grew in both countries, driving them south to Australia, where Lang Hancock was flying over the Pilbara in 1952, noting that all that red earth might just possibly be iron ore. The rest, as they say, is history. But as they also say, the past is prologue. China is coming south these days too, looking to build out its industrial and manufacturing base with Aussie coal, base metals, and minerals (heck, let's throw uranium and LNG in there too.)

Here are two scary charts for the RBA that suggest the terms of trade may improve even more in coming years, leading to more inflationary pressure in the economy via business spending.

First, when the terms of trade spiked in the 1950s, commodity prices were in a secular downtrend. What Australia was selling went up in price, while the general trend in prices for manufactured goods was down. Aussie ore went to Japan and Korea and came back, eventually as cheap manufactured goods.

Today, real commodity prices appear to have bottomed from a 200-year low around 2003. It was certainly a 20-year low. Whether the price of real commodities keeps going up, we'll have to see. But you have a situation where the price of manufactured goods continues to go lower (more global producers) at the same time the price of raw materials is going up.

As the chart above shows, Australian export prices are rising faster than commodity prices, while Australia's import prices are declining faster than world manufacturing prices.

Why that exactly would be the case is a bit of mystery. The paper's authors suggest that, "Australia's traditional mineral exports had been high value-to-bulk commodities such as copper, lead and zinc. Japan's prominence in Australia's commodity exports at the time is illustrated by the fact that by 1969/70 Japan imported 65 per cent of Australia's metal ores, coal, gas and petroleum exports."

The simpler explanation is that what Australia is exporting today-iron ore, coking coal, zinc, copper, and gold-is in greater demand than wool and what were 50 years ago, as reflected by higher prices. If anything, a recovery in the agricultural sector (rice and wheat especially) would deliver an even bigger boost to the terms of trade.

If China is the new Japan (and our theory of great post-war periods of industrialisation suggests that it is), then you see why the trend is sustainable and the terms of trade will grow even more. Export income should grow as export prices (and production volumes grow). They will only grow, of course, if business investment picks up. Business investment is the big driver of all wage and income growth, though. So if business investment grows, wages are going up.

Do you see why inflation is largely out of the Reserve Bank's hands now? It can control domestic consumption. But it cannot control foreign consumption of Australia's mineral exports. That's the demand driving business investment and Aussie wage growth.

On the import side, it's easy to see in a picture why Aussie import prices have been falling even faster than the average price of global manufactured goods: we're getting more stuff from Asia and less from Europe. Shipping costs are much lower. But prices are lower in the aggregate because low labour costs in Asia have led to a big decline in the price of manufactured goods globally. Wage and price disinflation from Asia, you could say.

So what does it all mean? It means export earnings will grow for commodity producers unless they run into the brick wall of rising energy costs, labour market constraints, or infrastructure bottlenecks, all three of which are possible.

There are other factors too. Rising global energy prices affect producers and prices. That could crimp global demand, Asian production, and thus Aussie resources. It's also possible that rising food and fuel prices trump falling prices for manufactured goods and lead to greater Aussie inflation. After all, food and fuel make up a greater portion of the household budget than DVDs and toasters.

Plus, 60% of Aussie GDP is consumer spending. If export earnings benefit mostly industrials and manufacturers, and they represent just 26% of all economic activity, then the effects of a huge boost in the terms of trade might be muted. Consumers will be hit hard by rising food and fuel prices while businesses, flush with export earnings, will hoard cash for the duration of the credit crunch.

And of course there's the possibility we could have big trouble in big China. We have speculated that China's long-term ambitions in Australia are…ambitious. But China itself a seething bundle of internal contradictions.

It is 1.2 billion people growing with great energy. But demographically, Chin is also getting old quickly and facing the health challenges that come from running an economy at breakneck speed without regard for workplace safety or the environment. It is a closed system trying to unleash the energy of economic growth but remain static politically.

Trying to move while standing still is neat trick. The only way we've ever seen it done is in a rocking chair, where you find motion and stasis at the same time. China's very attempt to industrialise right now may put the raw materials it needs to do so out of its strategic reach. This means price pressures on global energy and minerals.

It leads us to a world of energy haves and energy have-nots and of agricultural haves and have-nots. Where it takes us is anyone's guess. For Australia, for right now, it looks like it's taken us higher.

Dan Denning
The Daily Reckoning Australia

• Australian Trade Deficit Grows for 75th Consecutive Month
• The Future of the Australian Resource Market, Two Ways the Boom Could End
• Wage Pressure in China to Drive Up Cost of Goods in Australia
• Australia’s Current Account Deficit Up 4%
• China Performs a Kind of Financial Alchemy