Why the slump in commodity prices matters

Markets continue to focus on when the US Federal Reserve and the Bank of England will raise interest rates, by how much and for how long. Yet last month’s Federal Open Markets Committee passed by with chair Janet Yellen offering no more clarity than before, as the carefully constructed minutes left all options open to America’s monetary policy makers.

Yet amid all of the talk of economic strength prompting increases in interest rates, another trend is almost being lost in the noise – commodity price weakness.

• The Bloomberg Commodity Index, which tracks the futures prices of 22 raw materials, is languishing at levels last seen in 2003.

Commodity price benchmark index is still falling

Source: Thomson Reuters Datastream

• Oil is back in a bear market. Both the European Brent and American West Texas Intermediate benchmarks for the black stuff have fallen by more than 20% from the peaks reached during the spring rally

Oil is back in a bear market

Source: Thomson Reuters Datastream

• Doctor Copper, that great barometer of global economic health is stuck at a level last seen in 2009.

Copper still has a sickly hue

Source: Thomson Reuters Datastream

Much of the narrative from analysts deployed to explain this away focuses on supply. The rise of the American shale and fracking industries, the miners’ capital spending splurge over the past decade and more efficient farming techniques are all cited. Yet demand is rarely mentioned, even at a time when China, a massive incremental consumer of raw materials this century, is going through an economic rebalancing (at best) and a major slowdown (at worst).

There is the chance that the commodity price rout is a warning that deflationary forces are still strong. Inflation is still muted, despite central banks’ best efforts, and if Janet Yellen and Mark Carney truly believed the economy was strong then they would have moved on interest rates already. As Jack Nicholson’s mob boss Frank Costello says in the 2006 movie The Departed “If you coulda, you woulda.”

Even if Yellen and Carney oblige the market consensus by moving within the next two to six months, it seems likely they will do so in very small, well-telegraphed steps. The bond market may well have discounted at least some of this action already. And if the consensus is wrong then bonds might just surprise in the second half of this year, just as they did in 2014, despite understandable fears that central banks’ 2% inflation targets mean 10- and 30-year sovereign issues may offer little protection to investors’ savings should they eventually succeed. Perhaps commodities can be a useful guide as to the progress Yellen, Carney, Mario Draghi in Europe and Haruhiko Kuroda in Japan are making.

Ten-year sovereign bonds are rallying as yields fall

Source: Thomson Reuters Datastream

The same pattern is more pronounced in thirty-year paper

Source: Thomson Reuters Datastream

In the raw

To update a chart last used by this column some two months ago, just one headline commodities have eked out a price increase this year. Well done to anyone who owns cocoa.

Few commodities have risen in price so far in 2015

Source: CRB

Such action hardly smacks of an inflationary global recovery and could warn of a fresh deflationary scare. As former BBC economic correspondent and now JP Morgan strategist Stephanie Flanders shrewdly pointed out in the Financial Times last week, the CPB World Trade Monitor for May showed that global trade fell in May 2015, the fourth drop in five months. Add that to commodity price drops, an ongoing plunge in the Shanghai Containerised Shipping Index and the depressed level of the Baltic Dry Index (even after a big bounce this spring) and the outlook for global economic activity looks mixed at best. It can only be hoped that the first half’s ports strike in California had a big role in global shipping’s slump and that this effect will unwind.

Momentum in global trade growth remains weak

Source: CRB

Bounce in Baltic Dry Index offers grounds for hope

Source: Thomson Reuters Datastream

It can only be hoped that the first half’s ports strike in California had a big role in global shipping’s slump and that this effect will unwind. If not, we may be due for another deflationary fright, something no-one is really expecting, as a result of Quantitative Easing programmes in Japan and Switzerland and interest rate cuts across  more than 20 nations worldwide.

That would potentially favour bonds and bond funds at least in the short term, unless the collective in question was a flexible bond fund with a portfolio positioned for rate rises and an overweight of short duration paper. In this scenario that fund would still generate income and capital gains, but it would underperform its peers, as long-dated paper with higher coupons would be likely to do best.

Rubbed out

Amid the commodity slump, the shine has come off gold, which has plunged in dollar, and sterling terms and even when priced in euro and yen, despite the QE schemes there. This suggests the market remains convinced interest rate rises are coming.

Gold is in the grip of the global commodity malaise...

Source: Thomson Reuters Datastream

But if deflation strikes and central banks respond with rates that are lower for longer or even (heaven forbid) more QE, the precious metal could yet have its day in the sun. As Société Générale’s (admittedly notoriously bearish) strategist Albert Edwards reminds us, gold romped higher from 1970 to 1974 only to then halve by 1976 – and then rise nine-fold from $100 an ounce to $920 as inflation ran fast and loose and bonds took a pasting. The chart below shows how the price movement was no less dramatic in sterling terms.

... though gold fans will take comfort from the 1970s

Source: Thomson Reuters Datastream

Inflation would thus favour gold, deflation bonds, with equities potentially falling between the two. The tailspin in mining and oil stocks is a clear reflection of commodity price weakness. Both groupings remain anchored near the bottom of the performance rankings for the 39 sectors which comprise the FTSE All-Share.

Commodity stocks are the worst performers in the UK year to date

Performance ranking	Sector	Performance, year to date
1	Forestry & Paper	44.3%
2	Household Goods	23.0%
3	Software & Computer Services	22.6%
4	Non-life insurance	20.2%
5	Real Estate Investment & Services	19.5%
6	Construction & Materials	18.6%
7	Fixed Line Telecommunications	15.8%
8	General Industrials	13.9%
9	Media	11.2%
10	Real Estate Investment Trusts	10.9%
	FTSE All Share	1.3%
30	Healthcare Equipment & Services	-0.6%
31	Bevergaes	-1.0%
32	Chemicals	-2.2%
33	Industrial Engineering	-5.6%
34	Gas, Water & Multi-Utilities	-6.2%
35	Aerospace & Defence	-8.0%
36	Electricity	-10.8%
37	Oil & Gas Producers	-11.4%
38	Mining	-22.8%
39	Industrial Metals & Mining	-32.9%

Source: Thomson Reuters Datastream. From 1 January to 31 July.

Yet on a stock by stock basis, there are some beneficiaries too. Consumer discretionary stocks, such as general retailers, media, travel and leisure firms may feel perkier as consumers have more spare cash to spend owing to lower petrol prices, while some industries should benefit from lower input costs if oil stays weak – airlines and chemicals spring to mind.

Russ Mould

AJ Bell Investment Director