Commodity prices suggest world econ is troughing

 I talked about this, before, here.

The inverse relationship between the economy and commodity prices goes back a long way.  In the chart below, I show my calculation of world industrial production, compared with CRB commodity price index, inverted and lagged 24 months.  Why inverted, and why lagged?

When commodity prices surge, commodity exporters gain, but they don't necessarily spend their gains immediately.  Think of a rise in the oil price.  Motorists everywhere have to pull in their belts, but oil producers might just accumulate any windfall.   Total world demand, GDP, industrial production, etc., tend to go down.  At the same time, central banks respond to the rise in inflation caused by rising commodity prices by tightening monetary policy, and governments by tightening fiscal policy.   So a rise in commodity prices ultimately leads to a  fall in economic activity, and the response is lagged.  On the basis of the last 70 years, the lag is about 18 months to 2 years.

The irony is that a sharp rise in economic activity can lead to a jump in commodity prices which in turn leads, 2 or 3 years later, to a collapse in the economy, which leads to a plunge in commodity prices, and so on.  War, oil boycotts, sanctions can complicate this relationship, but the economic fundamentals remain critical.  For example, the export embargo by oil producers which led to the 1973 oil crisis and the deep 74/75 recession, only worked because economic demand was so strong.   

Right now, the turn in commodity prices, i.e., their sustained fall, is consistent with a troughing in the world economy towards the middle of this year.  It's not just the oil price which is falling, but also food prices.  Leading indicators, such as PMIs, have passed their low point, but the actual economy lags PMIs by 3 to 6 months, so that is also consistent with a mid-year turn. 

Why haven't we had the deep recession I forecast in my earlier piece?  Partly the stimulus provided by massive deficit spending by the USA as a result of the so-called Inflation Reduction Act ("IRA"), partly the spending rebound as the world came out of the covid crash lockdowns.   What will be the next factors to throw my forecasts awry?  Covid certainly threw several massive spanners into the works!

Commodity prices point towards a recovery in 2024

I talked before about how a surge in commodity prices can lead to a subsequent recession here.   The current decline in commodity prices points to an ultimate recovery in the world economy sometime in 2024.

There are several reasons for this relationship.   When commodity prices surge, they make commodity exporters richer, and commodity users poorer.  But the increased incomes of commodity exporters aren't spent immediately, while commodity users have to find the money to pay for higher commodity prices by spending less.  At the same time, rising commodity prices push up inflation and central banks tighten monetary policy.  This all plays out with a lag, but in essence it causes the world economy to slow. 

When commodity prices fall, commodity exporters lose out, and they have to reduce spending.  Often their economies struggle.  But there are fewer of them --- think of the small number of oil exporters vs the large number of oil consumers.  Meanwhile, the more numerous consuming countries are better off, because their real incomes improve.  Central Banks stop raising interest rates, confidence increases, and economies start to recover.

The complication comes from the fact that too fast economic growth leads to excessive commodity price increases, which in turn leads 18 months to two years later to the economic downturn.  Economic policy should be directed at stable growth, because of this feedback process.  But commodity price shocks can also occur because of politics.  The two oil embargoes in 1973 and 1979 caused the deep 1974 and 1980–1983 recessions.  But the embargoes only worked so well because the world economy was strong.   And of course, the deep 1980–1983 recession eventually caused the oil price to fall.

And the most recent strength in the world economy indirectly contributed to the war in Ukraine, which caused commodity prices to soar.  Why do I say this?  Because Russia is a major oil and gas exporter, and those prices rose as the world economy boomed post-covid, making the Russian government very confident that the war could be paid for and that the West couldn't respond with a boycott because it would cause commodity prices to soar, leading to recession and political crises.  They have been wrong so far.

Commodity prices now point to a late 24 or early 25 recovery.  But before that happens, we'll have a recession.   Looking just at this indicator, and there are obviously others, it looks as if it could be as deep as the GFC, but that was worsened by the Fed letting Lehman's go, which froze the banking system and caused a deep plunge in activity.  They have presumably learnt from past mistakes.  We'll see.

