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Falling Commodity Prices Signal A Weak Global Economy

September 8th, 2008 - The US economy continues to show weakness.  According to the government employment report released last week, non-farm payrolls fell again in August, for the eighth month in a row.  And the unemployment rate climbed to a five-year high. Meanwhile, another bad sign is that job losses are fairly widespread among industries.

The deteriorating state of the economy was probably worse than what the Federal Reserve had been hoping for.  However, the earlier Fed beige book report, which presented quite a gloomy picture, may have forewarned the policymakers of further bad news ahead.

So market expectations of possible interest rate increases have been put on the back burner.  This is buttressed by the fact that commodity prices continue to tumble, improving the outlook for inflation.  The slowing global economy is inevitably having an impact on the demand for commodities.   In addition, speculators are switching their bets from long to short

The CRB index, which is broad-based, has fallen very sharply since its high on the second of July. A mini rally in late August petered out and we are now in bear-market territory.  Falling oil prices, in particular, are beneficial in reducing inflationary pressures, but they are also signalling the feebleness of global growth.

Energy and basic-materials stocks are being hammered, but the weakness extends to many other sectors, as investors worry about the earnings outlook.  The best regional performer, on a relative basis, continues to be the United States.  Meanwhile, in the antipodes, the Australian stock market and currency have been hit particularly hard.

This is not surprising because Australia is a major commodity exporter, geared particularly to rapid growth in Asia.  And, of course, the aussie, as a commodity currency, is suffering accordingly.  But another reason for weakness is the carry trade.  With risk aversion rising and relative yields now appearing less appetising there is an unwinding of the carry trade.  As a result, the yen is up and the aussie is down.

The selloff in emerging markets has yet to show signs of bottoming.  Evidently, investors have been fleeing the area.  Risk premium has been marked up and the price marked down.  Stocks are cheaper but not at bargain-basement levels.  If the longer-tem positive structural story about the region is correct, then some nibbling may be in order.  However, further downside is also likely before the global growth picture becomes a bit more positive.

Currently, as far as market opinion is concerned, the US economy is the least ugly of all the sisters lined up in the beauty parade.  Why so?  Well, investors see plenty of warts on all the other ladies on display, and figure out that American policymakers are keener than just about anybody else to make their economy a winner.  They may not actually succeed but they sure try hard.

The betting is that the decision makers are so committed to turning around the economy that it will be the first one out of the starting block when a global economic rebound occurs.  So the dollar, which was previously so oversold, is still gaining ground against most other currencies, even though inflation-adjusted interest rates in the US are unattractive.

However, it is unlikely that the US economy will experience the normal cyclical rebound that we have seen in previous cycles.  The conditions and problems faced by the economy are abnormal and the likely outcome may be an anaemic recovery, when it arrives.

Meanwhile, the substantial rise in the value of the dollar is going to make it more difficult to sell in export markets that are already weakening because of slowing growth.  At the same time, there is some re-balancing going on as the US current account-deficit declines, causing a withdrawal of liquidity from the world economy.