Commodities Conundrum

The commodity prices are down sharply and there are talks of the famous commodity super cycle going bust as the US dollar reverses course, bringing an end to the wild rise in all dollar denominated assets, particularly Commodities, which were a big hit in last six and half years. Oil and Gold prices are off about 30% from their all time peaks earlier this year and a near term recovery looks unsustainable.

However, it might not be game over for commodities and we may well be in a corrective phase of a long term bull run for natural resources as a full-fledged slowdown in the global economy would only be followed by a cyclical upturn in years to come. It is needless to say that economic boom means demand for assets of all kind and in this particular case – from all over the world.

Current Downturn Is No End 2006

The recovery in the global equity markets after the US credit filled boom ended in 2001 witnessed a tremendous appetite for commodities like industrial metals, grains, soft, bullion and energies alongside it as the burgeoning demand from emerging economies, particularly China and India made up for a strong story on demand front. However, enter 2008 and after an initial period of unprecedented and unforeseen euphoria, commodities are in a swoon. This is not end 2006 when the rising global interest rates had taken a toll on major commodities. The price action in the commodities spectrum in last couple of years is an apt example of how the traditional commodity pricing theories have been put to a scrupulous test with prices for all assets rising in unified fashion even as the global economic outlook was turning from grim to gloomy. How to explain commodity prices go up while the economy turns down? If strong economic growth was not the explanation for the large increases in virtually all commodities, then what was?

World Headed For A Synchronized Slowdown

Since the US housing market took a transatlantic flight in August last year and the world looked headed for a significant, synchronized slowdown, the first in seven years, no factors were at play to provide a support to global commodities on a fundamental front. It was the weakness in US dollar calling the shots instead. The idea that commodities offer great hedge in times on economic uncertainty was also at the helm with falling equities making investors flock to hard and soft assets alike. Indeed, the near vertical rise in the prices of virtually all the commodities in last one year, particularly crude oil and base metals defied the basic economic principles of demand and supply.

Breaking Up Commodity Price Cycle

Before we analyze the commodity price trends in the last one-year of turmoil, it is important to do some historical hauling on the subject. The gigantic commodity price cycle could be phased out in three stages. The initial stage, where the argument was strong growth in developed as well as developing economies, followed soon after the recovery in the global markets started in 2002 and set the ball rolling for a boom that seemed built to last. The middle stage, which could be argued to have started somewhere in 2004-2005, was based on an embedded growth perspective, an idea which fostered on premise that global growth would continue uninterrupted for years.

The third and the most critical stage of the boom arrived last year and defied the primordial economic fundamentals to make the world believe that we are entering into a perennially high commodity price regime, insulated even in troubled economic times. This was further spurred by the monetary charade by the US Fed, which cut the interest rates too much and too fast, toppling the US dollar to all time lows and pushing up the dollar denominated assets in turn.

At this time, it dawned upon most of us that the last leg of the commodity super cycle was fueled to a large extent by butterfly effect that linked burst of massive credit bubbles in US to commodity prices. The last leg of the rally was an implication of the punishing downside of the global financial market integration, a downside that the world has witnessed on numerous occasions in the past, namely the Asian financial crisis, the LTCM episode or the currency crisis in South America.

Historically, Commodities Edge Out Other Asset Classes

However, it is hard to believe that the world could get a reprieve from the commodity price inflation in years to come and the era of global disinflation might be hard to experience as a response to good old supply-demand fundamentals. The empirical evidence is very much on side of commodities when it comes down to fighting recession as revealed in a groundbreaking study from the Yale School of Management’s Center for International Finance entitled Facts and Fantasies About Commodity Futures in 2005.

Leave The Markets On Their Own

Markets work best when they are left on their own. However, the Fed does not seem to believe in it. As soon as the Fed started its rate cutting campaign, the interconnectedness between currency and commodity markets. The Fed, characteristically, erred on caution in cutting rates too far and too much, in turn sending financial contagion around the globe. Only if the Fed had not cut the rates so drastically, it would have helped the global asset markets to sort out the things on their own. The slide in equities, which Fed managed to extend by a few months, would have been much quicker. However, the most important impact would have been on commodities, which experienced an upshot of gigantic proportions, pulling the multi-decade secular price trends into bubble territory. Bubbles, as we all know are called bubbles because they cant last forever.

Give It Some Time!

