Sector

Implications of Falling Gold and Commodity Prices

April 23rd, 2013 | By Nick Sargen

Highlights

  • Among the biggest surprises in financial markets this year has been a 35% drop in the price of gold, which has been accompanied by a broad-based decline in oil and other commodity prices. Investors are now questioning what's behind this development and the implications it has for the global economy and financial markets.
  • Many commentators attribute the recent fall in gold and other commodity prices to weaker-than-expected data in the U.S., Europe and China. There is also growing realization that quantitative easing by the leading central banks has not led to rising inflation; in fact, global inflation has declined over the past year. Combined with a firmer dollar, these factors have taken some of the speculative element out of gold's price.
  • According to Edward Morse, Citi's Global Head of Commodities Research, the recent separation of commodities from equity markets represents the end of the commodity super-cycle of the past decade. He believes movements in individual commodity prices will become more disparate in the future, and commodity indices will be less correlated with equity markets and currencies than in the past decade.
  • If so, there could be wide-ranging implications for stock, bond and emerging markets that we consider.
 

What's Behind the Plunge in the Price of Gold?

The steep drop in the price of gold this month caught most observers by surprise and left many wondering what's behind it. In my view, it represents the culmination of several developments.

The prevailing view among investors is that the world economy is expanding at a sluggish pace, which, in turn, has caused demand for commodities to soften. Following a strong start at the beginning of this year, the U.S. economy slowed in March, and Europe remains mired in recession. Meanwhile, the Chinese economy disappointed investors who expected growth in the first quarter to exceed 8%. While the miss was small (7.7%), there is a growing perception that the days of double-digit economic growth for China are probably over. If so, the trajectory for raw material demand is likely to be lower in the future.

At the same time, worries about inflation are ratcheting downward, as reflected in a decline in inflation expectations derived from the TIPS market. When the Federal Reserve and other leading central banks implemented quantitative easing following the 2008 financial crisis, gold and commodity prices surged, as many investors believed these actions would boost inflation. Instead, global inflation has decelerated by a full percentage point over the past 12 months to 2.5%. One reason is that banks have been willing to sit on substantial excess reserves; consequently, the increase in bank reserves has not resulted in faster money supply growth.

A third factor that has affected gold and commodity prices is the resilience of the U.S. dollar. When the Federal Reserve embarked on the latest round of quantitative easing last autumn, many investors thought it would weaken the dollar. However, this has not happened, partly because Fed officials subsequently have discussed the possibility of scaling back purchases of treasury and agency paper in the event the economy improves. Another reason is that the Bank of Japan has embarked on a more aggressive program of quantitative easing that has caused the yen to depreciate by 25% against the dollar.

Finally, there has undoubtedly been a speculative element contributing to the six-fold surge in the price of gold since the early part of the last decade. While this resulted in the price of gold reaching levels that were not sustainable, there was no way of knowing when the bubble would burst. (My own assessment was that it would probably require a tightening in central bank policies to alter expectations.) However, now that the price of gold has fallen decisively, many are wondering what the longer-term implications are.

 

End of the Commodities Super-Cycle

According to Edward Morse, Citi's Global Head of Commodities Research, the sell-off in gold and other commodity prices this year marks the death knell for the commodity super-cycle that has been in place for a decade. (See "From Commodities Supercycle to Unicycles", Citi Research, April 12, 2013.) He views gold as the linchpin for understanding underlying trends for commodities, and believes gold lost its luster as a safe haven as equity markets gained momentum in the first quarter.

This does not mean Morse is bearish on commodities as a whole. Rather, he believes there will be greater differentiation in the performance of individual commodities than was the case in the past decade, during which commodities tended to move in tandem with one another:

"For the next few years, each commodity looks more likely to be sitting on its individual supply/demand fundamentals than on more general factors affecting all of them. This means that…for some prices will rise while for others they will decline, and investors across commodities will be able to take advantage of alpha return strategies focusing on long versus short positions, other relative value relations across the commodity space…"

One implication is that investors will need to have a greater understanding of demand conditions for individual commodities. On this score, Morse cites shifts in investment patterns in China and other emerging markets from commodity-intensive fixed asset investments and industrial growth to household-based and service sector growth. He also sees increased production of natural gas in the United States posing a real challenge to oil's dominance of the transportation fuel market. His bottom line is that the coming decade will be one in which there will be greater focus on individual commodity "unicycles" and less emphasis on a broad-based trend in commodity prices.

 

Implications for Financial Markets

If the super-cycle in commodities is indeed over, I believe there are several implications for the global economy and financial markets:

  1. The countries that would be most adversely impacted are those which are major exporters of raw materials to China and emerging Asia. Topping this list are Australia, Brazil, Chile, Peru, Russia and South Africa, which have benefited from China's emergence as a global economic power.
  2. At the same time, this development would be positive for economies that are net importers of commodities and raw materials, as it would lessen production costs and leave consumers with more discretionary income to spend on other items.
  3. If Morse's thesis is correct that price movements in individual commodities will be more disparate in the future, it also implies there will be greater variation in the performance of individual countries that are classified as emerging economies.
  4. With respect to the United States, an end to the commodity super-cycle would be a plus in keeping inflation under control. We continue to believe U.S. bond yields will rise as the economy gains traction over the next few years. But there is less risk of a large spike in yields if commodity prices no longer are trending higher. At the same time, the combination of moderate economic growth and subdued inflation, in turn, should continue to buttress the U.S. stock market.