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Why have commodity markets cooled?

Posted on Friday, May 20, 2011 at 08:53AM by Registered CommenterSimon Ward | CommentsPost a Comment

Investors are debating whether recent weakness in industrial commodity prices is the beginning of a lasting move reflecting "fundamentals" or a temporary set-back, possibly due to disruption caused by the Japanese earthquake or a liquidation of QE2-related speculative positions. The balance of evidence seems to favour the former view:

1. Commodity price fluctuations are mostly explained by shifts in industrial demand in emerging economies. The close correlation of six-month changes in prices and E7 industrial output suggests little role for financial speculation – see first chart.

2. QE2 has probably boosted commodity prices but the "transmission mechanism" has been an unwarranted loosening of monetary conditions in emerging economies and resulting excessive industrial expansion rather than direct financial investment.

3. Accordingly, the set-back in commodity prices is evidence that emerging-world economic expansion is slowing, probably as a result of domestic monetary policy tightening designed to offset the inflationary effects of QE2. This fits with recent weaker E7 real money supply growth and a proliferation of earnings downgrades by equity analysts – second chart.

4. The global implications could be benign. Emerging economies have driven a strong global recovery but are overheating and need to slow, implying that developed economies must bear more of the burden of sustaining growth. A fall in commodity prices transfers purchasing power from the emerging world to developed market consumers, aiding the necessary transition.

5. A key risk is that China and other emerging economies declare premature victory over inflation, with policy relaxation leading to renewed overheating and upward pressure on commodity prices.

Growth "rebalancing" between emerging and developed economies suggests a slower overall pace of expansion, consistent with experience at the same stage of the late 1970s upswing – see previous post. For equity investors, the implication could be a further rotation away from materials and energy towards sectors likely to benefit from a recovery in developed economies' terms of trade, including consumer goods, consumer staples, health care – and even financials.

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