The Great Chinese Slowdown

In our last presentation in May 2011, I went over 4 main drivers for the likely crash in commodities for later in 2011. They were as follows:

1) The ending of QE-2 would immediately lead to a major slow down in the U.S. economy and expose once again the deflationary aspect of debt deleveraging. This has largely already played out.

2) The continued deterioration of the southern European countries would reassert the euro debt crisis and create a very destabilizing/depressant effect to the euro zone economic health. This also has largely played out.

3) The Realization of the above mentioned bearish fundamentals would create a flight to safety thereby exposing already record net long speculative futures positions to a mass liquidation event. We have seen over the last month a massive liquidation on behalf of the speculative funds.

Speculative fund liquidation still has further to go before subsiding.

3) Based upon historical precedent, the current liquidation phase of the speculative funds is about three quarters of the way through. This still allows for further downside in overall commodities to complete this liquidation cycle.

4) The realization of the great Chinese slowdown as the series of rate increases and capital reserve margin increases at banks would eventually place a tourniquet around credit growth and induce a major slowdown in capital investments. This bearish fundamental is just now beginning to be factored in and remains the prime remaining driving force for the final down phase in overall commodities that should complete over the next 3 to 6 months.

The spike in 5-year credit default swaps are raising huge warning flags

that all is not well in China

The current trajectory of Chinese economic growth is clearly in a classic

bubble phase that is unsustainable

How Can The Chinese Economy Be growing at 10% with power output

Crashing?

China’s consumer consumption growth rates are all crashing as runaway

inflation crashes confidence

The Chinese economy is becoming increasingly dependent on capital

spending alone. Danger Signal

Total Debt to GDP In China Including Contingent Liabilities Is Off The Charts

Victor Shih, an expert on China’s economy, is an assistant professor of political science at Northwestern University who holds a Ph.D. in government from Harvard had this to say in July 2011: “Large sectors of the Chinese economy are owned by the government. The debt of these state-owned enterprises is what’s called a “contingent liability” — ultimately it’s the responsibility of the government. If you count all of these liabilities, then you get to an extremely high number, something like 150 percent of the Chinese gross domestic product, or more.A more restricted definition is debt that's owed by either the central or local governments. That is about 80 percent of China's GDP.”

Jim Chanos, the legendary hedge fund short seller extraordinaire had this to say in September 2011, “The Chinese government balance sheet looks good on paper. But if we look at state enterprise (that are implicitly backed by the government), the debt to GDP ratio went from 100% to 200% that is the same or even worse than European countries, especially the PIIGS.

The Chinese stock market has been discounting the great Chinese

slowdown since November of 2010 having fallen over 36%

China 25 Index ETF

The Top commodity currencies have begun to crash signaling the likely

slowdown in the demand for commodities from China

Canadian dollar –redAustralian dollar –blueBrazilian real-green

The CCI (Continuous Commodity Index) Spot Price Chart has broken

down through critical support

A year end snap back rally is likely before the great Chinese slowdown pressures commodities to new lows

12 month moving average

CCI Construction

Inflation Adjusted CCI Using the PPI Index

The chart store

Major support resides near 500 on the CCI

Net Commercial Positions at the last two major bottom in 2008 and 2010

Current net commercial positions= -1,483,000It is highly unlikely that a major low will be reached in overall commodities until the 2010 net commercial position levels have been achieved.

GrainsCorn-Bearish Over next 12 months

1)The recent USDA annual grain stocks report showed a larger than expected increase in current corn inventories in the United States to 1.1 billion bushels. This adds 200 million bushels of corn to next years supply demand equation. All things being equal, next years supplies will now be an adequate 872 million bushels.

2) South America is expected to plant record corn acres which should lead to the potential for record exportable supplies over the winter/spring.

3) China is expected to have a record corn crop this year which should keep them as small importers of corn.

4) Ethanol demand will likely be flat to down in 2012 as reduced demand for gasoline in U.S. meets head on with government subsidy removals.

5) Dramatic reduction in animal feeding units across the poultry, dairy, cattle and hog industries in response to the very high average feed prices in 2011 will create a long

bearish demand side tail that should keep demand depressed well into 2013.

