Doctor (Not So) Feel Good

WED 29 JUN 2022

An observation we made last week is that the rapid and emotional tightening in broad financial conditions has started to impact the spot price of commodities in a more meaningful way. The good news is that the correction in spot prices has likely been influenced by some easing in supply side constraints in select markets and might lead to a moderation in headline price inflation. The bad news is that the weakness might reflect (at least some) demand destruction.

However, as some observers have noted, there may be a disconnect between the spot (financial/futures) price of key commodities and the real demand/supply picture. Stated differently, the correction in some commodity prices might reflect speculation or hedging of perceived weakness by macro-tourists in future growth rather than a genuine demand shock in the underlying market especially in key markets like oil and copper. To be fair, when there has been legitimate phases of tightening in financial conditions, that has tended to coincide with a material correction in cyclical commodity prices (chart 1). The relationship is even more convincing in rate-of-change terms.

Of course, sector specialists in the commodity markets will highlight the strength in trend global demand for copper relative to production and known reverses (chart 2). While China remains the largest consumer of copper (and most industrial metals) secular demand for copper has increased with EVs and other related industries. In addition to the strength in trend demand relative to supply, copper inventory remains relatively low.

While a proper global recession would clearly reduce cyclical demand for copper and other industrial metals, it is notable that China has clearly started to ease credit and implemented infrastructure spending. As we have often noted, phases of acceleration in the China credit impulse (rate of change in credit growth) have tended to lead to a cyclical rise in commodity prices (chart 3). Conversely, when China slows the credit impulse that tends to slow growth. In addition to infrastructure, recall that around 25% of growth (directly and indirectly) is from real estate and construction. Clearly that has been challenged by the episode in China’s property developers.

The forward looking point is that the current correction in commodity prices could be an emotional overreaction to the potential global recession, especially if the secular demand/supply structure remains tight and if China has started to ease credit to support cyclical conditions. In that context, the global materials sector is also inexpensive at 5.4 times EV/EBITDA. To be fair, the large and rapid tightening in financial conditions has typically coincided with a non-trivial correction in commodity prices sensitive to global growth.