To sum it up, the softness in commodity prices might stay around for some time, though it might not be the end of the world for commodities. The severity of the current downturn is just a counter action to the superfluous enthusiasm witnessed by commodities in the last leg of its price cycle. Dollar’s radical upturn may soon fade away, as the worse still awaits on the US financials front, with the Lehman disaster being just the tip of iceberg. The overwhelming debts in the United States, coupled with the strong probability the U.S. dollar will continue to fall, is one major reason natural resource prices might still be favorites. Futures market are not really leveraged casinos, as put forward by critics who blamed the unusual rise in the commodities over the first half of 2008, but they act upon laws of demand and supply only. That they act a little too fast and a little too drastically is only a part of the game called financial markets.

Waning Dollar May Not Help On Trade Deficit Front

The bold action by the US Fed may do little to ease the worries on the US trade balance front. Contrary to the popular opinions, the trade deficit of the all mighty US may not shrink in line with the perpetual slump the US dollar seems to have lurched into after the US fed cut its benchmark interest rates by 50 basis points on 18 September in order to prevent the economy from slowing down further as the sub prime contagion threatened to rip the global credit markets apart. The US dollar plummeted against all the major currencies after the surprise cut and is seen hitting all time lows against the Euro in the next few days.



The current account is the broadest measure of the U.S. trade balance as it includes, in addition to trade in goods and services, income received from U.S. investments abroad less payments to foreigners on their investments in the United States. In the second quarter, the United States had a $26.5 surplus on trade in services and a $9.4 billion surplus on income payments. This was hardly enough to offset the massive $204.2 billion deficit on trade in goods, and net unilateral transfers to foreigners equal to $22.5 billion.



The huge deficit on trade in goods is mostly caused by a combination of an overvalued dollar against the Chinese Yuan, a dysfunctional national energy policy that increases U.S. dependence on foreign oil, and the competitive woes of the three domestic automakers. Together, the trade deficit with China and on petroleum and automotive products account for about 95 percent of the deficit on trade in goods and services. To finance the current account deficit, Americans are borrowing and selling assets at a pace of $763 billion a year. U.S. foreign debt exceeds $6 trillion, and the debt service comes to about $2,000 a year for every working American.



The current account deficit imposes a significant tax on GDP growth by moving workers from export and import-competing industries to other sectors of the economy. This reduces labor productivity, research and development (R&D) spending, and important investments in human capital. In 2007 the trade deficit is slicing about $250 billion off GDP, and longer term, it reduces potential annual GDP growth to 3 percent from 4 percent.



There has been a lot of talk of the recent fall in the US dollar coming to the rescue of the economy by shrinking the value of the deficit. However, researchers at the University of Warwick, Warwick Business School and the European Central Bank have just published research that shows falls in US asset prices such as housing and equities have a substantially more important role for reducing US trade imbalances than changes in the US dollar exchange rate.



Their paper "Asset Prices, Exchange Rates and the Current Account," presented a few months back at the Royal Economic Society Conference at the University of Warwick, looks at the relationship between asset prices, exchange rates and the trade balance in the US over the period 1974-2005.



A number of scholars and policy makers believe that a large Dollar exchange rate depreciation is needed to increase US exports and, hence, reduce the trade and current account. However the researchers; Luciana Juvenal of the University of Warwick, Professor Lucio Sarno of Warwick Business School at the University of Warwick, and Marcel Fratzscher of the European Central Bank, found that equity market shocks and housing price shocks had by far the greatest effect on reducing the US trade imbalance accounting for up to 35% of the movements of the US trade balance. By contrast, shocks to the real exchange rate of the US dollar explained less than 5% of such movements and exerted only a temporary effect on the US trade balance.



Warwick Business School Researcher Professor Lucio Sarno said "Our findings suggest that a sizeable real depreciation of the US dollar may not be an inevitability for an adjustment of today's large current account imbalances, and that other factors, in particular global asset price changes, could be an equally or even more potent source of adjustment."



Luciana Juvenal of the University of Warwick said: "These results underline the importance of wealth effects, stemming from asset price developments, as drivers of today's global current account imbalances. The rise in asset prices over the past decade has in particular increased expected income of households in the United States and, therefore, raised their consumption. At the same time, investment has been facilitated in response to this higher demand and firms have found it easier to finance investment opportunities, thus overall worsening the US current account position. Significant falls in US asset prices, and equally stronger increases in asset prices in the rest of the world, will thus have the opposite effect and reduce trade imbalances."



The researchers show that a depreciation of the US dollar worsens the US trade balance slightly upon impact. After this initial reaction, the trade balance improves but the magnitude of the effect is fairly small. For instance a 1.2% real depreciation of the US dollar raises the US trade balance by about 0.06% of US GDP. This implies that even a relatively high real depreciation of the US dollar, for instance by 10%, would improve the US trade balance by a modest 0.5%.



