Commodity Prices Are Tanking – Should We Worry?

Commodity prices fell close to the lowest level since 2002 this week, under pressure from a rout in precious metals, lower oil prices and weakness in most agricultural and soft commodities. The Bloomberg Commodity Index, which tracks a basket of 22 materials, fell to its lowest point in almost 13 years as the strengthening US dollar weighed on well-supplied markets for energy, metals, grains, etc.

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Across commodities, there are increasing signs that the more than decade-long “commodity supercycle” has ended. Commodity producers have responded to several years of elevated prices by bringing on new supplies, which have more than met growth in demand from China and emerging markets.

Gold dropped below $1,100 an ounce this week for the first time in five years; US WTI crude oil futures fell below $50 a barrel this week, less than half its level from July last year; and copper fell to a six-year low below $2.40 a pound. Prices for aluminum, a metal heavily used in car making and packaging, have declined 10% since the beginning of the year.

The US dollar Index hit a three-month high on expectations that the Federal Reserve will raise interest rates this year. A rising dollar tends to make most commodities cheaper. Likewise, a rising US currency usually sends the dollar-denominated gold price lower.

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After an encouraging start to the 2Q, the commodity rally has fizzled out and the outlook for the rest of the year is a difficult one. Last year commodities recorded their biggest annual loss since the global financial crisis, with the spot Bloomberg Index falling almost 17%. It has lost another 10% this year.

Excess supplies have hammered oil prices, while an expected bumper crop in the US (the largest agricultural exporter) put pressure on grain prices. The price of sugar fell to a six-year low this week after news of a bumper harvest in Brazil compounded fears of a global supply glut. Making matters worse, demand for artificial sweeteners is rising rapidly in China.

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Falling commodity prices have taken their toll on the mining sector. Six of the 10 worst performers in the FTSE 100 this year are mining stocks, while the FTSE industrial metals and mining sector is down 26% since January.

The price of iron ore, the key ingredient in steelmaking, is down 77% from its peak as supply has overwhelmed demand. Iron-ore prices are being punished in part because of slackening demand from steelmakers. Chinese steel production is expected to fall for the first time in 40 years in 2015. Steel demand in China fell 3% last year and is expected to fall more this year, the state-backed China Iron and Steel Association said recently.

Investment funds have been pulling money out as commodities have underperformed other markets. “Financial flows seem to be at least partly responsible for this recent leg lower in prices,” said Aakash Doshi, an analyst at CitiGroup.

Weakening global growth has hurt demand for commodities across the board. All eyes are on China since its economy cooled to the slowest pace since 2009 in the first half of this year. Fears of a hard landing in China have been rekindled by weakness in the country’s stock market, which collapsed apprx. 30% recently, wiping out more than $3 trillion of paper wealth at one point.

At the end of the day, the question is whether the drop in commodity prices is a good thing or a bad thing. If you are a producer of commodities, then it’s a bad thing. On the other hand, for consumers of commodities, it’s a good thing – at least in theory. However, some fear that the sharp decline in commodities, along with the slowdown in global growth, could lead to deflation – which in turn could lead to a new recession.

We’re not there yet. The IMF still forecasts global growth of 3.3% this year, down from its earlier forecast of 3.5%. I will not be surprised if the IMF revises its forecast even lower later this year, but a global recession does not appear to be in the cards just yet.

Finally, we have to wonder how the severe weakness in commodity prices will affect the Fed’s decision on when to raise interest rates. Fed Chair Janet Yellen was pretty hawkish in her recent congressional testimony, warning that “liftoff” could come at any time. We’ll see.

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