How to capitalise on plunging commodities
Global economic sentiment has shifted in favour of advanced economies, driven in part by the sharp declines in commodities prices in recent years. So what does the fall in commodities mean for traders?
Emerging market economies staring down a barrel
The trend is unmistakable: emerging market economies have suffered immeasurably since 2012. Equities markets in international bourses have consistently deteriorated against advanced economies, due in part to slumping commodities prices, weaker currencies, higher inflation and increased unemployment. These are but a smattering of the many complex factors interacting to bring about a reversal in the global dynamic.
The commodities market boom post-2008 burned like a red-hot poker, but fizzled when the US economy started turning the corner. Quantitative easing policies enacted by the Fed brought unemployment figures down, boosted US GDP and restored confidence in equities markets. At the same time, reductions in the monetary stimulus began impacting heavily on emerging market economies. Viewed holistically, the US dollar rapidly appreciated while the cross-currency exchange rates of other countries deteriorated.
That a bear market exists is important on many levels. For starters, the emerging market countries feel the pinch more than advanced economies. Since many of the world’s raw materials supplies are in Africa, the Indian subcontinent and Latin America, countries in these regions suffer most when prices plunge. Advanced economies typically tend to be net importers of commodities, while emerging market countries tend to be net exporters – with the exception of China.
The proof of the pudding is in the numbers: the South African rand, the Turkish lira, the Brazilian real and the Indian rupee have all come under heavy pressure against the US dollar. Devalued currencies cannot simply be rectified by printing more money and raising prices. Instead, many emerging markets are now faced with an inability to repay dollar-denominated debt and they have to raise prices to generate more revenues, while laying off thousands of workers in mining and energy industries across the board.
Speculators shorting commodities for windfall gains
The big story for 2015 however is the declining purchasing power of China. As the world’s second largest economy (or largest if you believe certain reports), any downward revision in China’s growth rate naturally impacts heavily on demand for commodities. Since the Chinese consume massive amounts of agricultural produce, plus copper and other metals, slowing Chinese growth depresses prices.
Traders have been shorting commodities like copper, gold, silver, oil and coal as the Chinese economic engine slows down. This self-fulfilling prophecy only assists in driving prices lower, thereby helping speculators profit from the volatility. Recall that at the end of July 2015, the Shanghai Composite index lost 8.5% of its value – wiping out trillions of dollars from Chinese equities.
During July, OPEC pumped more oil onto the global markets – fuelling the supply glut. This sent the price of Brent crude oil and WTI crude oil even lower, where the former was trading around $50 per barrel and the latter around $46 per barrel. Low oil prices are a testament to weak demand and oversupply. But the reality is more sinister: the global economy is sputtering. Oil inventories are at record highs, with tankers positioned offshore waiting to offload their cargo. Now that the P5+1 has agreed (in principle) on a nuclear deal with Iran, even more oil will be made available – depressing prices further.
Of course, money can be made by going short on oil futures, gold and general energy stocks. But the key question is when will commodities prices turn the corner? OPEC oil producers realise that by continuing to dominate the market they will force US oil producers to shutter. The shale oil fields across the US run at substantially higher cost than the major OPEC producers. Since it is a nascent industry in the US, sustained periods of low prices will lead to a decreased supply of oil. The energy-independent US will gradually see increasing oil prices after WTI supply diminishes.
What impact will a rate hike have on commodity prices?
There are many interesting theories about the effect of an interest-rate hike in the US and its impact on the global economy. For starters, the US economy does not exist in isolation, and has accounts with many emerging market countries. An interest-rate hike makes the debt repayable to the US unserviceable by these developing economies. Since rate hikes cause the dollar to appreciate (conversely causing emerging market currencies to depreciate), debt obligations from these countries could turn to debt defaults.
Since most commodities are priced in dollars – oil, natural gas, copper and gold – any rate hike will make these commodities appear to be more expensive. Remember however that the price of any commodity is determined by global supply and global demand – not the price of dollars. Right now we have an oversupply of oil and weak demand, hence the low price. It just so happens that the dollar is now relatively strong, and countries with weaker currencies now have to pay more per dollar of the commodities they wish to purchase. An interest-rate hike increases dollar demand, which means that more foreign currencies are being sold to buy US dollars.
Already we know that the International Monetary Fund has reduced its growth forecast for the world economy to 3.3%. Last year the global economy grew at 3.4% – sluggish by anyone’s admission. Another indicator of global economic sentiment is the yield on government bonds, which remains at a low level. The US Federal Reserve Bank acts in the interests of America only – the international community is not factored into the decision-making process. If it appears that the rate hike is inexorable, traders will be wise to short emerging market currencies. As always, time will tell…
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