I really like the quote that says ‘an optimist invented the plane, whereas a pessimist invented the parachute’. I am not declaring myself in either of these camps (I am obviously a well-balanced realist), but believe it would be misguided not to consider the upside and downside risks to current commodity pricing. Admittedly, some of these issues apply more to some commodities than others, but essentially, the sentiment is an ever present theme. So, let’s kick off with looking at some of the ingredients that could derail markets:
Economic data turning for the worse, led by housing, manufacturing and employment
- A deflationary economic environment
- A falling equity market
- Excess supply
- Emerging markets successfully cooling their economies
ECRI Weekly Leading Index
Let’s tackle each one of these individually (yet briefly too). First up, economic data turning for the worse. The chart (left) illustrates the ECRI weekly leading index, which takes the temperature of the US economy on a regular and timely basis (ie, erm, weekly). This index bottomed out at the start of the recession (which makes sense as it it is a leading index = forward-looking), and has moved higher at a fair clip ever since. That is, until the last 12 weeks, when it has turned decisively lower. This index is an aggregation of a number of data points, hence its weakness raises a rather large red flag. Next up, a deflationary environment. We are already seeing signs of deflation creeping into markets, be it through wages or rent, or through pricing pressure on everyday goods due to new-found frugality in consumers. And a falling equity market would likely occur through the simple equation of the above bullets: 1 + 2 = 3. As for commodity-specific data, serious risks of surplus supply exist across commodity markets; for US natural gas it is from shale plays and increasing rig counts, for crude oil it is from quota non-compliance by Opec, for UK natural gas it is from LNG; and the beat goes on. Then the final bullet: emerging market risk. This one is a toughie. Too much growth could power commodities to such a high price that they crimp potential growth in lagging developed markets. On the other hand, if governments in these emerging markets (especially India and China) go overboard in efforts to quell excessive liquidity and credit in their economies, they risk putting the brakes on growth, which would surely upset global markets.
That was all a bit hectic. Let’s have a brief interlude of humor before we truck on with the flipside of the coin:
Alrightee. Now to the path that could lead prices higher. In all fairness, it is pretty much the polar opposite of the pessimistic points:
- Improving economic data – especially industrial production / manufacturing
An inflationary environment
- Continuing strength in equities
- Continuing demand growth for goods / commodities
- Continuing emerging market strength
- Bloomberg Financial Conditions Index (Mar 07 – Mar 10)
For the prosecution of falling prices, I would like to present exhibit number one – a chart which illustrates an improving environment in financial markets – aptly named the Bloomberg Index of Financial Conditions. This shows that financial conditions have continued to improve at a trampolining rate since the financial meltdown-panic heydays of late 2008, an indication that the market is continuing to normalize after the shocks of recent years. Essentially, we have clambered over the wall of worry and beyond the territory of financial woes.
As you well know from my rants, markets are all interlinked, hence bullets 1,3, 4 and 5 go essentially hand-in-hand here. Improving economic data (1) will undoubtedly be driven by higher demand for goods (4), boosting equities (3), while continuing emerging market strength (5) from domestic growth will too spur on global investor sentiment (back to 3, then 4, then 1). It is as inevitable as wrinkles and gray hair that inflation will once again rise up, although when this will arrive it is impossible to say. But one thing is for sure, a commodity rally will be a natural by-product of both an inflationary environment or an improving economic environment. It is on the horizon.
I don’t know what’s going to happen. I can make a guess, but that is all it would be – a guess. It is much more important to to keep an open mind, but also be aware of all eventualities. So I sign off as I began; with a good quote – ‘the pessimist complains about the wind; the optimist expects it to change; the realist adjusts the sails’. I believe we are poised between the devil and the deep blue sea, and all we can do is hang in there, and sail broad reach. Ahoy.