Emergence of Deflation: Bane for the commodity markets

Hitesh JainIndia Infoline

At the onset of the new millennium, we witnessed an astronomical rise in most of the commodities, including energy, metals and bullion prices. Strong economic growth in Asia fuelled burgeoning demand for the commodities. As a result, an unabated bull run prevailed during the last decade. The need to diversify the portfolio risk augmented investor’s participation. The development of new investment instruments (derivatives and ETFs) also encouraged investors to take a plunge in the commodity universe. Commodities represented as an asset class in their own right, with investments outperforming the risk-free returns during the last decade.

However, the situation has changed during this decade. Slowdown in the global economic trajectory has changed the complexion of the game. Chinese economy, which constitutes 40-50% of the world demand for most of the industrial commodities, is undergoing a tectonic change. Slowdown in the Chinese economy has raised questions about the sustainability of the decade-long commodities super cycle. Deceleration in the industrialisation of the emerging economies has led to moderation in global demand for most of raw materials. Not surprisingly, several investment funds/banks have exited the commodity trading business.

An improvement in global economy, tapering in the US bond buying programme and rising sovereign bond yields seemed to be the unanimous call by various economists at the onset of 2014. However, things have panned out quite dramatically. Although Fed’s quantitative easing programme came to an end, sovereign bond yields have contrastingly moved lower. Forget inflation, the threat of deflation is looming large across various economies. The predicament of the contemporary central banks can be illustrated by the fact that regardless of loose monetary policies adopted by various central banks during the past six years, the outcome has been a fall in commodity prices and slowing growth across the globe. This is antithesis to the theory that injection of money supply leads to inflation and stimulates growth. Such is the sorry state of affairs that ECB and BOJ have miserably failed to attain even benign inflation levels. In fact, US Federal Reserve has not yet garnered courage to hike interest rates in spite of improvement in economic landscape. Majority of the Federal Reserve officials are still concerned that a premature rate hike can jeopardize the growth prospects, considering the fragile health of the global economy.

Recent decline in oil prices have also aggravated the deflationary situation. European economy is particularly bearing the brunt of lower oil prices. The region is witnessing contraction in growth for the past two years. Making matter worse, emergence of deflation has poured water on European Central Bank’s endeavour to revive the economic trajectory. Eurozone GDP expanded by meagre 0.2% and 0.3% during the third and fourth quarter of 2014. The economy is in the state of dire straits, as cheap and easy money is yet to trigger higher business investments and consumer spending.

Various countries (categorically Japan) have devalued their currencies to revive the economy, however, the efforts till now has proved futile. In China, interest-rate cuts and monetary stimulus has failed to rejuvenate the sagging economic trajectory. The country is targeting growth rate of 7% for 2015, the lowest rate of expansion in 25 years. Considering this gloomy scenario, there is a wide expectation that the Chinese regime will initiate steps to arrest the ongoing slowdown. However, Chinese will be dissuaded from following the Western monetary policy, as abysmally low interest rates have failed to deliver any kind of steady growth.

We seem to be dwelling in an environment, wherein growth in money supply overlaps the growth in demand for goods and services. The eventual outcome is disinflation, which can simply aggravate into deflation. Recent flow of economic indicators across the globe corroborates the same. Commodity markets, particularly during the past few years, have clearly manifested signs of deflation. Excessive lending in the world economy has created excess production capacity. For example, energy markets have borne the brunt of shale revolution in United States, with oil prices collapsing to six-year lows. Economic slowdown and credit bubble in Chinese economy have also adversely impacted demand for various industrial commodities. Effectively, prices of commodities like Copper, Aluminium, Zinc and Iron ore have hit multi-year lows. Cheap credit over the years stimulated large investments in the production capacity and as a result created excess on the supply side. Supply glut and weak demand across the globe is symptomatic of long term deflationary trends. Strategic acumen teaches to keep the powder dry before the problem arises. However, such is the plight of the central banks that they seem to have already exhausted their arsenal to avert deflation. Persistent quantitative easing and ultra cheap interest rates have failed to nip the mess in the bud. Inefficacy of the alternative monetary policy has also compelled nations to debase the currency and in the process permeate deflation on the global stage.

Most importantly, commodity/stock markets have been addicted to the instant gratification provided by the monetary injection. Once the effect of the stimulus wanes, the financial fraternity starts dwelling on the perception of an extension of the quantitative easing. Such a scenario is reminiscent of the cliché ‘Charity degrades dignity and never begets real prosperity.’ The root problem remains unresolved. The billion dollar question is whether such a practice is sustainable, with no notable improvement in the real economy? The experiment of Quantitative easing seems to be failing as central banks will soon run out of the ammunition to tackle the burgeoning mess. There is hardly any breathing space, with literally zero interest rates in most of the developed nations. Emergence of Deflation will continue to haunt the commodity markets. Buoyant equity markets may portray a Utopian world. Nevertheless, the real economy has a different story to tell.