Five factors pointing towards US recession

Money Supply

M1 is falling almost as fast as it during the Great Depression

The Yield Curve

The last time the yield curve (the gap between the 10-year bond yield and the "cash rate"/Fed Funds rate) was this negative was before the deep 1974 recession and the deep and long 1980-1983 recession.

The Fed Funds rate

The Fed Funds rate has risen as much as it did during the '74 and '80-'83 recessions.

Credit tightening

Banks' willingness to lend is collapsing, and banks are tightening credit standards.  This is not yet at levels seen in the GFC, but the data are quarterly, so we don't know what's happened in the most recent three months.

Commodity Prices

I wrote the piece I linked to above a year ago.  

The lag between a sharp rise in commodity prices and the subsequent economic downturn is quite long --- 24 months, though it has been as short as 12 months.  

All 5 Factors

If we combine all these indicators into one index, we get the chart below.  As an "average" of five indicators, it isn't as severe as some of its components.  On the other hand, it has not yet bottomed.

What seems clear enough is that there is likely to be a US recession.  How long and how deep it gets depends on whether there is a banking crisis, whether the Fed raises rates further, and whether the post-Covid rebound in services continues.  I'll keep you posted.

Note that where the 5 factor index appears to coincide with recessions, 
that's because it has been plotted with a 12-month lag.

Fibre prices correlated with world econ

 I've been doing some research (yes, I know, I have a life to live, but I thought it interesting---and it was.)

One would expect (I expected) that the prices of wool and cotton are driven primarily by agricultural conditions:  floods, droughts, snowstorms, et cetera.  It turns out that they are in fact strongly correlated with the world economy, in other words, with demand.   As such, they turn out to be a useful indicator of the movements in the world economy.   I haven't updated world IP for a couple of months, but the slide in fibre prices suggests it's weakening.  I'll be updating my world industrial production indices soon, I promise.

In particular, the fall in the wool price (uniquely, among commodities, wool is priced in A$, because of the importance of Australia to wool production), points to a faltering China recovery. 

Click on graph to see clearer image.  

Here's what the fibre index looks like over a shorter term.

Precious metals rising as risk increases

Precious metals (gold, silver, platinum and palladium)  are used to make things, like other commodities, but they are also stores of value.  During crises, the prices of precious metals rise.

In the chart below, you can see the index for the average of precious metals prices, daily since 2000.  Note how the index falls during recessions, and rises during recoveries  (the 2001 recession, the 2008 GFC, the slowdown in 2016 before the Trump tax cut sugar-hit sparked a recovery, ended by the covid crash.)

Click on chart to see clearer image 

However, shorter term, you can clearly see how other factors than demand have impacted prices.  The covid plunge (early 2020) is obvious, the rebound in response to massive fiscal and monetary stimulus is clear, up until H1 2021.  Then the index falls as interest rates are raised, followed by a spike in response to Russia's invasion of Ukraine.  Notice how over the last couple of months, the index has been rising, as concerns about the safety of the global banking system grow.   Other commodity prices are declining on average, as the world economy slows, yet precious metals, which in the longer run tend to follow the broader economic cycle, are rising. 

Click on chart to see clearer image.

US existing home sales point to GFC recession

 Existing home sales in the US, like most time series associated with the housing sector, lead the cycle.

The chart below shows home sales vs my monthly indicator, which tracks GDP quite well.  Note how home sales peaked in 2005, but only really started to fall fast in 2007.   This plunge preceded the GFC (global financial crisis) of 2008/2009.  History seems to be repeating itself.  However, as bond yields and therefore mortgage rates may have peaked, home sales may be close to a trough.  If there is a deep recession, the trough may be postponed.  Banks are in a much sounder financial state than they were then, on the face of it, but there's plenty of debt owed by emerging markets and zombie companies.  What drove the GFC to its depths was actual and potential banking collapses.  What will (most probably) drive the current cycle into its depths will be the surge in commodity prices, which only peaked in June last year, and central banks overtightening. 

