Highway to Sell (Heavy Metal Version)

TUE 26 APR 2022

Financial market volatility has continued over the past week, but has started to take on a new dimension. In contrast to the recent inflation and rate-driven weakness in equities and fixed income, markets have started to consider the potential growth and profit downgrades over the coming year. In Asia Pacific there has also been a renewed deterioration in growth expectations emanating from China. The downgrades are clearly a function of renewed lockdowns which exacerbate growth weakness and supply-side constraints. However, they have also coincided with tighter global financial conditions and dollar liquidity and might be consistent with a challenging phase for industrial commodities.

It is an obvious point, but given China’s 40% plus share of global consumption for most major commodities, weakness in final demand clearly matters for price. While the episode has been complicated by broader supply-side constraints related to the war in Europe and under-investment over the past few years, the economic cost of the latest lockdown measures in China has contributed to a renewed growth scare with parallels to the phase in 2015. Recall that the PBOC devalued the CNY in August 2015 following a similar phase of growth weakness and tighter US financial conditions associated with the start of policy normalisation in the last Fed cycle (chart 1).

The good news for the commodity markets and growth expectations later this year is that the PBOC has already started to ease liquidity and credit (after tightening over the past year). The credit impulse in China has started to improve sequentially following the deterioration since the end of 2020. As we have noted previously, China has started to tighten policy much earlier in this cycle or well in advance of the Fed. Credit easing might start to support final demand for commodities again later this year once the latest lockdown measures are removed (chart 2).

However, in the near term, the elevated starting point for many commodity prices and the deterioration in final demand from China and globally is probably consistent with downside risk in the near term (the commodity price index is inverted on the right hand scale in the time series below so that a rise in the dark blue line is consistent with commodity price weakness – chart 3).

Historically, deterioration in global new orders to inventory ratios have been consistent with lower commodity prices. The other correlated factor has been US dollar strength associated with tighter dollar liquidity. Clearly commodities are also priced in dollars. Therefore, dollar strength also translates into commodity price weakness. It is notable that the US dollar index has rallied to the strongest level since the 2020 episode and commodity linked currencies have started to depreciate over the past few weeks.

In conclusion, recent financial market volatility appears to have been caused by a deterioration in growth expectations, rather than inflation and policy-rate driven weakness. Of course, the later has contributed to higher US rates, tighter dollar liquidity and financial conditions. Growth downgrades in China are self-inflicted from renewed lockdown measures. However, on the positive side, have led to policy (credit) easing in China. From a currency perspective, US dollar strength against the major currencies and domestic growth considerations are probably consistent with further weakness in the renminbi and industrial metals prices.