What is the outlook for commodity prices? The answer to that question is likely to determine the trajectory of the Indian market.

Forecasting commodity prices in today’s volatile markets is by no means easy. It is no longer a question of mere supply and demand; commodities are now an important asset class and lots of people, from the government of China to a humble retail investor in an exchange-traded fund, have been betting on them.

Also see | Rising Commodity Prices (PDF)

Also read | Manas Chakravarty’s earlier columns

Nevertheless, the International Monetary Fund (IMF) has had a stab at it. Its World Economic Outlook (WEO) points out several trends: 1) emerging markets have been the drivers of global growth and these economies are commodity-intensive; 2) demand growth for commodities has been stronger than the past relationship between economic growth and commodity consumption would lead us to expect; 3) the supply response to stronger-than-expected demand has so far been limited; 4) weather-related supply shocks were important in raising food prices; 5) the US dollar, in which international commodity prices are denominated, has been depreciating, raising commodity prices; 6) loose monetary policy, which has led to low global interest rates, keeping inventory financing costs low; and 7) the continuing financialization of commodity markets, with commodity assets under financial management reaching a new high.

Net inflows into commodity index swaps and exchange-traded products based on commodities have been substantial. In April, according to the Bank of America-Merrill Lynch survey of fund managers, a net 24% were overweight commodities, compared with 21% in March.

What does all this mean for future commodity prices? IMF says that macroeconomic prospects remain supportive for commodity prices, although it points to a slightly lower rate of global growth and particularly growth in China, a pick-up in supply and better weather to argue for “some easing in demand-supply balances and for a moderation of upward price pressures". In other words, the pace of increase may not be as rapid as it has been in the recent past.

The chart shows IMF’s projections for commodity prices for 2011 and 2012. Note that while the assumption is for strong commodity prices this year, the world commodity price index in 2012 is expected to be lower than in 2011. Commodity prices this year are expected to rise quite sharply compared to 2010. And finally, the average level of commodity prices this year is expected to be well above that in 2007, a bumper year for commodities. Indeed, the IMF numbers show that average metal prices in 2010 were already higher than their 2007 levels.

WEO projects lower commodity inflation in 2012 despite global growth being more or less the same as in 2011. That’s probably due to an increase in the supply of commodities. But, like the Reserve Bank of India (RBI), IMF says the risks to commodity prices are tilted to the upside.

For India, of course, what matters most is the price of oil. Oil is so important that IMF devotes an entire chapter of WEO to it. Its main findings are that we’ve entered a period of oil scarcity that is likely to keep prices high. For oil importers, while higher oil prices will lead to slower growth and higher inflation and fiscal pressures, those negatives will be offset to some extent by higher exports to the oil exporting countries and by lower world interest rates as a result of all the surpluses being accumulated by petroleum exporting countries, especially their governments. In the 1970s, after Organization of Petroleum Exporting Countries increased oil prices dramatically, a period of low global interest rates followed.

Interestingly, commodity prices have bounced back quite sharply from last week’s lows, supporting the view that all that has happened is that punters used the opportunity to take some profits off the table last week and are now coming back. This is despite a moderation in global growth as evident from the Global Purchasing Managers’ indices, slower Chinese growth as seen from lower imports and the determination of central banks in emerging markets to stamp out high inflation.

To put matters in perspective, however, look at the World Bank data on commodity prices for low and middle-income countries, as shown in chart. Notice that while the index for energy trended higher in April, the indices for many of the non-energy indices were lower in April than in February. So it’s not as if commodities had not reacted earlier to slowing growth, but the impact is not likely to be much.

Lower energy prices are undoubtedly good for the Indian equity markets and this was reflected in the bounce in the market when commodity prices collapsed last week. But, as on 10 May, the MSCI India index was lower by 4.5% this month, well below EM Asia, which was down 2.1%. That suggests RBI’s actions to slow growth will outweigh any minor reduction in commodity prices. As for foreign institutional investors, they seem to find India’s debt markets far more attractive than its equities. As of 10 May, they have invested a net $3.274 billion this year in our debt markets, compared with $453 million in equities.

Graphic by Yogesh Kumar/Mint

Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome at capitalaccount@livemint.com