It seems to be entirely natural that commodity prices should move inversely to stock prices, as we’re seeing currently. After all, don’t high commodity prices lead to higher inflation, which is bad for stocks? But strangely enough, it wasn’t so long ago that both commodity and stock prices were moving up together. During the golden years of 2003-07, the International Monetary Fund’s (IMF) commodity price index went up from 65.04 to 134.9, yet that was also the period of a great bull run in stocks and nobody complained of inflation.
That’s not the only mystery. Go back a few years and we find that the huge rally in global stocks in the 1990s, which lifted the MSCI Barra World Free Index from 122 as of 29 January 1993 to a peak of 350.8 on 31 March 2000, was accompanied by essentially flat commodity prices. Over the period, IMF’s commodity price index rose all of 20%. And global inflation, according to IMF’s calculations, fell from 35% in 1993 to 4.5% by 2000.
Over the last 15 years, therefore, we’ve had times when commodities were stable while stocks rose, periods when both commodities and stocks languished (2000-02) and another period when stocks as well as commodities climbed. And now we have rising commodity prices and falling stocks.
To explain this conundrum, we have to turn to none other than Marc Faber, the perma bear who revels in the sobriquet of Dr Doom. In November 2005, Faber wrote a piece for the website Whiskey and Gunpowder titled Fed Rate Hikes: A Roadmap to Financial Ruin, in which he explained that the reason lax monetary policy in the 1980s and 1990s did not result in inflation in the US was because commodity prices were falling at the time. Wrote Faber: “In the eighties and nineties, the developed world enjoyed the tailwind of declining commodity prices and the outsourcing of production and services to low-cost countries, which, despite easy monetary policies, didn’t lead to rising consumer price inflation. (Other factors contributing to disinflation were the peace dividend, privatizations and aggressive cost-cutting measures by the corporate sector, and—not to be forgotten—declining interest rates, which reduced the financing costs of companies.)”
And then he added, with uncanny prescience: “But the next time the Fed embarks on a massive liquidity creating exercise (such as the one Alan Greenspan implemented following the Nasdaq collapse in 2000), these favourable conditions may no longer be in place.” In other words, when commodity prices are low, inflation can be contained despite loose monetary policy. It’s only when the commodity cycle turns that loose monetary policy results in higher inflation, which in turn affects stocks. That’s what happened in the 1970s, when a combination of loose monetary policy and high oil prices sent inflation soaring. Small wonder that comparisons are now being made between the current situation and the oil shocks of the 1970s.
But surely, the beneficial effect of low-cost production from China and low-cost services from India continues? Observers have long argued that while the prices of manufactured goods may fall because of competition from low-cost producers, the prices of raw materials needed to make those goods will rise. Hence the market aphorism: Buy what China buys, sell what China sells. The impact of strong growth in emerging markets on commodity prices is easily seen from the fact that, while IMF’s commodity price index moved up by 18.5% in the 11 years between 1992 and 2003, it rallied by 107% in the next four years. That’s not all—Chinese producers, beset by higher raw material prices, have no alternative but to pass it on to their customers in other countries.
In 2005, Faber predicted that the US Fed would slash interest rates dramatically if it saw a threat to growth. Wrote Faber: “When the Fed realizes that the economy is weaker than expected, it will reverse its tightening bias, cut rates, and ease massively.” That is precisely what happened. Faced with the collapse of the housing bubble, the US central bank slashed the Fed funds rate from 5.25% in September 2007 to 2% by April. But the effect hasn’t really been what the Fed wanted. US mortgage rates are nearly at the level they were at a year ago, in spite of all the rate cuts.
Faber predicted that dollar weakness, rising commodity prices and rising import prices could lift the rate of consumer price increases and the yield on long-term bonds above the rate of asset and wage inflation (which means declining asset prices and wages in real terms). Wrote Faber: “If that were to occur, the economy wouldn’t benefit from the easier monetary policies at all. Moderate stagflation would follow.”
That is exactly the scenario facing the US Fed as it debates whether to call a halt to rate reductions at its meeting on Tuesday and Wednesday.
Unfortunately, Faber spoilt the effect by going on to predict an apocalypse for the world economy, with hyperinflation, war and religious strife. His final prediction: “A deflationary stabilization crisis will follow in phase four of our road to financial fiasco. Large segments of the population will be totally impoverished. Smart hedge fund managers will all have sold their businesses to banks and will have left the US to live in the Caribbean, Brazil, Singapore, or Thailand, while...Ben Bernanke will flee the US in a hurry.”
Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome at firstname.lastname@example.org