Thursday 21 May 2009

Commodity Prices: Recovering too fast?

RGE Monitor, one of the most renowned economic research groups in the world and chaired by the now famous Nouriel Roubini, believes commodity prices are getting ahead of fundamentals again. The following piece is quoted from one of their latest newsletters:

As of May 13, 2009, the Rogers International Commodity Index rose 7.6% since the start of 2009 on the belief that 'green shoots' around the world validated a V-shaped economic recovery in 2009. However, these 'green shoots' might still be a signal of the stabilization of economic activity at low levels, rather than a return to trend growth. Even if GDP growth around the world has bottomed, growth may continue to be negative or sluggish until 2011.
As such, commodity price gains might reveal a false sign of economic recovery – and so might the recent spate of bear market rallies in stock markets and inflows into emerging markets. The strong uptrend in commodity prices since February has been propelled more by technicals (investment demand, opportunistic stockpiling at low prices) than fundamentals (real growth in physical demand and production). Commodity prices could snap back to reality before resuming a more moderate uptrend in line with a U-shaped global growth path.
Base metals posted the strongest rebound among the commodity groups. The S&P GSCI Industrial Metals sub-index rose 21.1% ytd as of May 13, 2009. Copper led the rebound as it had the smallest surplus (as a percent of supply) and China's copper imports reached an all-time high in March. China's import rebound was driven by strategic reserve buying and the re-stocking of depleted inventories to take advantage of low prices - not to reflect (as yet nonexistent) strong growth in global manufacturing or consumption. China’s infrastructure-heavy fiscal stimulus will provide some support to commodities as will the nascent stabilization of the property market, but other private demand may continue to be weak, suggesting that China’s commodity demands may level off at somewhat lower levels than recent trends. Although China's PMIs are the first and only ones globally to indicate expansion in the manufacturing sector with external demand weak, they have a long way to go just to return to mid-2008 levels. Elsewhere, bankruptcy in the U.S. auto sector, dismal auto sales among Europe and Japan's carmakers and weak housing markets have obviated metal stockpiling. Metal demand has been flat globally, leaving the metal price uptrend without any real economic backing. But technicals aside, metals will be hard pressed for a fundamentally sustainable rally until consumer demand growth revives. Moreover, higher average commodity prices might lead some of these green shoots to wither.
Gold is a special commodity in that the fundamentals of physical supply and demand are minor influences on its price. Gold’s price is most often driven by speculative demand for a hedge against inflation or economic uncertainty. Many investors see gold as a substitute for fiat currencies. Consequently, gold prices sometimes track changes in central bank holdings of gold. Gold markets largely ignored China’s surprise revelation that it had increased its gold reserves as much of this had already been priced in by speculators. Moreover, China produces its own gold. The increase in China's gold holdings is just a mere drop in the bucket of its total $1.9 trillion in foreign exchange reserves. Gold's share in China's foreign exchange reserves remains much lower than the global average and well below the U.S. share. But China's interest in gold is consistent with its taste for real assets to gradually diversify from its U.S. bond-heavy portfolio. If other central banks followed suit, gold demand could increase sharply.
The commodity group trading closest to fundamentals has been agriculturals. S&P GSCI Agriculturals registered a small 1.77% ytd increase as of May 15, 2009 – a reasonable price gain in line with the subtle inflection in global consumer demand. Intra-group price performance has largely reflected differences in supply-demand situations: Sugar and coffee have outperformed grains, meat and dairy. Supply deficits due to cane crop failures in India and weather damage to coffee in Colombia have kept sugar and coffee prices at multi-year highs. Meat prices have fallen with the reduction in meat demand due to falling incomes around the world.
Oil futures have risen sharply since March, touching $60 per barrel May 15 2009, despite the weak demand outlook. Preliminary data and economic forecasts suggest that 2009 will mark the second back-to-back annual oil demand decline since the 1980s as industrial and residential demand slows and commercial inventories are high around the world.
There are several macroeconomic implications of this recent increase in commodity prices. Commodity exporting economies and their currencies are, like commodities, vulnerable to a reversal of risk appetite. The green shoots which prompted the in rush into commodities have likewise prompted inflows to commodity exporters like Russia, South Africa as well as Australia and other commodity exporters. The U.S. dollar’s weakness has contributed to strengthening of both G-10 and EM commodity currencies.
The generalized increase in commodity prices across the board and in transportation fuels in particular poses the risk of choking off any global economic recovery. And although current production cuts and delayed investment may have only limited effect on prices in 2009, they could raise the risk of a significant price shock in 2010 which could send the economy back into weakness. Swift increases in commodity prices as we saw in 2008, tend to exacerbate recessions as well as worsen external balances in the U.S. and key oil importers and adding to the amount of capital needed to finance fiscal and financial support packages.

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