Divining the future: The case for being skeptical about commodity prices as a leading indicator

Some indicators are available in real time, every second, every working day of the year. These are understandably attractive to anyone wanting to understand the state of the global economy. Taken at face value they can be downright misleading as observers ignore the influence that supply-side factors can have on the price. This article looks at three of these real-time indicators – the price of US lumber futures, the copper futures price and the cost of shipping balk commodities around the globe (the Baltic Dry Index).

Timber!

House purchase activity is an important signal as to the health of the economy. It’s not just the cost of the house but spending on all the other things involved with a house; renovation, construction and utilities etc. Together housing represents around one-sixth of the US economy.

A house is by far the largest single purchase that most people will ever make and so it’s an important signal of consumer confidence. Who wants to buy a house when they are worried about where their next pay check will come from?

Housing starts are a terrific leading indicator of the US economy. It can take several months for homebuilders to construct a new property and homebuilders are reluctant to break ground on new projects if they fear the economy may slump later in the year. Every recession in the US since 1960 has been preceded by decline in housing starts of on average around 25%.

Could there be an even better, even longer leading indicator? Well, the price of lumber is often seen as a leading indicator of the US housing market. Construction companies need to purchase materials to build new houses and the cost of the lumber is a key factor influencing the overall build cost.

If you start to see lumber prices decline sharply and for a prolonged period it typically means that a slowdown in housing starts is around twelve months away. However, the price of lumber is very volatile and supply as well as demand influences the price.

The dramatic drop in lumber prices since the middle of 2018 (down 45%) is being used by some to predict a sharp slowdown in the US economy. On its own that piece of information sounds scary enough, but it ignores the factors behind the previous surge in lumber prices.

The catalyst for higher lumber prices came in 2017 when the U.S. Commerce Department announced anti-dumping and anti-subsidy duties on lumber imports from Canada. The duties were implemented in early 2018 and average 20.23% for most Canadian lumber producers.

This was not the first time that the US has picked a fight with Canada over the price of imported softwood lumber.  On previous occasions in the early 1990’s and early 2000’s tariffs were imposed, lumber prices spiked yet the impact on prices proved temporary. As of today lumber futures prices are back at the same level they were two years ago – before the tariff announcement.

Housing market demand has indeed weakened, but the dramatic drop in lumber prices over the past year is creating the impression that the situation is much worse, and is going to get even worse than the underlying fundamentals suggest. Also, beware that the lumber futures contract is one of the most illiquid commodity futures contract, and so it becomes an even larger leap of faith to draw fundamental conclusions from movements in the price.

Dr Copper

Copper is often referred to as “Doctor Copper” with trends in the copper market often touted as being a useful indicator of the state of the world’s economy. Rising copper prices — and by implication, rising demand for the indispensable metal — signals that the future is bright and shiny. Conversely, if copper prices decline, that’s a sign that the global economy is losing steam; lower copper prices may suggest faltering demand, which in turn implies that less of the metal is going into manufacturing and construction.

However, the evidence suggests that the copper market isn’t as smart as many would believe. It’s possible to find numerous “bear” markets in copper, with price declines over 20 percent. In most of those cases, no recession followed. If anything, copper prices more consistently rose in advance of recessions and continued to rise during the economic downturn. This was true for recessions that began in 1970, 1973, 1980, 1990 and 2008.

Why might this be the case? One study of commodity prices found that copper prices are sensitive to positive news about the economy, but much less sensitive to negative news. That may help explain why copper prices continued rising even as the economy enters recessionary territory.

All of this ignores the fact that all commodities are a function of supply, as well as demand. Meanwhile, the copper price is also affected by investor sentiment, which means that significant price fluctuations can occur even though there is no reason for price movements on pure fundamental demand grounds.

The Baltic Dry Index

The Baltic Dry Index (BDI) is a measure of the cost of shipping coal, iron ore and other commodities around the world, and it is often seen as a leading indicator of economic growth and commodity demand. However, using the BDI to predict changes in economic activity as well as financial and commodity markets is a fool’s game.

The BDI is an indicator of short-term demand and supply for ships, and as so if the cost of shipping increases it is because there are not enough ships available and there is too much demand for commodities at a particular moment in time. With the supply of ships being sticky in the short term (ships can take many weeks to travel to the port where they are needed) and demand for commodities being volatile, any mismatch can easily be reflected in a sharp movement in the BDI.

As an example, imagine you have ten loads of iron ore and nine ships, and that every load of iron ore must be sent, no matter what, and every ship must be filled, no matter what. Imagine the bidding war between those ten iron ore consumers fighting over just nine ships. Shipping costs would rocket, since they all need to ship regardless of the cost.

As with the price of copper the BDI is also affected by supply – the supply of ships. If the number of ships increased (perhaps because earlier strong shipping rates incentivised shipbuilders to manufacture more ships) then the BDI may still fall even if demand for ships has increased.

In early 2019 the BDI fell to its lowest level for three years. Demand for ships fell leading some to believe that the index portend a collapse in world trade and the global economy. In reality a combination of disruptions affecting over 80% of the seaborne iron ore supply reduced demand for bulk shipping.

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