If you want to talk about economic and investing trends at home and abroad, it's hard to imagine a better team than Martin Barnes and Chen Zhao, both managing editors at BCA Research, one of the world's top research firms. The Financial Post's David Berman met with them recently at their offices in Montreal to talk about the sustainability of the commodities boom, the rise of China, the resilience of the U.S. dollar and the current state of emerging markets.

Q Commodities have performed extremely well in recent years. Where are we in this commodity cycle?

BARNES The bullish story for commodities is very compelling, and it's all to do with demand in the emerging economies. If you look at per-capita consumption of any commodity, whether it's oil or copper or aluminum, the consumption in China is a fraction of what it is in the developed world.

So the idea is that if everyone in China goes from owning a bicycle to owning a car, or they move from rural areas into the city, a slight increase in the per-head consumption of commodities ends up as an enormous increase in demand given China's population.

If you extrapolate things out five or 10 years, you end up with mind-boggling amounts of commodities that can be absorbed in China -- and India and other emerging countries as well.

The problem is: How do you go from a big-picture, long-term bullish case to what makes sense for prices today? My view is that any price that goes vertical over a short time, chances are there is a lot of speculation there. No matter how bullish the fundamental story might be, if the graph looks like the Eiffel Tower that's often an unsustainable move.

ZHAO Inflation is a critical element to the commodities boom. If you have low inflation, you have very steady economic growth. We have very powerful anti-inflationary forces in the world. And if we don't have inflation, then the central banks don't have to act very aggressively. As a result, there will be no major business cycle fluctuations, and demand for commodities will stay fairly steady.

Overall, I think we're still in a bull market for commodities. But if inflation pops up, I'd be the first guy to run. Forget about the bull market story.

The environment today is much more complex than it was a year-and-a-half ago. Then, everything went up. But now commodities are behaving differently. Natural gas prices have fallen about 60%, whereas oil prices have high.

So investors need to be nimble. You have to figure out the relative demand in given commodities, the speculative position and which commodities are likely to correct. For example, copper is going to correct because the price has gone too high. Demand doesn't go like that.

Q Has gold become a valuable commodity now or is it a speculative investment?

BARNES In a sense, you've had a great environment for gold: easy money and no currency has looked like a good bet. The problem with gold, though, is that it's very hard to value it because it doesn't give you any income. To me, it's the ultimate greater-fool investment. The only reason to buy gold is that you think the price is going up and you can sell it to someone else tomorrow.

ZHAO I'm bullish on gold. I think it needs to correct, but gold prices three years down the road are going to be a lot higher than they are today. Competitive devaluation is a key force behind the gold price boom. Every country wants a weaker currency, and the irony is that at the end of the day no currency will be devalued. However, something has to be bid up and the something is gold. Besides, gold prices are also benefitting from the fact that the marketplace is very distrustful of the three major currencies -- the U.S. dollar, the euro and the yen.

Q Where are we in the current North American equity bull market?

BARNES By normal standards, we are very late. We're into the fourth year of the U.S. equity bull market. So by this time, in the past, you would normally expect a pretty bad market.

But, at this stage of past cycles, you would also be having more inflation and tough monetary policy, which we don't have now. The equity market is reasonably valued -- not dirt cheap, but okay. Interest rates aren't causing pain and economic conditions are pretty good, so the path of least resistance for stocks is up. Those who are waiting for a bear market are going to be disappointed.

ZHAO We are very bullish on U.S. equities. They are cheaper than bonds, real estate and commodities. Secondly, U.S. equities have underperformed globally, even though the U.S. economy has been strong. They've had a huge multiple contraction even though profits have gone through the roof.

The Fed will soon stop raising rates and the pressure of multiple contraction will reverse. The U.S. will outperform.

Q Emerging markets have enjoyed a great run in recent years. Are there more good times ahead?

ZHAO Just like commodities, the environment is much more complex now than a couple of years ago. In general, the backdrop is still very bullish. They are very cheap stocks, with an overall price-to-earnings ratio of about nine.

From a structural perspective, the emerging market economies are very different from the 1990s. Back then they all had big twin deficits. Now they have big surpluses. They got rid of all the financial market rigidity. These changes should be reflected in share prices, but I don't think they have.

High-inflation markets like Brazil, Mexico and Turkey are good disinflation plays. Their inflation rates are coming down fast. When interest rates drop, stock prices will go up fast. I also like Taiwan, where stocks are probably the cheapest among the emerging markets. It is a completely undervalued market.

Q We hear a lot about companies attempting to pass along price increases due to rising commodity prices. Why haven't we seen a significant rise in inflation yet?

ZHAO We're experiencing a low-inflation boom. China is a major producer of goods and its unit labour costs are falling. If you look at the developed world, from Japan to Europe to the United States, we are seeing restrained wage growth due to corporate restructuring. Every country is trading with everyone else. In that kind of environment, how are you going to raise prices?

Yes, some prices are going up -- for things like gasoline. But that is not really an inflation issue; that is a relative price shock. Anecdotally, I can think of a whole bunch of things where prices are going down too, such as electronics and clothes.

BARNES If I had wanted to create higher inflation a few years ago, I would have had a very easy monetary policy, a loose fiscal policy, I would have driven the exchange rate down and raised energy prices. All these things happened in the United States, so you have the perfect breeding ground over a period of many years -- yet there wasn't any inflation.

So you can take two positions. You can say: Well, just be patient. The conditions are there and inflation is going to pop up any time now. Or you can say that something else is going on. The problem with the being-patient story is that the lags aren't that long. If you were going to see inflation, you would have seen it by now.