6) With normal weather for the 2012 crop cycle in the U.S., it is highly likely that a 1 billion bushel surplus will be seen that will help rebuild the much needed buffer stocks. As such, sub $5/bushel corn is likely by the fall of 2012

Soybeans-Bearish over next 6 months

1) No surprises to the USDA annual grain stocks report which showed a modest decline to 215 million bushels down only 10 million from prior expectations. This leaves U.S. stocks adequate for 2012.

2) It is my expectation that yields in the U.S. are currently too low and will have to be raised. This should add at least 50 million bushels to U.S. stocks in 2012 and create even more comfortable inventories.

3) Global inventories remain historically high with sizeable inventories remaining in Brazil and Argentina.

4)Also the crash in the Brazilian real against the Renminbi also makes South American beans more attractive than U.S. prices to the Chinese.

Wheat-Bearish/neutral over next 6 months

1) There remains plenty of wheat in the world although record feed wheat demand as a replacement for corn feed has kept global ending stocks from growing.

2) The regional shortage created by the Russian drought in 2010 have been resolved and now a more normal supply flow should emanate from this region. This should keep U.S. wheat exports constrained over the next year.

3) Wheat is beginning to get very cheap from a valuation basis and this should limit the downside when compared to the other grains.

4) Also speculative funds have completely liquidated and have gone record net short leaving very little liquidation pressure left in this market.

Wheat remains very cheap

Wheat prices Relative to the CCI Price Chart

SOFT’SCotton- Despite the horrendous cotton crop in the U.S. global ending stocks rose by almost 20%. Given that demand will likely remain constrained it is highly likely that another surplus year is coming for 2012.

Coffee-Supplies will remain very tight heading into the spring of 2012. The coffee market still has upside spike potential should the current on-season crop be reduced due to poor weather or should the Main Colombian coffee crop come up on the short side as seems plausible given poor weather earlier in the year.

The crash in the Brazilian Real has created a much more bearish U.S. price structure and should allow for greater hedging pressure out of Brazil. The 2011 crop continues to look smaller than expectations in Brazil and is beginning to create a firmer cash market.

Cocoa-I am a cocoa bull. Current large supplies from very large crops from the Ivory Coast and Ghana have been fully factored in to current prices. Crops over the next crop cycle will be much smaller given the need for the cocoa trees to rest. Also the long term impacts of the recent civil war will be to further delay the needed investments to rehabilitate aging trees and improve infrastructure. As such a deficit is expected over the next crop cycle and with spec funds near record net short, further fund liquidation is not likely.

SOFT’sSugar- Large surpluses remain likely over the next crop cycle despite the disappointing Brazilian sugar corp. Huge crops coming out of India, Thailand and Europe should more than makeup for Brazils shortfall and still lead to a 7 mmt surplus.

Spec funds remain very exposed to further fund liquidation while relative value to the CCI remains elevated. The crash in the Brazilian real will continue to promote sugar expansion in Brazil and add additional hedging pressure. Sugar remain relatively expensive in relation to cocoa. This is another supportive bullish argument for cocoa.

Live StockI remain very bullish the entire live stock asset class for the back half of 2012. Draconian reductions in herd sizes will leave a supply shock environment in the U.S.

Near term however large herd liquidations will continue to pressure spot prices heading into the end of the year and into the first quarter.

Live stock prices relative to the price of corn and relative to the CCI are near 40 year lows. This argues for a spike up move in deferred contracts that could be as much as 50% to 100% higher to normalize price with long term economics.

Summation1) Current prices for overall commodities are likely near a short term low that can see a

sizeable snap back rally heading into the end of the year. This will likely be induced by Europe avoiding the worst case scenario thrown around by perma bears.

2) Then the Asian crisis which will include Japan but more importantly China will take center stage and create a new down leg in overall commodities to new lows and likely place a longer term intermediate low in the first half of 2012.

3) Then a period of base building will ensue that will breed the conditions for the next bull market leg in 2013-2015.

4) The live stock commodities remain the most undervalued with the most compelling supply/demand fundamentals when the dust settles. I expect this group to lead the way in the next bull market leg. I would also keep a bullish eye on the cocoa market.

5) The two unknown variables that could change this forecast would be another year of adverse weather around the globe and a surprise global synchronized expansion of monetary policy.