The researchers found that both equity shocks and housing price shocks have larger, and more persistent effects on the US trade balance than a real exchange rate shock. A positive relative equity shock of 10% lowers the US trade balance by 0.9%. Moreover, relative equity market and housing price changes in particular throughout the 1990s have been substantially larger than those for real exchange rates.



However, the gush of liquidity provided by the liberal Fed interest rates cuts has made the US equity markets rally at a rampant pace. This is likely to trickle down to housing, which seems to be in a beleaguered stage at the moment in terms of prices as well as activity. However, the US consumers still continue to spend freely and the retails sales fail to show any convincing slowdown of sorts, which can be correlated with the slowdown syndrome in the economy. It goes without saying that in such a scenario, correcting the fundamental mismatch on the trade balance front is a difficult task, by merely banking on the dollar’s decline.

Futures Perfect- Always

The domestic futures markets are pricing in market fundamentals in an absolutely precise manner, contrary to a popular belief that futures spiral up the prices

The Refined soy oil futures for the month of November are trading to a discount to the spot prices as well as near month contract pricing in the set of fundamental factors in a precise manner- contrary to a popular belief that futures spiral up the prices. At the beginning of the year, Forward Markets Commission (FMC) imposed a ban on futures trading in urad and tur in an effort to control their soaring prices. The government believes that excessive speculation in these two pulses had led to a sharp rise in their prices.

The depressing run for the market continued further as the year progressed as the government axed two more commodities. Under pressure to cool inflation running near two-year highs, the government banned new wheat and rice futures contracts in February in a bid to check speculation and tame prices. On the other hand, market players believe that the price rise is more due to a demand - supply mismatch. The production of pulses has stagnated in last seven years, whereas the population has grown by 20% in the same period.

Prices of Tur and Urad moved in accordance with the poor supply conditions. Tur production was lower last year, slipping to 24.7 lakh tonnes as against 25.7 lakh tonnes previous year, leading to higher prices. In case of Urad, which is primarily a khariff crop, a large chuck of the production was affected due to the incessant rains in AP and Maharshatra, two of the largest producing states of the commodity.

However, these figures carried much more weight when analyzed from a historical perspective. Pulses and indeed, most of the important items of mass consumption have a lop-sided demand-supply equation in the country. The production of Tur was 17 lakh tonnes in 1950 –51 while the latest figures suggest that over the last five and half decades, its gone up by a mere 45%, which, compared to a 300% rise in the country’s population during the same period looks not only very poor but utterly disappointing in terms of assessing the performance of agricultural reforms in the country.

Thus, in case of the major food articles, what drove the prices relentlessly up was the hopelessly lop-sided demand-supply equation and costlier substantial imports. Demand side pressures also proved to be an important catalyst in keeping a shortage syndrome firmly entrenched in the economy. In economic survey 2006-07, the government stated that “Higher demand as a result of an accelerated growth in GDP, higher growth in reserve money because of a faster increase in foreign assets, the multiplier effect of increase in broad money, and credit growth have also exerted pressure on demand side”

The series of bans spooked the investors and made the commodity futures market witness its first pullback in terms of the trading volumes since its inception. In April-June 2007, the total turnover of the three exchanges – the Multi Commodity Exchange of India (MCX), the National Commodities and Derivatives Exchange (NCDX) and the National Multi Commodity Exchange (NMCE) - has fallen by 11.12 per cent compared with the first quarter of the previous year. The commodity futures market had recorded a stupendous growth rate of 96.05 per cent in the last financial year

In the context of these developments it is heartening to see the futures still pricing in the market dynamics in a flawless manner. The above cited price movement of refined soy oil defines the realities in the marketplace which stand testimony to the fact that the markets are serving one of the very basic purpose for which they were launched.

Domestic oilseeds acreage fell in the last year as farmers switched to more profitable crops such as pulses and wheat. While this lead to almost 17% fall in production of oilseeds, a sharp rise in international prices of palm oil and Soya oil led to a sweltering 14% rise in domestic prices of edible oils as a group. Such sweltering buoyancy in price prompted the farmers to increase their acreage of oilseeds in the current kharif season

Futures and options markets also provide the economy with price discovery. Futures prices are determined by supply and demand. An exchange itself does not set prices; it simply provides a place where buyers and sellers can negotiate. If there are more buyers than sellers, the price goes up. If there are more sellers than buyers, the price goes down. The prices discovered through futures markets offer valuable economic information about supply and demand in a competitive business environment.

Instability of commodity prices has always been a major concern of the producers as well as the consumers in an agriculture -dominated country like India. Farmers’ direct exposure to price fluctuations, for instance, makes it too risky for many farmers to invest in otherwise profitable activities. Agricultural products, unlike others, have an added risk. Many of them being typically seasonal would attract only lower price during the harvest season.

