Rising stock prices may be self-sustaining, but rising commodity prices are self-limiting

By: ECR_Research

The upswing in resource prices continues. From a fundamental perspective this is no surprise. As the US, Japan, and Europe pursue an unremittingly loose monetary policy, credit supply to the “real” economy is more or less stagnant. Therefore a lot of capital is available for speculation. In addition, growth rates (and the anticipated returns) in the emerging economic nations outpace those in the West, whereas the former consume relatively high quantities of commodities. Owing to various capital restrictions it has now become easier and cheaper to speculate on buoyant growth in the upcoming economies through the commodity markets. On top of this US growth is accelerating while resources are becoming more popular as an inflation hedge.

The prices of most resources have a ceiling (unless the commodity in question happens to be in short supply as demand stays high irrespective of the price). Once the price breaks through this upper limit, it becomes profitable:

• To look for alternatives to this particular commodity and use it more efficiently (recycling is one of the option), which will depress demand. A good example is the search for alternative source of energy that took off as oil prices soared towards $140.
• To exploit new sources that may have been uneconomic when prices were lower. Usually, expanding supply has a delayed negative effect on prices but in general terms this process is virtually always running in the background. For instance, quite a few stocks of companies supplying the mining industry are performing above average, indicating that investment in (new) mines and energy sources is increasing.

Furthermore, let’s not forget that purchasing power per capita is far lower in the emerging economies than in the rich countries. People in developing countries are often more motivated to produce more efficiently or to find substitutes for existing resources. But also for the rich economies, higher commodity prices bite. For example, economists have calculated that every $1 increase in the oil prices is subtracting $100bn from the US economy. This is why commodity prices and stock prices (although they are traded by many investors as just different asset classes) have a different effect on the economy. Rising stock prices causes a positive feed back loop, as consumers feel wealthier and companies can issue new stock to fund investments or acquisitions. The positive wealth effect of rising commodity prices on the other hand, is out weighted by the negative effect of more expensive commodities on the real economy

Nevertheless, commodity prices may well continue to rise for longer than the economic fundamentals are suggesting. Mainly because raw materials are increasingly regarded as an asset class that should be part of every investment portfolio (commodity ETF’s are increasingly popular). At the same time, investors are latching onto significant price rises on the commodity markets in hopes of making a sizable profit as prices continue to rocket. So there is a high chance that the prolonged upswing in prices is predominantly driven by investment flows. Simultaneously, the demand/supply ratio is shifting towards expanding supply in combination with lower growth (or even a decrease) in demand. We suspect the world economy is presently at, or very near, that turning point.

The question is, for how long – and to what levels – will investors drive up resource prices? A loose monetary policy is an argument in favor of a prolonged upswing yet counter forces are coming increasingly to the fore:

1) Real interest rates are rising and it is becoming more expensive to hold on to commodities in anticipation of higher prices. (Often storage charges are substantial as well).
2) More and more economists are expecting the emerging nations to implement rate hikes in response to rising inflation and a monetary policy, which is in many Emerging Markets still too loose. In other words, a tighter policy would only normalize monetary policy. Higher rates of interest will impact negatively on growth prospects and asset prices in general.
3) The dollar has appreciated, which has a depressing effect on the prices of commodities traded in dollars.

We at ECR think these developments will gain momentum in the coming months (for reasons why we expect a stronger USD see also our report on EUR/USD). Over the coming weeks or months resource prices could well continue to rise. Yet on balance a substantial downswing is likely in the coming quarters.

ECR Research (www.ecrresearch.com) is one of Europe’s leading independent macroeconomic research institutes focusing on the main currency and interest rate markets. The ECR reports reach a worldwide audience of sophisticated investors and treasurers and CFO’s within corporations and financial institutions. ECR offers a wide range of research products which are online accessible and updated on a weekly basis.

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