The end of the reflation trade?
The current fall in the commodity complex does not seem to portend a steep fall in global growth prospects
Once again commodity prices are getting hammered. Oil prices have dropped below $50 a barrel, and continue to show weakness. Iron ore prices are down 30 per cent, with many other commodities, including copper, down double digits. There are growing fears that the whole commodity complex is once again coming under pressure. Does this price action have any information value for global growth? Should we be worried? Equity markets globally are expensive, and priced for accelerating growth and earnings. Worryingly, the two pillars of the global reflation trade, China and the US, are both showing weakness.
The economic surprise index for the US has turned decisively down, after a period of outperformance, with the recent data being quite weak. US real gross domestic product (GDP) rose by only 0.7 per cent in Q1 2017 quarter-onquarter (Q-o-Q) and was only up 1.9 per cent year-onyear (Y-o-Y). Real personal consumption expenditure rose by only 0.3 per cent (Q-on-Q) in Q1 2017, with auto sales down 2.4 per cent year-to-date. All this data indicates that the US economy has slowed down. Is this the same seasonal lull of the past few years or something more sinister? We will need to see movement on tax reform, fiscal policy and infrastructure investment to trigger renewed enthusiasm on growth and acceleration in the underlying economy. Absent policy action the Trump trade may stall.
China seems to be having its own issues, linked to the slowdown in credit, as the authorities start to focus on systemic issues and clamp down on the shadow banking complex. There is a fear that this clampdown on wealth management products and the shadow banking system, will trigger an accident which could put the whole China cyclical rebound story in doubt. Markets do not like tightening financial conditions in a highly leveraged economy. There has been fear around the unwinding of leverage in China for many years. The whole bear case on China is largely built around this leverage unwind. Markets are concerned that any slowdown in credit may push some borrowers over the edge. If we see a wave of defaults it may spiral out of control, and the authorities may lose control.
Till recently everyone was talking about a synchronous global recovery, for the first time in years, has that been derailed? Is the weakness in commodity prices a harbinger for slower growth and weaker global demand. Or is it simply a resetting of demand/supply dynamics?
China is the largest consumer of commodities, and the driver of prices on the margin. Despite an administrative tightening of credit conditions and a clampdown on shadow banking, the outlook seems to be benign. Construction is the biggest driver of China’s demand for commodities and the drawdown on housing inventories over the last 18 months and the need to refill these inventories will ensure that residential construction demand does not fall off a cliff. If construction demand holds then commodities will not go into a death spiral. There is also a very strong conviction on the part of most investors that this clampdown on the shadow banks will not be allowed to push the economy over the edge. When push comes to shove, in recent years the Chinese authorities have always sacrificed long-term structural reform to salvage short-term growth.
Most experts also seem convinced, that Q1 is a cyclical aberration for the US demand, with the economy coming back on track in the subsequent quarters. With Europe’s cyclical upswing gaining strength, especially after the election of Emmanuel Macron, and the outlook for Emerging Markets or EMs (ex-China) looking strong, the global demand for commodities looks fine. The current decline in prices has not been driven from the demand side.
It seems that a reassessment of the supply side has driven the current fall. Futures liquidation explains much of the steep decline in Chinese prices of commodities. It seems that the underlying real demand for commodity inputs is stable, but recent speculation on China’s commodity exchanges had driven prices well ahead of the fundamentals. Worried by this rampant speculation, the authorities in China launched a crackdown, which has precipitated the price fall across commodities in China. Iron ore, down by 30 per cent, has borne the brunt of this regulatory backlash. This is more speculative unwind rather than demand collapse.
For oil prices, again the market is moving to a more rational set of expectations. Saudi Arabia has been unable to crush the US shale industry. Whatever production cuts Saudi Arabia and OPEC have delivered, the US shale has filled the breach, ramping production and taking full advantage of the stability in oil prices. Saudi production cuts seem to be simply handing even greater market share to their shale competitors. In these circumstances, market participants have come to the conclusion that further production cuts from OPEC are unlikely and the Saudi Arabia will once again focus on market share rather than another futile attempt to keep prices high. Accepting this new reality, market players have reduced their bullish bets on oil and cut long positions.
Given the above, the current fall in the commodity complex does not seem to portend a steep fall in global growth prospects. It seems to imply a more rational normalisation of demand supply dynamics. There is also an element of unwinding of financial positions.
Outside the resource sector, its stocks and countries heavily dependent on commodities, this ongoing decline in the commodity complex is an unalloyed positive. It is a wealth transfer from producers of commodities to consumers. India, for example, is a huge beneficiary of falling commodity prices but stable global growth. It is a goldilocks scenario for India. Stable global growth and liquidity conditions, cheap commodities and reasonable risk appetite. India stands apart from most countries in the EM world in such an environment. Let us hope these conditions continue.