The "Commodity Super Cycle" Stalls Out
The "Commodity Super Cycle" took many traders by surprise from 2002 thru 2006, but the rally has stalled out over the past two years. There have been numerous rotations within the five major sectors of the Dow Jones Commodity Index, energy (33%), metals (26%), grains (21%), livestock, (10%), and softs (9%), but the overall index is simply consolidating within a narrow sideways range.
That's surprising, because Chinese and Indian economies, which account for one third of the world's population, are growing at a 12% and 9% clip respectively, the fastest in more than a decade. The big-3 central banks, the Bank of Japan, the European Central Bank, and the Federal Reserve, are pursuing super-easy money policies, with the Euro M3 money supply expanding at an 11.7% annual clip in June, an all-time high, and the US M3 money supply is 13% higher from a year ago.
The Bank of Japan pegs its overnight loan rate at just 0.50%, far out of alignment with the rest of the world, and provides the ammunition for the estimated $500 billion to $1.2 trillion "yen carry" trade, that is inflating markets around the world.
The DJ Commodity Index has been locked within a tight trading range between the 160 and 180 levels, since the Fed capped its rate hike campaign at 5.25% in June 2006. Now that the Fed is finally poised to start lowering the fed funds rate to defuse the sub-prime mortgage debt bomb, which way will the DJ Commodity Index move in response to an easier US monetary policy?
Unilateral rate cuts by the Federal Reserve is expected to weaken the US dollar, and by deduction with simple logic, could also boost dollar denominated commodities such as crude oil, copper, and gold, silver, and base metals. If correct, the DJ Commodity Index can rally towards the 200-level, sparking a whole new round of inflation, a bitter pill to swallow to bail out greedy Wall Street investment bankers, and their sophisticated customers who were duped by rating agencies.
On the other hand, the DJ Commodity Index hasn't been able to escape the recent turmoil in global stock markets, and a mad dash for cash, linked to a global credit market squeeze. Key commodities have tumbled in tandem with sinking stock markets, while the low-yielding Japanese yen and safer government bond markets moved up. Nowadays, global stock markets are viewed as real-time indicators about the health of the global economy. If global stock markets continue to sink in the second half of 2007, it could translate into selling pressure on commodities.
It took a 10% correction for the MSCI All World Stock Index since mid-July to weaken the DJ commodity index by roughly 5 percent. During August 1998, both stock markets and commodities experienced significant drops, rattled by the collapse of Long Term Capital Management, which controlled $100 billion of assets, and threatened a systemic liquidity crisis. Gold, considered to be a safe-haven in times of financial crises, has simply gyrated in a tight range during the recent volatility.
If the US economy sinks into a housing led recession in the months ahead, the global demand for commodities might be balanced out by super strong industrial demand in Asian tigers such as China, India, and South Korea. Industrial production in China is 18% higher, India's factory output is up 9.8%, and Korea's is up 14% from a year ago. But a US led recession could weaken Asian exporters in the months ahead.
The Shanghai red-chip market looks like a Nasdaq-style bubble, and if this one bursts, it could deal a sharp setback to China's political stability and market reforms. China can ill-afford unrest from a market correction, with the nation racing to finish preparations for the 2008 Summer Olympics, to be held in Beijing. So is the Shanghai surge above 5,000 a bubble that is about to burst, or can it remain perched in the stratosphere, supported by strong fundamentals?
The Chinese central bank prints yuan each day, in exchange for foreign currency flowing into the country and has limited the yuan's rise against the US dollar to less than 4% this year, offsetting $256 billion that flowed into the country from abroad in the first half of 2007. Massive printing of yuan has fueled an 18.5% annualized growth rate for China's broad M2 money supply, and a nasty side effect of high inflation, which hit 5.6% in July, its highest in 10-years.
With the yuan undervalued against the US dollar by as much as 35%, China's exports are booming, hitting an all-time high of $107.7 billion in July. To meet booming export demand, China's factories are working overtime. Industrial production is 18% higher in July from a year ago. Yet despite a booming Chinese economy, the Dow Jones Commodity Index tumbled 5% since mid-July, caught in the web of contagion sales from weaker global stock markets.
In contrast, the Baltic Exchange's Dry Freight Index, (BDI) which measures the cost of seaborne trade for dry commodities, such as coal, iron ore, cement and soft commodities like grains and sugar, hit a new record high of 7,474 points this week, and is up from 2,600 in January '06. The index has been driven by huge demand in China and India, and snags from Brazil to Australia. More than 90% of the world's traded goods by volume are carried by sea.
The real force behind the BDI's rise may be China. Seaborne shipping costs are tracking the Shanghai and Hong Kong stock markets, for real time clues about Chinese demand. China's State Reserve Bureau currently oversees the nation's commodities reserves, has said it will step up domestic exploration and increase the country's proven reserves of iron ore by 5 billion metric tons, of copper by 20 million tons, and of bauxite by 200 million tons by 2010.
The Baltic indexes (BDI) measure the cost of various cargoes of raw materials on various routes, 150,000 tons of iron ore going from Australia to China or 150,000 tons of coal from South Africa to Taiwan. The BDI is a good leading indicator for economic growth and production, and an accurate barometer of global trade volume, because it measures deals that are linked to intermediate production, - bulk carriers shipping building materials, cement, grain, coal, and iron. And unlike stock markets, the BDI is devoid of speculation and doesn't deal with "yen carry" traders.
Though China represents only about 5% of the global economy, the mainland consumes about 20% of global aluminum and copper, some 30% of steel, iron ore, and coal, and 45% of cement produced each year. The four giants of the emerging world, China, India, Russia and Brazil, and countries like Venezuela, Algeria, Nigeria and Angola, are using their trade surpluses and petro-dollars to build their economies, and are putting strains on the global transport system.
The Baltic Exchange's Capesize Index, a gauge of iron ore and coal demand for merchant ships carrying 150,000 tons or more, smashed to new records of 10,446. The Baltic Exchange's Panamax Index, an indicator of grains and minerals demand for 80,000-ton shipments, raced higher to 7,332.
Because the supply of cargo ships is usually tight and inelastic, it takes two years to build a new ship, small marginal increases in demand can quickly push the Baltic Dry Index higher. And big increases in demand can send the BDI into orbit. That's precisely what happened this year. As Baltic Cape size Index chart shows, it's more than tripled from a year ago, an unprecedented jump. China's steel factories are consuming massive quantities of nickel and iron ore.
Does the Baltic Cape Size Index chart represent a Nasdaq-style bubble ready to deflate, due to recent sharp declines in global stock markets, or is there a demand-led structural change, led by explosive growth in the Asian tiger economies, reflected by the skyrocketing Shanghai red-chip market? The DJ Commodity Index is caught in the middle of this tug-of-war, between bullish signals from the Baltic Dry Index, and bearish signals from the slumping MSCI All World Stock Index.
The future outlook for the Dow Jones Commodity Index, crude oil, gold, the US dollar, the Euro and Japanese yen, and the fascinating interplay of the "yen carry" trade with global bond and stock markets is presented with lots of cool charts in the August 31st edition of Global Money Trends.
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