The decoupling debate took on a greater significance for commodities in the fourth quarter of 2007 as market participants pondered whether strong demand from emerging markets was sustainable despite slow or even negative growth in the US and other western economies. Traditional analyses of commodity markets indicate that a US economic slowdown causes demand to slump, resulting in lower prices for commodities. However, despite the consensus view that the US is entering a period of low, if not negative growth, commodity prices have remained strong, driven in large part by the continuing success of emerging economies in the face of the poor US economic outlook.
One may expect that demand in the supposedly export-driven emerging economies would suffer at the hands of an American slowdown; however on closer analysis these economies have become less dependent on exports to developed economies than many believe. For example, exports to the US account for only 8% of GDP in China, 4% in India, 3% in Brazil and 1% in Russia.
Whilst export growth from emerging economies to the US has slowed, trade growth between emerging economies has surged. Exports from China to the US grew by only 5% in the year to January 2007, yet over the same period exports to Brazil, Russia and India rose by more than 60%. Domestic demand now also plays a huge role in the growth rates of developing economies. Indeed, some 95% of Chinese GDP growth in 2007 came from domestic demand. The resilience of emerging economies has been a driving force behind the continued strength in demand for commodities.
Take crude oil as an example; tight supply and rampant demand growth in emerging economies has helped push crude oil prices to record highs. Yet despite high prices, there has been none of the demand destruction that many analysts would have predicted not so long ago. A number of factors shed light on the capacity of the global economy to absorb high oil prices. Whilst oil prices are at record nominal highs, spending on oil as a percentage of global output would not compare to the level reached in 1980 until oil rises above US$150pbl. At the same time GDP growth in emerging economies such as China is becoming increasingly more energy efficient. Consumers in a number of emerging economies are also insulated from the high oil price as their governments heavily subsidise energy consumption. In fact, demand destruction has hardly manifested itself even among the battered American consumer, despite record oil prices of over US$125 at the time of writing.
The second factor driving commodities in 2008 has been the declining US Dollar. Not so long ago currency speculators would lean towards economies experiencing high inflation with the expectation of inflation-fighting interest rates from central banks.
However, currency markets have taken note this year that the US Federal Reserve holds little concern for fighting inflation in the face of credit market turmoil and domestic economic slowdown, slashing rates aggressively and leading to sharp Dollar falls against other major currencies. In response, the prices of dollar-denominated commodities have had to rise in response to the weakening value of the dollar.
Moreover, since many emerging economies still peg their currencies to the Dollar, monetary policy has become far too loose in some of these rapidly expanding economies, further fuelling commodity price inflation.
Thirdly, investment demand for commodities has accelerated in 2008, pushing prices higher. Commodities are unquestionably the vogue asset class of the day, attracting great interest from hedge funds, ETFs and index investors. Research by Lehman Bros indicates that commodity index investments alone have ballooned from US$70 billion at the end of 2006 to US$235 billion in April 2008. These large capital inflows have a considerable manipulating impact on price, especially in some of the less liquid markets like Cocoa, where Lehman Bros has suggested that an allocation of US$1 million in the S&P GSCI can cause prices to rise by as much as 3.2%. Higher prices in turn attract more speculative capital from the technically driven and momentum-following funds, as well as inflation-hedging portfolio managers, creating a self-fulfilling prophecy of rising prices. The pace of capital inflows into commodities has undoubtedly increased in 2008 as more investors have diversified away from equity and fixed-income markets.
What does all this mean for the second half of 2008? The factors that have driven commodity prices in the first half of the year are unlikely to abate in the next 6 months. Commodities as an asset class continue to shine and investors will stay with commodities until other asset classes begin to look attractive again. This could happen as early as Q1 2009, although the road to recovery may take significantly longer. In the meantime the arrival of large numbers of new players in commodity markets has served to ramp up volatility as most of these new participants react to the same changes in currencies, technical indicators and other exogenous factors. Indeed, witness the large-scale sell off that swept across a number of commodity markets as risk-aversion took height on 17 March and large numbers of index investors withdrew cash to fund positions in other asset classes.
Herein lies what will be the big story for the second half of 2008: extreme volatility across the commodities complex
Ebullio Capital Management was founded by Partners Lars H Steffensen and Grahame (Chad) Benson in September 2007. Between January and April 2008 Ebullio has made an average return of 7.91% per month. It is a discretionary investment manager, gaining exposure to commodities through a combination of futures, options and physical trading of commodities.