After a longer than normal delay, commodity prices have entered a significant correction on the back of slumping global growth and a stronger $US.
Notwithstanding, occasional bounces (such as that seen in the last 24 hours) the downwards correction in commodity prices has further to go over the next six months or so.
The AMP’s Dr Shane Oliver says this is good news for the global growth outlook and for shares generally as it takes pressure off inflation and hence clears the way for lower interest rates.
But it is bad news for resource shares and the $A, as we have seen with its 12 cent fall in a month against the US dollar.
While the correction in commodity prices has further to go, their long-term trend is likely to remain up, he says.
Commodity prices have fallen sharply.
From recent highs oil, gold and copper prices have fallen around 20% and wheat and corn prices are down around 30%.
Of course this has occurred from very high levels, as evident below.
What is driving the slump in commodity prices?
What are the implications?
Is this the end of the commodity bull market or just a correction?
Commodity prices and the global growth cycle
In a normal global economic downturn commodity prices fall in response to slowing economic activity.
This takes pressure off costs and inflation, allowing interest rates to fall which sets the scene for an economic rebound.
This time around has been a bit different. Until a month or so ago commodity prices remained very strong being propelled by still strong growth in the emerging world (notably China), investor demand for commodities as a hedge against a falling $US, and speculative demand made possible by the growth of commodity funds and partly fuelled by investor scepticism with financial assets.
The problem was that the surge in commodity prices, notably for oil, was not only cutting into profit margins and consumer spending power but that it was directly adding to global inflation; this was keeping global central banks far more hawkish than they should have been.
So while the credit crunch meant interest rates should have been falling, in the US and UK and being increased in others (e.g., in Europe and Australia).
The end result has been more global economic pain than would normally be the case.
Back to normal
The past month has started to see commodity prices return to something like their normal relationship with the global growth cycle with sharp falls now becoming evident.
There are several reasons for this.
Firstly, recent data has shown that Japan and Europe are flagging just as badly if not worse than the US. In fact the recent flow of economic indicators suggests that both regions may now be in recession.
This is bad news for the emerging world including China because they will find it harder to divert their exports away from the already weak US.
Secondly, it has become increasingly clear that China, India and other emerging countries are also slowing.
Chinese economic growth looks like being 9 to 10% this year compared to last year’s near 12%.
As a result, Chinese authorities are now starting to back pedal on some of last year’s tightening.
Indian growth is likely to slow back to 7% from 9% last year with aggressive monetary tightening starting to bite.
Growth in Brazil is also likely to slow on rising interest rates.
Thirdly, the slump in share markets as oil went through $US120 a barrel in May and increasing evidence of falling oil demand indicated that the surge in the oil price was starting to “choke off” growth and hence oil demand.
Rising base metal inventories are also starting to become evident. See the chart below.
Fourthly, the realisation that growth outside the US is now slowing faster than that in the US has seen the $US break higher.
This in turn has suddenly removed investor demand for commodities, such as oil and gold, as a safe haven against a falling $US.
The combination of all of these fundamental developments has seen commodity speculators squeezed.
The favourite trade recently was long oil/short banks, but in the last few weeks it has suddenly reversed.
This has forced investors to close their positions, which has only added to the severity of the moves.
A pause, not the end, in the commodity super cycle
China may be slowing but is not about to collapse and the long term demand potential in emerging countries is huge.
China’s copper usage per person is less than half US levels and its oil usage per person is around 10% that of developed countries.
Rising income levels and the increased use of agricultural products for fuel will also see ongoing upwards pressure on agricultural demand.
Just as we have seen in the last six years, supply will struggle to keep up with commodity demand over the long term.
As such, the long term trend in commodity prices is likely to remain up. See the chart below.
In this context the recent pull back in commodity prices should be seen as a correction, but it likely has further to go.
Commodity prices remain well above their rising trend (as evident in the previous chart) and speculative positioning and sentiment regarding commodities is yet to fall back to levels associated with a durable rebound.
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