Why a deep recession is likely

 I wrote earlier about one reason why the 2023 recession could be deep:  the extreme rise in commodity prices (including oil)  Here is an updated and slightly amended chart showing the relationship.  Because a sharp rise in commodity prices leads to a later fall in economic activity, commodity prices in the chart are plotted with an inverted scale and with a 24-month lag.

The relationship isn't perfect, and the lag isn't consistent from cycle to cycle.  Nevertheless, it seems plausible that we will experience a recession as bad as the GFC (2008) or the recession after the first oil shock (1974-75).  Note that the covid crash (2020) distorts the relationship in that year, but of course, the crash led to a plunge in commodity prices, shown as a rise in the yellow line through 2021. 

The second reason why the recession will be deep is that Central Banks have raised interest rates sharply.  Once again, the economy falls, with a lag, when interest rates are raised, and rises, with a lag, when they are cut.  So the rise in interest rates over the last few months will only start showing up in economic growth in 2023.  Note that, even though Central Banks may have started increasing their discount rates more slowly, they are still raising them.  The red line in the chart below (falling because it's been inverted) hasn't stopped its decline.  A turn could be 3 to 6 months away.  Once again: this implies continuing and worsening recession all through 2023, prolly deeper than the GFC.

Then there's the behaviour of my US longer-leading index, which points to the deepest recession in 35 years.  The US is the world's dominant and most influential economy.   If it goes into recession, the rest of the world is likely to follow (with the exception of China, discussed below)

And in most countries, fiscal policy is tightening.  This is normal in an economic recovery---as the economy recovers, tax revenue recovers even faster.  However, the large debts built up over the Covid Crash have left less room for manoeuvre.  It will be harder for governments to stimulate activity by cutting taxes during the 2023 recession.  

What could mitigate against this possible deep downturn?  In a word: China.  China has been loosening monetary policy, not tightening, for the last year.  This hasn't led to much acceleration in growth because of frequent abrupt and arbitrary lockdowns, but after recent protests, which have obviously unnerved the Chinese authorities, these policies have been relaxed.  Yet mass deaths are bad for growth.

The steel price in China has started to rise, as have global iron ore prices.  These are classic signals that China is stimulating its construction sector to encourage economic growth, as it has done in every cycle for 40 years.  Given the slowdown in China's population growth and the rise in the percentage of pensioners, this method of stimulating the economy might not work so well this cycle.  There is a significant oversupply of flats, and ppl burnt once by property company collapses may be happy to buy pre-existing flats in preference to new ones off the plan.  Nevertheless, the Chinese economy is out of phase with the rest of the world, and it is big enough to mitigate the global downturn elsewhere.

In my judgement, and it is not new, there will be a deep global recession in 2023, but some countries will move against the tide: China, India (possibly -- it's still holding up) and maybe Australia, because of iron ore exports to China.  But plunging house prices in Australia and a reluctance to use fiscal policy to prevent recession suggest that, at best, Australia will avoid a deep recession.

I'll be updating my US and Chinese indices and indicators over the next few days.  I'll keep you posted.

Commodity prices to fall further

 It's obvious that commodity prices, as measured by the CRB index, have peaked.  Commodity prices follow the world growth rate, though of course there are obviously other factors, such as war, droughts or boycotts, which help nudge prices higher at times.  

The chart below shows my world diffusion index, which measures the percentage of monitored times series rising.   At zero, all series are falling, at 50% half are rising, and at 100% all are rising.  My world diffusion index monitors up to 303 time series, covering a wide range of different activities for most countries in the world.  It is not weighted by country GDP, unlike, for example, my calculation of the Big 8 PMI or industrial production.   

In my judgement, world economic activity is going to continue to slow, and so world commodity prices on average will too.  "On average" is a key qualification.  Some commodities, such as lithium, are still rising.  But oil and gas are falling, despite supply constraints, though the declines are not yet precipitous.

