Emerging markets will remain in focus this week as the world watches anxiously to see if China’s move to devalue the yuan will ultimately transform an already precarious situation into an outright crisis.
Slowing demand from China has been the major concern for commodity exporters and indeed, wide open capital markets (thanks to ultra accommodative monetary policies across the globe) have served to keep struggling producers afloat, perpetuating a global deflationary supply glut.
Saudi Arabia’s attempt to squeeze the US shale complex has only exacerbated the problem, as persistently low crude prices put further pressure on the commodities space as well as on the FX reserves of oil producing countries. When China devalued the yuan, it validated the suspicions of those who had assumed that the country’s economy was in far worse shape than anyone at the NBS was willing to admit. Additionally, it marked a new escalation in the global currency wars and threatens to undermine the export competitiveness of many an emerging economy.
Now, markets are in turmoil and the dramatic plunge in EM currencies threatens to upend markets the world over on the way to ushering in a new financial crisis.
If we have indeed entered a "new era" - to quote Kazakh Prime Minister Karim Massimov - for crude and for commodity prices more generally, it could have widespread implications for everything from oil producers’ FX regimes to demand for USD assets. As Goldman noted earlier this year, "the new (lower) oil price equilibrium will reduce the supply of petrodollars by up to US$24 bn per month in the coming years, corresponding to around US$860 bn over the next three years." That could portend a meaningful loss of liquidity across some asset classes.
It’s against this backdrop that we bring you the following commentary from Barclays on the outlook for commodities in the new era.
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"Long, slow, and painful (probably with more to come..)"
It is an old saying in commodities that the best cure for low prices is low prices. Market participants are now asking how much further prices need to fall and how long they need to stay there to bring supply and demand back in to balance and halt the price declines across a broad swathe of different raw materials markets. The fear is that just as the upside of the supercycle brought an unprecedented and long period of historical price highs, the plunge to the downside is shaping up to be equally dramatic and may yet have a way to run. In terms of depth, length and breadth, this is already a much more severe commodity price downturn than any the market has experienced in recent history. The 15% decline in the broad-based Bloomberg Commodity Index since May means prices are on average about a third lower than they were a year ago, only half what they were when the initial recovery from the financial crisis peaked in March 2011 and only a third of the all-time highs for the index hit in 2008. Almost all the gains associated with the so-called “commodity supercycle” have been eroded, and the index is back at levels not seen since 2002.
There are three key structural factors that are reinforcing the long-term downtrend in commodity prices. The bad news for producers is that it is difficult to see any of them easing in the short term.
First is the slowdown in China and a shift in its economic growth model leading to a big reduction in overall commodity demand growth rates. Over the past five years, Chinese demand for oil, copper and aluminium has risen on average by about 6%, 9% and 13%, respectively, each year. We forecast those growth rates will slow to 3%, 2.4% and 2.5%, respectively, for the next five years, and the transition to those much slower growth rates is under way (see Figure 3).
Last week’s China devaluation spooked commodities markets because it underlined just how difficult it is for China’s policymakers to manage such a large-scale transition. However, it will do little to improve the competitiveness of China’s manufacturing sector, and although there are hopes that infrastructure spending is about to pick up a little, the massive indebtedness of China’s local governments mean any improvement is likely to be quite modest compared with previous stimulus programs.
Just too much
The second factor is the fact that many important commodity markets remain hugely oversupplied and the producer adjustment process still has a long way to run. In every commodity price downcycle, commodity producers tend to hang on for as long as they can even when margins are cash-negative, in the hope that others will close first. However, this time oversupply is being made a lot worse by fierce competition for market share. This is most evident in the oil market where OPEC countries have made market share gains a specific aim and the group has raised its production by more than 1m b/d so far this year. While its high level of output may be difficult to sustain due to threats in some OPEC countries such as Iraq, there is little sign yet of any marked OPEC declines.
Our third and final structurally bearish factor for commodities is the long-term upward trend in the value of the dollar, which, in our view, still has some way to run. This is putting downward pressure on producer cost curves and ensuring even lower prices are required to bring about cuts to output, while at the same time raising prices in non-dollar currencies and, thus, reducing price-sensitive demand.
Figure 4 shows how the decline in commodity prices has become intertwined with the falling currencies of major producers. These two trends are tending to reinforce each other. Commodity prices fall, leading to reduced growth prospects in commodity-producing countries such as Brazil, Australia or South Africa. That puts downward pressure on local currencies, which reduces producer operating costs in those countries and means that even lower prices are needed to force them to cut back. In this way the vicious circle continues.
While it may come as welcome relief to some, the last thing the commodities markets need right now is a short-lived price recovery. There is little doubt that the Q2 rally in oil prices – by enabling producers to lock in decent margins by selling forward and encouraging some US tight oil producers to start drilling again – has lengthened the downside for oil prices by prolonging the supply-side adjustment process. A repeat of that process will just prolong the pain even more.