However, the current backwardation in the November futures contract- which has shown a constant tendency to drift lower since its launch and continue to trade below the spot prices as well as near month futures - embodying the scarcity premium which seems to be widening as the harvesting season approaches. The total coverage of oilseeds so far has been 149.38 lakh ha as compared to 141.83 lakh ha on August 2, last year. Soybean has been sown in 6% and groundnut in 10% higher area as compared to that in 2006. Thus, while the markets go on about their business in their usual self, justifying that " futures are perfect", the current price movement, when looked in the context of falling turnover on the bourses, makes one wonder – is the government solution to any problem is usually worse than the problem?

“Panic Buying” May Not Last Longer

“Panic Buying” May Not Last Longer

Bubble warnings, structural global imbalances, probable Chinese slowdown, rising global interest rates, soaring energy prices – nothing has been able to scuttle the party in the global equity markets these days.

However, the frenzy and the enthusiasm in the across the board rally can be attributed to “Panic Buying” than sound investing based on a robust set of fundaments. Panic Buying is when investors start purchasing a stock following a large, substantial price increase. It is driven by the fear of being "left out" of the "next bit thing."

Yesterday, in the Asian trades, the bets in the options market against the Standard & Poor's 500 Index exceeded wagers it will rise by a 2-to-1 margin for a month, the longest since Bloomberg began compiling the data in 1995. That's seen as a warning sign the market is due for a decline of 5 to 10 percent after the S&P 500 rose to two records last week, say managers of almost $1 trillion at Morgan Stanley Global Wealth Management, National City Private Client Group and Russell Investment Group.

The Bank for International Settlements issued a warning in the first week of July that the Federal Reserve’s monetary policies have created an enormous equity bubble, which could lead to another “Great Depression”. The BIS--the ultimate bank of central bankers--pointed to a confluence of worrying signs, citing mass issuance of new-fangled credit instruments, soaring levels of household debt, extreme appetite for risk shown by investors, and entrenched imbalances in the world currency system.

The movement in the US markets in the last two sessions of the previous week was baffling. The DJIA rose to all time high levels on the day the US Trade deficit for May rose to $60.04 billion, 2.3 percent more than in April and continued to witness follow up buying in the next session, with the US retail sales declining by 0.9% last month - the biggest fall since August 2005.

Given these economic numbers and the sheer pace of the acceleration in the global equity markets, the scorching rally seen in the last week is likely to top out very soon. The Shanghai composite is clearly overbought with more than 60% gain in the current year and the inflationary pressures continued to linger around the Chinese economy. China's National Bureau of Statistics said this week that it revised its reading for 2006 GDP to 21.09 trillion Yuan, bringing GDP growth for the year to 11.1 percent, compared with the initial report of 10.7 pct.

Meanwhile, global growth accelerated for five straight years to 5.4% in 2006, the highest in at least 27 years, according to the International Monetary Fund. That's despite oil prices doubling over that time. Clearly, while it demonstrates that the ability of the global economy to absorb the oil shocks has improved drastically over the last five years, the risks are inherent at a time when the balance of global economic power is shifting from the US to new age economies like China, India and other emerging markets like Latin America and Russia. Statistics due this week are expected to show that China is on track this year to pass Germany as the world's third-biggest national economy, behind the U.S. and Japan, in another indication of the rapid change of the global balance of power.

Goldman Sachs have also made note of this in one of their latest research updates. The investment back has said “China needs to take 'decisive' action on the monetary front to prevent the economy from overheating, even though the recent upward GDP revision for 2006 may cloud the picture somewhat because of the higher base to compare latest quarterly data with”. Sachs have further noted that “'Therefore, we maintain our view that monetary policy needs to be tightened decisively in the near term to prevent the economy from becoming overheated”.

Since the last two years, when the rally in the global markets intensified, most of the global markets have turned into asset classes, with sentiments driving the market forces significantly than the underlying fundamentals. The fact that the global equity markets are zooming to new highs just at the same time when the crude oil is witnessing a surge towards its all time peak of $78 strengthens this argument. Coming weeks should witness a moderate correction in the global equity markets as the technical funds look to flex their muscles to lock in gains after an extended rally in most of the asset classes. Chronic US sub prime-mortgage woes may spook investors further as housing cracks open up wider dents in the broad economy.

U.S. Treasuries are already pricing this as investors seek a haven for their funds. The 30-year bond yields broke through a 7 year high in the beginning of June and is now holding above where it gapped up at that time. Soaring yields for long-term bonds in turn means higher interest rates, which translates into higher payments for consumers and a drain on discretionary income that can't be put into new purchases to keep the economy growing at the pace needed.