Small 6 economies slowing with Big 8

The GDP-weighted average PMI for the "Small 6"  economies (Australia, Canada, Israel, Sweden, Switzerland, South Africa) continues to track the GDP-weighted average PMI for the "Big 8" economies (US, UK, Europe, Japan, China, Russia, Brazil, India).  As has been amply demonstrated in the past, when the Big 8 slow, the Small 6 follow.  

A recession in the Big 8 is very likely:

• US: because of high inflation and tightening monetary policies
• The UK: ditto, plus the Brexit disaster
• Europe: inflation, commodity prices, ECB raising rates, severe gas shortage
• Japan: inflation and commodity prices
• China: Covid lockdowns, property crash, plunge in confidence
• Russia: war
• Brazil: rate tightening
• India: might avoid recession, except for contagion from elsewhere

Rubber price plunges

The rubber price is falling fast.  Its correlation to world economic activity is not perfect, but it's not bad either.  The fall in the rubber price is indicative of an impending recession.

Deep recession in 2023?

The chart below shows the deviations from trend of the CRB commodity price index, and of my index of world industrial production.  The CRB deviation from trend has been smoothed, inverted and lagged 18 months (i.e., plotted with an 18 months lag)

Why should rising commodity prices lead to a recession later on?

First, there is the income transfer.  When commodity prices double or quadruple, then the exporting country  experiences a jump in income, and consumers in importing countries experience a fall in (real) income.  The two should offset each other, but they do not.  Consumers have no alternative to reducing their spending when the prices of food and energy rise.  But commodity exporting countries do not need to spend the extra income they're getting.  Of course, they do eventually spend it, but the delays involved reduce world demand and output.

Second, a surge in commodity prices leads to a jump in general inflation, as rising commodity prices spill over into the rest of the economy.  Policymakers respond to rising inflation; Central Banks by tightening policy (raising interest rates, and reversing quantitative easing); governments by (perversely) tightening spending and raising taxes.  This especially applies to developing countries, which are more dependent on foreign borrowing to fund expenditure.  These countries often have no choice but to tighten fiscal policy.

Third, these tightening measures lead to a fall in asset prices, including commercial property and housing.  Often the decline in asset prices leads to banking crises and collapses.   A credit crunch is added to the original downward impetus, making the downturn even more severe.

These are general patterns ― the specifics in every cycle are different.  But it will do to go on with.

So a rise in commodity prices leads to a subsequent downturn in economic activity.  The relationship is inverted, and also lagged.  The effect of surging commodity prices isn't immediate, it lags ― by an average of 18 months, as the chart below shows.

Relative to its trend, the rise in commodity prices (plotted as a negative in the chart, because the effect of commodity prices increases is inverse to the effect on economic activity) is even larger than in 1972/73.  And that implies an even deeper recession than in 1974/75.

However, this is only one of possible indicators pointing towards recession.  I will examine others over the next couple of weeks.

The last time commodity prices rose as much ....

50 years ago, in 1972 and 1973 commodity prices soared (especially, but not only the oil price).   This led to the deepest (until then) post-war recession.  Not just because of the rise in commodity prices, but the aggressive tightening by central banks which ensued.  I fear that we are facing a similar situation today.  I think there is a high chance that  2023 will be a recession year, and there is unfortunately the chance that it will be a deep recession.

Wheat prices at record high

 Thanks to Russia's war in Ukraine, wheat prices are at record highs

Source: Trading Economics

Ukraine war causes biggest price shock in 50 years

From the BBC

The war in Ukraine is set to cause the "largest commodity shock" since the 1970s, the World Bank has warned.

In a new forecast, it said disruption caused by the conflict would contribute to huge price rises for goods ranging from natural gas to wheat and cotton.

The increase in prices "is starting to have very large economic and humanitarian effects", Peter Nagle, a co-author of the report, told the BBC.

He said "households across the world are feeling the cost of living crisis".