But there is a twist: There is still an inflationary environment, and it is showing up in asset prices. So instead of having higher inflation for the stuff you buy in stores, you're seeing it in real estate prices, in commodity markets and equity markets.

Q Alan Greenspan was criticized for allowing a so-called housing bubble to grow in the United States when he was chairman of the Federal Reserve. Is housing now a concern of central banks?

ZHAO I think central banks are in a very difficult situation now. What will a central bank do if growth keeps accelerating and inflation falls? What is the right policy response? I don't think any central bank in the post-war period has had to deal with this sort of situation.

Also, can central banks target asset prices? They can target anything they want, but it's very risky. If you have a low inflation environment where asset prices are rising, you face the possibility of creating deflation.

Q This new situation you speak of sounds a bit scary. Should we worry?

ZHAO I think things are incredibly steady. In the past, you had a lot of fixed exchange rate regimes and in the 1960s we saw interest-rate controls. All of these controls created enormous fluctuations in real economic activity.

Today, we have complete nominal flexibility: a floating exchange rate system, interest rates are fluctuating all the time and financial markets are becoming very self-regulating. I think the world is incredibly stable.

Q Are we in the midst of a change in economic leadership, as China rises?

BARNES I think China's geopolitical power is going to increase tremendously as its economic power increases. That is going to have a profound impact going forward.

The power of the United States, in relative terms, is going down -- but it will stay the world's most important economy for the foreseeable future.

ZHAO We should not lose sight of the fact that China is a very small economy in terms of per capita GDP. Of course, in aggregate terms, it is getting big. Within Asia, the power is shifting. Japan will become some sort of an island economy. China will replace Japan in Asia as the dominant economy within 10 years.

Q The U.S. dollar has been remarkably resilient lately, but where is it headed?

BARNES There is no precedent for a country with such a large trade imbalance to have anything other than a weak exchange rate over time. This trade deficit has to adjust somehow and history tells us that the exchange rate plays a big role in that adjustment.

ZHAO I believe this current account imbalance is a sign of economic health. It is a result of globalization. For example, if you take out New York City and treat it like an independent state, its current account and trade balance would be in deep trouble. Does this mean that New York is facing an impending crisis? I don't think so. It's the nature of the economy.

The United States is the most aggressive nation to allow the creative destruction process to run its course. As a result, the U.S. has the lowest manufacturing content in its economy.

As Martin says, the current account imbalance normally needs to be corrected. But right now, the pressure of competitive devaluation is very strong. Every country wants a cheaper currency, even the United States.

When you have a tremendous supply-side expansion, you need a cheaper currency in order to reduce the deflationary tendencies of your economy and generate better growth.

BARNES The fact that the U.S. has such a large external borrowing requirement, you can't assume that there's always someone out there prepared to lend that marginal dollar at these exchange rates. It leaves the U.S. vulnerable at some point in the future. We know currencies can be volatile. There's no sense of impending crisis, but it's a risk factor.

Q The U.S. yield curve is flat right now, and in the past this has tended to signal a coming recession. Are you concerned?

BARNES No. In the past, the yield curve has been flat when monetary policy has been very tight or restrictive. This time, the yield curve is flat when interest rates are still quite low, or certainly not restrictive. There's no sense of liquidity being constrained, so it's a very different monetary environment. I don't think you can ignore the yield curve completely but there is no sign that a recession or a bear market is coming.

Q Is the Fed done raising rates?

ZHAO Not yet, but we're very close.

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Montreal's BCA a world leader in getting it right

David Berman, Financial Post

Published: Saturday, April 08, 2006

Mention BCA Research to any mutual fund manager or hedge fund guru and the person's eyes will invariably widen in recognition and admiration.

From its home base in Montreal, where it was founded in 1949, BCA has become one of the world's most influential research firms. Its dozen financial publications -- which include the flagship Bank Credit Analyst, as well as Global Investment Strategy and Foreign Exchange Strategy -- have a strong following among clients in more than 80 countries.

In addition, BCA's editors are regular voices in top publications such as The Economist, The Wall Street Journal and Barron's.

In an era when research is often viewed skeptically because of its authors' conflicted ties to big banks and brokerages, BCA stands apart with its independence and willingness to point out the potential pitfalls in an investment strategy. Its Montreal location, far from Wall Street and Bay Street, bolsters this image.

"We would always tell people where the risks are, rather than saying, 'Hey, go for it. You might make a quick buck here,' " said Martin Barnes, managing editor of The Bank Credit Analyst.

As a result, BCA Research has earned a reputation for doom-and-gloom bearishness -- particularly in the 1970s and '80s, when inflationary and then deflationary forces were on the rise. (They correctly called the October, 1987, stock market crash.)

But in more recent times, BCA also has had its share of bullish calls. For example, its editors currently note the relative attractiveness of U.S. equities. "We don't regard ourselves as optimists or pessimists. We just try to get it right," Mr. Barnes said.

Over the past 57 years, the firm has gotten a lot of things right -- it recognized early on the rising importance of emerging markets and China -- thanks in part to its approach: Its core discipline is looking at what drives markets by focusing on financial liquidity, money supply and credit.

In addition, BCA values curiosity among its staff, who navigate a course between a highly theoretical research institute and a practical financial shop.

"We have our feet firmly planted in the real world of day-to-day financial markets," Mr. Barnes said. "But we also have the ability and resources to do serious research as well. That's an unusual combination these days."