Musings: Commodities Soar: Green Shoots or Underlying Inflation?

Parks Paton Hoepfl & Brown

The recent stock market rise has been keyed by the dramatic rise in materials and energy company stock prices in response to soaring commodity prices. In May, the Reuters-Jefferies Commodity Research Bureau (CRB) index of 19 commodities futures prices had the largest monthly increase since 1974 - 35 years ago! That historical period was marked by accelerating inflation following the Arab oil embargo and the quadrupling of oil prices from $3 per barrel to $12, the misallocation of domestic economic resources due to wage and price controls introduced by the Nixon administration and fear about the value of the U.S. dollar given the growing pool of international petro-dollars due to the global oil price hike.

The question overhanging the investment community today is why we have experienced this explosion in commodity prices. The global economy remains mired in a recession that has crippled world trade and left the world's manufacturing plants and workers idle, so shouldn't commodity prices - the raw materials of economic activity - be tame?


The 12.3% rise in the CRB index during May was led by crude oil that increased almost 30%, the best monthly gain since March 1999 when oil prices jumped 36% following the agreement between key OPEC producers and Russia to cut production and end the petroleum industry depression resulting from the Asian currencyinduced recession of 1997-1999. Copper, a high profile industrial commodity, saw prices rise nearly 9% during May while lead prices increased 13%. The second largest commodity price jump was experienced by silver, which was up 27%, the largest monthly gain in 22 years or since the Hunt brothers went broke after failing to corner the silver market in the late 1970s.

If one examines the chart of historic performance of a select group of commodities since 2000, it is evident that so far in 2009 the strength has been concentrated in industrial commodities. Copper and lead have been the leaders so far this year with silver and crude oil next. Maybe the more interesting measure is that only three of the 14 commodities tracked have shown negative price changes so far this year. Those commodities include aluminum, coal and natural gas. Natural gas has been the victim of weak demand and surging supplies in the U.S. while the coal industry has been hit by lower electricity demand, weaker industrial consumption and fears about carbon regulations in the U.S. making it a less desirable fuel for the future. Aluminum is the one industrial commodity most hurt by the economic contraction, especially given the cutbacks in the aerospace and automobile industries.


The strength of commodity markets has been attributed to the "green shoots" of economic recovery sprouting around the globe. People have cited the continuing strength of manufacturing data for China as support of the economic recovery scenario. The Chinese Purchasing Managers Index has risen for the past three months. In addition, there have been several positive early economic statistics in the United States, but the key support for the "green shoots" theory has come from antidotal observations by financial and corporate executives suggesting that the pace of the global economic decline has slowed and may actually be forming a bottom. For Wall Street, these signs breed conviction that the next move in economic activity is up, and that stocks will be the primary beneficiary. That could prove wrong, but it is the conventional wisdom, which is driving both commodity prices and stock prices higher.

The economically sensitive Baltic Dry Index (BDI) that measures prices charged for ships engaged in world cargo trade also has been recovering this year from its second half of 2008 collapse. The index surprisingly rose every day during May. In fact, the BDI rose for 23 straight sessions before falling last Wednesday for a brief respite. Since its low on December 5th, the BDI has climbed a staggering 517%. In 2008, however, the index fell 94% from its May peak. To return to that previous peak, the index still needs to rise by another 188%. Global factors attributed to driving the BDI rise are increased iron ore demand in China in response to its economic stimulus program, harbor congestion in China and a shortage of ships in the Atlantic Basin. What is quite interesting about the performance of the BDI is its close correlation to the changes in the Chinese PMI.


The BDI has also shown a remarkable parallel performance to the Economist Metals Index. This would suggest that the recovery of both the BDI and industrial commodities is signifying the early signs of the resumption of global economic activity. It may still be premature to ascribe these actions as confirmation of the start of a robust economic recovery, something the bulls on Wall Street would like to see happen.

Many economic and financial problems still exist to inhibit a robust pace of economic recovery. The 345,000 job losses for May reported last Friday was considerably better than expected, but it extends the monthly job losses to 17 months, equal to the string of monthly job losses experienced in the 1981-1982 recession. The unemployment rate for May climbed 0.5% to 9.4%, higher than the forecasted 9.2% rate. Economists expect the unemployment rate to continue to rise probably into 2010 and exceed 10%.


Until job losses cease, it will be hard for the economy to experience a robust recovery. An additional problem for the pace of the recovery was the worker productivity data reported by the U.S. Labor Department on Thursday. It showed productivity improving in the face of the economy's slowdown. That pattern is atypical of what normally occurs during a recession. The government reported nonfarm business productivity rose at a 1.6% annual rate in the first quarter, double the initial estimate, and compared with a 0.6% decline in the fourth quarter. In contrast, during the recession of 1981-1982, labor productivity fell as much as 5%. The implication is that manufacturers can generate output with fewer hours worked, or fewer workers. When the economy recovers, the productivity gains could be significant in the early stages of the recovery delaying the need to hire additional workers thus prolonging the consumer pain from the economic downturn. Since consumers account for 70% of economic spending and are being counted on by the Obama administration to help drive the economic recovery, this data is not a positive for a strong recovery. That possibly means a weaker energy demand increase, also.

Another factor driving commodity prices higher is investor fear that the value of the U.S. dollar is being debased by the federal government's spending splurge and its need to print money to finance the economic stimulus program. The U.S. dollar index has recently hit a new low this year of 79, taking it back to levels experienced at the end of last year. That drop has contributed to the rise in the value of many foreign currencies such as the British pound and the Canadian dollar. It also drives foreigners to buy commodities that become cheaper in U.S. dollars and afford some inflation protection.

The impact of the fall in the value of dollar from early 2007 through to its trough in the summer of 2008 can be seen in the upward move


of the CRB index during that period. The fall in the dollar's value so far in 2009 has to be partially responsible for the strengthening of the CRB, which merely reflects what is happening to the underlying commodity prices. Some observers have pointed out that the most recent dollar slide started when Chrysler filed for Chapter 11 protection. At that point, many investors, both here and abroad began to recognize the structural changes underway in the U.S. economy driven by the Obama administration's willingness to become deeply involved in its functioning. Economic involvement of this scale by the government has not been seen in the U.S. since the 1930s and its possible ramifications continue to haunt investors.


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