Commodities Showing Cracks - August 7, 2002
by Stephen S. Poloz, Vice-President and Chief Economist
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Include commodity markets among the various economic indicators now warning us that the global recovery may be faltering. Prices for both copper and nickel, which are often credited with good economic forecasting ability, have rolled over decisively in recent weeks.
Why are commodities a good barometer of global business conditions? During a recession companies cut production and sell their inventories. This reduces demand for resources, weakening their prices. Once inventories have been trimmed, production resumes to meet the lower level of demand, and commodity markets strengthen. When the recovery begins, companies ramp up production to meet the stronger demand and to rebuild their inventories, both at the same time, and commodity prices can surge. Once inventories have been restored, production eases back to a more normal pace, and commodity prices find a stable trading range.
Indeed, resource prices usually give leading information about the global business cycle. This is mainly because companies must order the materials well before they become finished goods. Also, investors buy commodities when they think stronger economic growth is around the corner.
Commodities gave a strong recovery signal late last year. By early this summer, nickel, copper and steel prices had risen by more than 50% from their 2001 lows. However, copper and nickel prices have now retreated by over 10%, fuelling concern that the recovery may have faltered. The commodity-sensitive Canadian and Australian dollars have also stumbled, another confirmation.
The popular interpretation of these developments is as follows. Allegations of corporate fraud have produced a major sell-off in global stock markets. There is a high and rising correlation between the stock market and U.S. consumer confidence, which has started to erode. A big drop in consumer confidence could lead to cutbacks in consumer spending and slower U.S. economic growth, thereby delaying the global recovery. Hence, companies are turning cautious, and this may already be showing up in reduced orders for such base metals as copper and nickel.
There are other possible explanations, of course. It may be that some commodity markets are simply seeing the usual inventory cycle – the surge in demand early this year has given way to a slower growth phase, causing a temporary weakening in commodity prices. This pattern also occurred in early 1999 as the world recovered from the near-recession of 1998. Alternatively, it may be that speculators have sold copper and nickel based on their readings of the tea leaves, while underlying commodity demand remains solid – notice that steel prices are holding up, and most of the evidence of slower growth to date is based on surveys, not actual spending data.
The bottom line? The possibility that stock market turmoil will lead to softer spending and slower growth later this year must be taken seriously. But the possibility remains that the recovery is intact – we always expected the second half of 2002 to be softer than the first half.
Stephen S. Poloz
Vice-President and Chief Economist
Export Development Canada
spoloz@edc.ca |
