Soft commodity prices can still prop up US equity

Equities investors are spooked. This is October, the month of Halloween and of virtually all the stock market’s best-known crashes over history.

After a lengthy rise, stocks are showing the heaviest volatility in more than a year, while the S&P500 is almost halfway to its first 10 per cent correction in more than three years.

Factors from the Ebola outbreak to conflagrations in Ukraine, Syria and Iraq give cause for alarm.

Screening out this noise, the problem is familiar. The bet has been on for months, as it has been several times before during the five-year post-crisis rally, that the world economy, led by the US, is ready to achieve ignition and show strong growth. Now investors are having second thoughts about that bet.

Why? The Federal Reserve’s latest minutes suggested that it is more reluctant to raise rates than had been thought. Markets like low rates — but dislike the Fed’s concern that the economy is not strong enough to withstand rates above zero.

Conversely, the European Central Bank took markets in the opposite direction, disappointing by not yet moving to full-scale QE bond purchases. These reactions are not contradictory; traders believe that the Eurozone still needs help, and hope the US has gone beyond this.

In such conditions, it helps to step back and look at the commodities markets. They are a “truth-teller” for the global economy, as they are the first place where shifts in supply and demand show up in prices.

By setting the price of basic materials, they also drive economic outcomes. What story do they tell?

Oil has seen the most drama, with Brent crude down almost 24 per cent since midsummer and at its lowest since late 2010, despite an intensification in the fighting in the Middle East, which would usually push up the oil price, as it carries the risk of an interruption to supply.

According to the International Energy Agency, oil prices have been “weighed down by abundant supplies” and by “weakening oil demand growth”.

The US has increased production, thanks to shale. This pushes down prices. Libyan oil is pumping once again.

Meanwhile, much of the world economy is sluggish, while the US is starting to economise on fuel. This feeds into lower prices, which strengthen corporate profits for non-energy companies, and the dollar.

US profit margins, and the US equity market’s performance relative to the rest of the world, are greatly helped by cheaper oil. But cheaper oil is very bad news for countries that rely on producing oil — and the greatest victim is Russia.

The price of Brent crude and the value of the rouble move in lockstep. As for Russian equities, which have long looked cheap, the MSCI Russia index is down 24.6 per cent for the year and is almost back its lows during the spring crisis over Crimea.

Americans may have found the best and safest way to retaliate against Vladimir Putin: produce more oil, and use less of it. Miles driven per capita has now fallen for nine years in a row.

Industrial metals, meanwhile, are also weak. The Bloomberg industrial metals index is down 37 per cent from its post-crisis high (and 50 per cent from its record in 2007). A rebound this year has been snuffed out in the past few months.

China has long been the world’s biggest consumer of metals at the margin, and so this reflects returning concern over the Chinese economy.

As for precious metals, they are locked in a bear market. Gold is down 38 per cent since its high in 2011 and 11.5 per cent since the top of its latest recovery earlier this year.

Gold’s bull market was driven by concerns that loose monetary policy would eventually lead to sharply higher inflation. Buying it was a means of hedging against a drop in the value of other currencies.

The sell-off shows growing confidence that QE bond purchases have not sparked inflation. This may show that central banks have not been irresponsible; but it also shows that they have failed to spark life into the world economy.

This is profoundly discouraging. But a weak economy may, perversely, support US equities. Low rates and lower raw materials prices are good for profits.

Commodity prices suggest that the optimism driving equities is misplaced but may also thwart a further and more serious sell-off.

Financial Times