The biggest slump in commodity prices since 2008 is undermining confidence on Wall Street and fueling speculation that a new bear market has been born.
Despite forecasts for accelerating economic growth and higher prices, commodities, with the notable exception of gold, are taking a big hit.
The Journal of Commerce (JOC) Commodity Index that tracks the growth rate of steel, cattle hides, tallow and burlap plunged 57% in May, the most since October 2008 – something that gave analysts a sense of déjà vu.
In 2008, commodities nosedived when the index fell 56% to its lowest level since 1949. What followed was the greatest stock market crash since the Great Depression.
The JOC index reflects clearer signs of supply and demand than futures markets because half the items it tracks don't trade on exchanges used by speculators, Lakshman Achuthan, the managing director at Economic Cycle Research Institute told Bloomberg News.
Burlap, used for industrial packaging, is down 9.7% this year, almost matching its 9.9% drop in 2008, while tin is down 9.5%.
Commodities extended their slump last week, led by declines in industrial metals and energy prices, as separate reports showed manufacturing slowdowns last month in China, Europe and the United States.
Copper, a commodity widely seen as an economic indicator, declined 7.4% in May, the biggest monthly slide since January. Recent reports showed the rate of manufacturing slowed in China and the United States, the world's biggest copper users.
Now, "the collapse in the commodity index is telling us that the peak in global industrial growth is imminent, it's here right now," said Achuthan. "Markets are going to have to deal with the reality of a slowdown."
While the Organization for Economic Cooperation and Development (OECD) on May 26 raised its growth forecasts for this year and next, investors are dumping holdings at the fastest pace since February.
"As risk-taking falls, expected growth is reduced," Colin P. Fenton, the chief executive officer of Curium Capital Advisors LLC in Boston, a former commodity analyst at Goldman Sachs Group Inc. (NYSE: GS) told Bloomberg. "Demand for commodities is going to be softer than it might otherwise have been."
China Cuts Raw Material Imports
Chinese policymakers are reigning in stimulus measures this year after a $1.4 trillion lending binge sparked growth in 2009. Officials are targeting a 22% reduction in new loans and have raised banks' reserve requirements to suck money out of the financial system.
In April, China posted a significant drop in imports of raw materials, leading some analysts to speculate China's appetite for commodities has waned. If that's the case, demand for certain commodities could plummet as China further tightens monetary policies to slow growth.
Take lead, for example. China consumes about 40% of the world's lead, primarily to make auto batteries. Since mid-April, prices for lead have plunged as much as 26%, compared with an 11% decline in the Dow Jones-UBS Commodity Index.
China said last month that it would crack down on the price speculation and hoarding of some food commodities in an effort to limit inflation to about 3% this year. Consumer prices jumped 2.8% in April from a year earlier, the fastest pace in 18 months.
"Chinese economic growth remains a significant risk in the eyes of investors, particularly given the uncertainty surrounding other regions, particularly the euro-zone," Tim Schroeders, at Pengana Capital Ltd. in Melbourne told Bloomberg.
But several analysts who visited China recently maintain that domestic demand remains strong. In fact, some say commodity imports are declining at least partly because the country and its industrial companies are tapping reserves, possibly because they expect prices to fall further.
After a field trip to China in mid-May, analysts at Macquarie Securities told The Wall Street Journal that some end users of steel, such as automakers and home-appliance producers, are "choosing to eat into their own inventory, rather than continue to purchase" goods on the open market.
It's a typical "buyers' strike" when prices are falling, the analysts wrote. "Why buy steel today when it'll be cheaper tomorrow?"
Copper & Steel Prices Hammered
Demand for copper declined in May as manufacturing in the United States and China slowed.
Freeport-McMoran Copper & Gold Inc. (NYSE: FCX) and Codelco Corporación Nacional del Cobre de Chile, the world's two largest copper producers, said China's plans to curb its economy threaten to reduce demand for the metal after prices slumped 15% in two months.
"China is the biggest user, so any concerns about demand there will continue to be a drag on copper," Donald Selkin, the chief market strategist at National Securities Corp. in New York, told Bloomberg in a telephone interview.
The copper market will be "volatile" for possibly another year, Codelco Chief Executive Officer Diego Hernandez said in an interview with Bloomberg last week. While Freeport CEO Richard Adkerson said the Asian nation is a "risk to the world's market place in the near term."
Still, both companies are investing in expansion plans with the expectation that demand in China and other emerging economies will rise in the future. Combined, they account for about 20% of the world's copper output.
Codelco will invest $15 billion over the next five years to revamp production at its aging mines, Hernandez said. Production will rise to over 2 million tons a year from about 1.7 million tons through the increased spending.
China, India and other emerging economies need copper "for their growth, urbanization, programs that they have and I don't see how that could stop," he added.
Mills in China and Eastern Europe are churning out record amounts of steel. Chinese production rose 20% in April from a year earlier. It was up 13% in the Middle East and 4.1% in South Korea. European steelmakers boosted output 2.5% even though the European economy has stalled. Only the United States and Japan cut output, and just by 1% and less than half a percent respectively.
Annualized global steel output, based on a record April, is expected to climb to 1.5 billion metric tons from about 1.25 billion metric tons in 2009. At the forecast 2010 rate, output will exceed consumption of 1.3 billion metric tons, according to the World Steel Association.
Gold Bucks the Trend
Throughout the recent meltdown in commodity markets, gold has been the exception to the across-the board plunge.
Investors who have been spooked by a confluence of worrying global economic trends yesterday (Tuesday) pushed the price to an all-time high above $1,250 per ounce.
Gold's reputation as a "safe haven" investment causes the metal's price to move inversely to investor confidence, which has been rattled by the Greece debt crisis and last week's plunge in the Dow Jones Industrial Average.
Lower Commodities Demand Hurts Corporate Earnings
Most analysts expect the slowdown in demand for commodities to last awhile longer.
Raw materials may drop another 10% because the economy is on the "cusp" of deflation, Philip Gotthelf, the president of Equidex Brokerage Group Inc. told Bloomberg. That would drive the Reuters/Jefferies CRB Index of 19 commodity futures down 22% from a Jan. 6 peak and into a bear market. The gauge plunged 8.2% in May, the most in 18 months.
Gotthelf correctly predicted in October 2008 that oil would fall below $40 a barrel and said he is now shorting most commodities and buying gold.
So how will a slump in commodities demand hurt the stock market?
As manufacturing slows and commodity prices tank, analysts say corporate earnings estimates for coming quarters will probably need to be revised downwards.
"If commodity prices are coming down, there is some downside risk to the manufacturing sector," Chris Rupkey, the chief financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd (NYSE ADR: MTU) told Bloomberg. "It's too early to see it in people's numbers yet, but if I had to guess, people will shave their estimates" for growth this year, he said.
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