Andrew Pyle
March 05, 2022
Commodity boom might mean consumer gloom
Take a look at the screen for the world’s major stock indices and you will see mainly red, even though we saw some stability in the first few days of March. The only index to still show green is, in fact, the TSX with a modest gain since the start of the year. The rest of the pack is down, from a 2% loss in London to more than a 13% decline for the NASDAQ. The commodity screen is a different matter with already tight markets being compounded by the crisis in Ukraine. With the exception of some soft commodities, it is a sea of green and this past week a measure of commodity prices saw the largest weekly increase since 1974.
The Bloomberg Commodity Spot Index, which measures more than 20 futures prices, had gained almost 10% as of Thursday, driven by wheat, oil, gasoline, natural gas and corn. Since the start of the year, the advances in these key areas are spectacular. UK nat gas futures are up an amazing 193%, while crude oil and wheat futures have risen more than 74%. There was an added boost on Thursday as news broke that Russia had bombed a nuclear power plant in eastern Ukraine. Metal prices have also been on fire, with aluminum futures rising more than 32% since the beginning of the year and nickel prices up close to 30%. Keep in mind that the gains in crude oil and aluminum have materialized even without export sanctions on Russia in these areas.
To understand what these developments mean for investors, we first have to examine the factors influencing commodity prices. How much of this is being driven by demand versus supply? How sustainable are these influences for both demand and supply? Finally, what are the potential recoil effects on the global economy and markets?
In 2021, the answer to the first question was relatively easy. Higher prices for commodities stemmed mainly from strengthening demand as economies rebounded from a pandemic-induced recession in 2020. The lingering effects of the pandemic constrained output in many regions, which sent many commodities into negative balances. Aluminum, for example, went from a global surplus (production over demand) of around 1.2 million tons to a deficit of 1.0 million tons in 2021, according to the World Bureau of Metal Statistics. This situation persisted into 2022, although production was ramping up and there were nascent signs that demand growth for some commodities may be starting to diminish. With the Ukraine situation, those signs disappear in the face of perceived supply disruptions. Emphasis on the word “perceived”.
Up until now, there have been no material reductions in the production of key commodities. As I said, even Russian oil is still flowing, though crude production in Russia is still about 5% below where it was before the pandemic and is basically back to where it was five years ago. This sheds a little light on the debate out there about just how important supplies from the country are, although the fulfillment of future contracts might be in question. It is the risk of disruption that is being factored into models, resulting in a speculative binge on commodities.
I believe we are on the cusp of another transition in the demand-supply balance, which speaks to a combination of the sustainability of present-day factors and the knock-on effects on demand. It is one thing to talk about the impact of energy prices on household and business budgets, requiring a re-allocation of spending away from other areas. Expanding that impact, which I think of as a tax, to a much larger commodity basket is potentially even worse. Studies have shown that large spikes in agricultural prices can actually turn out to be a boost to industrial stocks, given the capital investment requirements from increasing production. The problem is that industrial activity and business investment are much smaller contributors to overall economic activity than consumption.
This morning, the US reported a stronger-than-expected rise in February non-farm payrolls (a gain of 678K versus calls for 423K), and the unemployment rate fell to 3.8%. Normally, we would expect this to lift consumer confidence and ultimately spending. Unfortunately, February also saw zero growth in hourly wages (the annual pace of wage inflation fell to 5.1% from 5.7% in January). Hence, consumers are falling further behind in terms of real wage inflation or, more accurately, their negative wage inflation has gotten worse. In the above chart, you can see how consumer confidence (as measured by the University of Michigan Consumer Sentiment index) has continued to fall, despite healthy job growth. Last month, we saw the index fall to 62.8, which is the lowest since 2011.
The advance March estimate will be released next Friday, and I would suspect it will be a tug of war between jobs and the Ukraine conflict. Odds favour a further decline in the index, which suggests consumer spending will come in weaker for March. Other regions of the globe are going to experience a similar weakness, which should translate into slower overall GDP growth. Similar to 2014, this could spill over into the commodity complex to the extent that weaker demand outweighs the influence of tighter supply. For that reason, we don’t believe this is the time to add to energy or material exposure and consumer stocks might also be vulnerable. Financials and technology, however, should see room for a bounce and, provided economic activity isn’t severely impacted, credit quality should remain positive. That argues for a continued overweight in corporate debt and floating rate instruments.
On behalf of the Pyle Group, have a wonderful weekend.
Andrew
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