Morgan Stanley Dean Witter expects commodity prices to rebound during second half of 1999 and fears of deflation to give way to fears of inflation.
Global: Supply or Demand?
Stephen Roach (New York)
Commodity markets are seemingly in a state of total disarray. In inflation-adjusted terms, the CRB
composite index of spot industrials has been setting new record lows for each month since last August.
Many believe such a trend portends a world that is slipping dangerously toward a secular deflation. A
recent study by the World Bank lends credence to this notion, stressing that structural forces should
both depress demand and boost supply. Largely for those reasons, the World Bank goes so far as to
suggest that real commodity prices could be lower in 2010 than they were in 1997. How likely is such
an outcome?
One of the first things budding economists are taught is to be wary of "the identification problem" --
attributing an observable economic phenomenon to one of two competing hypothesis. Such may be the
case with the current softness in commodity prices. Most seem convinced that this outcome is traceable
to chronic capacity excesses on the supply side of the equation. But it may well be that there is an
equally powerful explanation on the demand side of world commodity markets. Consider the following:
There is fairly conclusive evidence that the Asian crisis triggered a severe shock on the demand side of
the commodity equation, effectively wiping out the largest incremental source of consumption growth
in these markets in the 1990s. About nine months ago, the International Monetary Fund published an
interesting study on the linkage between the Asian crisis and trends in global commodity demand (see
Annex II of the IMF's May 1998 World Economic Outlook, "Recent Developments in Primary
Commodity Markets"). IMF researchers found that non-Japan Asia accounted for approximately 65%
of the total growth in worldwide industrial commodity consumption in the five-year pre-crisis interval
of 1992-96; this was true of petroleum, base metals, rubber, coarse grains, oilmeals, and fats and oils.
In other words, the crisis economies of Asia were, by far, the most commodity-intensive consumers in
the world, accounting for an enormous increment of the growth in overall commodity consumption that
is nearly three times the region's 23% share of world GDP. Not surprisingly, as Asia went, commodity
prices were quick to follow.
There is a broader point also worth noting. Prior to the global currency crisis, non-Japan Asia played a
very important role in driving the global economy in the 1990s. The region surged at an 8% average
annual rate over the 1990-97, rapid enough to have accounted for approximately 55% of overall world
GDP growth (which averaged 3.2%) over this same interval. In other words, non-Japan Asia's share
of global growth in the 1990s was about two and a half times its 23% slice of world GDP.
Consequently, courtesy of the Asian crisis, the world growth engine has lost its major source of fuel.
Little wonder that the supply-demand balance has tipped steadily toward deflation.
The key question is whether these deflationary forces will remain intact in the years ahead. In my view,
there are several reasons to believe the answer is no. For starters, our baseline case for the global
economy envisions world GDP growth accelerating to 3% in 2000, fully 50% faster than the average
gains of only about 2% that we estimate are occurring over the 1998-99 period. Moreover, a weaker
dollar automatically provides a sharp uplift to commodity prices, 95% of which are quoted in
dollar-denominated terms; this is effectively the mirror image of the strong-dollar scenario that was in
place from the spring of 1995 through the summer of 1998, which acted as a major depressant for most
commodity prices. Additionally, as the global economy awakens from its slumber, there should be a
gradual restoration of pricing leverage, especially in a rapidly growing and fully-employed economy
such as the US where labor cost pressures are bound to build. Finally, the current depressed level of
commodity prices could well trigger a round of consolidations and "shut-ins" on the supply side of the
equation, an outcome which could reinforce the dynamic we see unfolding on the demand side.
For oversold commodity markets, our global scenario hints at a very different outcome than a simple
extrapolation of recent trends might suggest. If the world slowly begins to heal, as we suspect, I would
not be surprised to see a meaningful rebound in commodity prices commence at some point in the
second half of 1999. This is consistent with the belief that both Byron Wien and I share -- that by the
end of this year, fears of deflation will be replaced by concerns over reflation. If that turns out to be
true, keep an eye on the stocks of long-depressed commodity cyclicals and intermediate materials
producers. At the same time, watch out for bonds -- they're still priced for the virtual absence of any
pickup in inflation. If we've got the demand piece of the commodity story correct, that key assumption
could also be challenged by the end of this year. |