"We're particularly worried about the poorest households since they spend a larger share of income on food and energy, so they're particularly vulnerable to this price spike," the senior economist at the World Bank added.

Energy prices are set to increase more than 50%, pushing up bills for households and businesses, the World Bank says.

The biggest rise will be in the price of natural gas in Europe, which is set to more than double in cost. Prices are forecast to fall next year and in 2024, but even then will remain 15% higher than they were last year.

The World Bank said this means that from the lows of April 2020 until the highs of March this year we have seen "the largest 23-month increase in energy prices since the 1973 oil price hike", when tensions in the Middle East sent prices soaring.

Similarly oil prices are expected to remain elevated into 2024 with a barrel of the benchmark measure, Brent Crude, projected to average $100 this year, something which will lead to widespread inflation.

Russia produces about 11% of the world's oil, the third biggest share, but the report said "disruptions resulting from the war are expected to having a lasting negative effect" as sanctions mean that foreign companies leave and access to technology is reduced.

Russia currently provides 40% of the EU's gas and 27% of its oil, but European governments are moving to wean their countries off of supplies from Russia. That has helped push up global prices by creating more demand for supplies from elsewhere.

The World Bank commodity outlook also warned many foods are set to see steep rises in their costs. The UN food prices index already shows they are at their highest since records began 60 years ago.

Wheat is forecast to increase 42.7% and reach new record highs in dollar terms. Other notable increases will be 33.3% for barley, 20% for soybeans and 29.8% for oils and 41.8% for chicken. These increases reflect the fact that exports from Ukraine and Russia have fallen drastically.

Before the war the two countries accounted for 28.9% of global wheat exports according to JP Morgan, and 60% of global sunflower supplies - a key ingredient in many processed foods - according to S&P Global.

Prices for other raw materials including fertilisers, metals and minerals are also predicted to go up. The costs of timber, tea and rice are amongst the few expected to fall.

"Wheat is one of the hardest agriculture exports to replace," according to a research note from the Bank of America. It points out that poor weather conditions in North America and China are likely to exacerbate the impact of Ukrainian supplies being reduced, something which will continue because the war has disrupted the spring planting season.

The note also suggests grain and oilseed shipments from Ukraine have fallen more than 80% because of the fighting and these lost exports, over the course of a year, "equate to about 10 days of world food supply".

Ukraine is a major exporter of crops such as sunflower oil but the war has reduced supplies
Source: BBC/Getty Images

This is very bad news for the world's poor.  And it is likely to lead to a deep recession as well as adding to already surging inflation.

The Commodity super cycle

A fascinating analysis from Visual Capitalist

Given how long commodity super cycles last, we're prolly in for another 10 or so years when commodity prices broadly decline.  Especially given just how weak global growth is likely to be.

Germany: solar power costs fall 25%

From this piece in PlanetSave:

Prices for German solar power storage systems have reportedly fallen 25% since the spring. The data come from the German Solar Industry Association (BSW-Solar).

Also according to BSW-Solar, approximately 15,000 German households now use battery storage combined with solar power, and that number has been growing faster and faster as the costs have come down. As an example of that, KfW, Germany’s development bank, approved 32% more funding applications for home storage in the third quarter of this year than in the second. Needless to say, I think word is getting around that this is a smart move for many now that storage costs have fallen.

Solar costs and the costs of storing sun power to use later are going to continue to slide fast. At a 20% per annum compound rate of decline, they'll fall 60% in 4 years. This will be devastating for coal.  The coal price has already more than halved over the last 4 years; it is now lower than it was during the GFC.  Note also that every year-end for the last 5 years (in the northern hemisphere winter) the coal price has had a seasonal rebound.  Not this year.  That augurs very ill for coal prices during 2015.  And the explosion of solar (and to a lesser extent wind) is a key ingredient in this collapse.  Of course, China's slower growth is a factor, but that turn to slower growth is itself driven by the extreme air pollution in China.  As solar and wind prices collapse, no new coal-fired power stations will be built, and old ones will be pensioned off.