Merrill Lynch’s latest global overview of the commodities market has good news and bad news. The good news, it says in its Commodity Strategist, is that consumption in the emerging markets is on the up and up. However, the United States, its researchers conclude, is “on the brink of a recession”, and inflation in emerging markets is creating risks to the demand for commodities.
After a phenomenal year for returns on commodities in 2007, the financial management company reckons 2008 should be another year of positive returns.
A benign demand environment, subdued supply growth and low inventories will likely support spot prices at elevated levels, they say.
In addition, finely balanced energy and metals markets and a growing deficit in agriculture suggest roll returns are unlikely to become a major drag on index performance. Limited supply growth will once again remain the constraining factor on demand, at least during the first half of 2008.
Merrill warns that cyclical headwinds remain, and the US Federal Reserve has been working hard to turn the US economy around. The Fed slashed US interest rates by 125 basis points in the last three weeks, the most aggressive easing policy since 1974. This is further fuelling the ongoing emerging markets liquidity boom. In addition, the People’s Bank of China has just expanded the supply of credit on an emergency basis to help fight the most severe winter in decades.
This un-intended Asian liquidity boom may well support commodity prices in the first half of this year.
Spot prices of oil, gold, wheat, corn and others spiked to record highs, continuing the super-cyclical price appreciation they embarked on a few years ago. The broadly-diversified Merrill Lynch Commodity index eXtra TR posted stellar returns of 33 per cent last year. Importantly, all sub-sectors with the exception of base metals contributed to generate returns – the combination of spot returns and roll yield – with energy and agriculture providing largest contributions.
The researchers’ central base case scenario is that aggregate commodity demand growth globally will remain firm, even in the face of a US economic slowdown. In their last Commodity Strategist report, they found plenty of evidence that the commodity markets have decoupled from the United States. First, US consumption of commodities has hardly contributed to global demand growth over the last years. In the case of oil, the United States just contributed 10 per cent to global growth in the last five years, relative to an average contribution of 20 per cent in the 1990s. Second, the slack is picked up entirely by emerging markets, and not by the remaining OECD economies.
The share of emerging markets (EM) in global oil demand growth has averaged 92 per cent in the last five years, from just 20 per cent in the 1990s. Of course, the United States is still a big consumer of commodities in level-terms, but it is the rapid acceleration in EM demand that has driven commodity prices over the past years.
The research finds that, ultimately, increasing EM demand is a net positive for commodities in the long-run. No doubt income inequality has been increasing all over the world in recent years with the advent of globalisation. However, the emergence of the middle class across a broad range of developing economies, has brought about a growing equality of consumption.
In effect, this means middle classes in EM may not yet be able to afford expensive European sports cars, but they can increasingly afford a vehicle.
This is particularly true considering India’s Tata has continued to crush the price of low-range vehicles, recently announcing a $2,500 (Dh9,175) model.
Thus, Merrill Lynch finds, any cyclical headwind coming from the US economy will likely be offset by growing EM demand for oil and other commodities.
Looking back over the past six official business cycles in the US economy, the report concludes commodities mirror the peak in the business cycle; however they do so with a delay. Monthly total returns in commodities are still positive at the onset of a recession (the cycle peak) and remain positive for two more months. Quite staggeringly, commodity prices typically increase six per cent on average just after the peak. In fact, the worst downturn occurs only five months after the start of the recession. Thereafter, returns in the commodity space continue to accelerate. Using the trough of the cycle – or the point after which economic activity accelerates again – as the main reference point indicates commodity returns are worst during the three months preceding the trough. Net, the turn of the cycle can actually be a sweet spot for commodities. It is very difficult to time the cycle exactly but Merrill Lynch’s analysis suggests a severe downturn matters for commodity returns.
Looking back over the past six business cycles, they find commodity spot returns have returned just 0.5 per cent during a recessionary phase, versus 1.1 per cent during an expansionary phase.
However, they also find strong evidence the extent of the economic downturn has mattered greatly in the past. Long and deep recessions, like the one in 1981, tend to hit commodity spot and total returns significantly harder than shorter ones.
In addition to this, the impact across the sector is not the same. Their analysis indicates investments in industrial metals get hit disproportionately hard. US demand for copper or aluminium always fell at the time of a US recession.
However, they do find plenty of differentiation in other sectors. In energy and transportation, demand tends to hold up better than industrial demand, particularly in the later period.
Commodities bear very little, or even negative, correlation with other asset classes, while generating strong positive returns over long periods of time. By adding commodity investments to a portfolio composed of traditional asset classes such as equities and bonds, investors increase the risk-adjusted returns of a broad basket of investments.
Inflation is a risk
Merrill Lynch makes it clear that it is not trying to downplay the risks to commodity markets from a US recession. In its view, it is unlikely that the world can sustain a deep, very prolonged recession driven by a collapse in domestic consumption. This situation could ultimately create a Black Swan scenario for commodities, driving prices substantially lower.
However, in the absence of that, Merrill’s researchers believe that rising emerging markets (EM) inflation is posing a much more serious risk to the global economy and hence commodities than the US slowdown. Inflation has not yet increased across the board, but inflation surprises are ticking up dramatically. This could eventually trigger a much sharper reaction by EM central banks than the moderate tightening seen so far.
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