Monday, July 03, 2006

Andie Xie of Morgan Stanley on Commodity Prices and Liquidity.

Andy Xie (Hong Kong)

*High commodity prices are causing demand destruction. A significant downturn in Chinese demand for hard commodities suggests that demand is reacting to unsustainably high prices. As the property cycle turns down globally, demand for hard commodities should weaken further.

*Commodity prices reflect liquidity rather than demand. Commodity prices react sharply to the policy outlook for major central banks, indicating that liquidity rather than demand drives commodity prices. Hence, demand weakness is insufficient to bring down prices in the short term.

*Oil prices should lag demand even more. Oil exporters have become enormously rich from high oil prices in the past three years and are in a strong position to cut production to sustain high prices. It may take a global recession to bring down oil prices.

*Property downturn may exacerbate inflation. The global property boom has increased the share of corporate earnings in GDP, which has allowed businesses to hold price increases despite rising costs. As the property cycle turns down, businesses may have to raise prices more.

*High commodity prices force central banks to tighten. Global inflation is reaching ten-year highs and is likely to move higher in the coming months. Commodity prices are a major factor. As weak demand is insufficient to bring down commodity prices, central banks have to tighten aggressively to contain inflation even as the global economy cools. Financial speculation makes it difficult for central banks to achieve a soft landing for the global economy.

Global inflation is close to a ten-year high and is likely to rise further into 2007. The culprit is the unsustainably high level of liquidity, whose inflationary effect has been held back by deflation shocks (e.g., the emerging market crises, China’s SoE reform and Japan’s banking reform) in the past. As deflation shocks have ended, the current level of money supply is not consistent with price stability, in my view.

Commodity inflation is a major channel for excess liquidity to turn into inflation. Even though high prices are destroying demand, prices remain very high despite the recent decline and tend to surge whenever the expectation for rate hikes by central banks diminishes. This suggests that central banks have to tighten more than what the real economy requires in order to contain inflation.

Central bank signaling has been driving financial markets lately. Their ambivalence towards inflation only incites more financial speculation and, hence, more inflation, which makes a soft-landing more difficult to achieve, in my view. In the end, the reality of high and rising inflation will catch up with central banks, and I believe that the more dovish they are now, the more they will have to raise their interest rates later.

High commodity prices are destroying demand

Evidence is mounting that high commodity prices are destroying demand. The IEA estimates that global crude demand is rising at 1.24 mb/d, much lower than its forecast of 1.5 mb/d at the beginning of the year. Further, OECD crude stock is at a 20-year high or 54 days of demand coverage. These data suggest that crude demand has cooled and supply is more plentiful compared to 2005 or 2004. Nevertheless, Brent crude still averaged US$65.2/bbl in the first half of 2006, up 34% and 94%, respectively, from the same period in 2005 and 2004.

Demand destruction is even more apparent in base metals. China’s imports of base metals have declined sharply this year. Despite the recent correction, metal prices remain extremely high: compared to average prices in 2005, copper is currently 92% higher, aluminum 29%, nickel 45% and zinc 119%. While the commodity bulls usually cite strong demand and tight supply as reasons for the high prices, it is obvious to me that financial investment has driven up these prices.

Dovish central banks encourage speculation

The reaction to the Fed’s statement last week is a good example that commodity prices are far more sensitive to liquidity indicators than real demand. As the Fed sounded more dovish than the market expected, commodity prices rebounded sharply from the recent decline.

The commodity bubble is a knife hanging over the heads of dovish central bankers, in my view, because it encourages more speculation, which in turn causes more inflation, and I believe that the reality will catch up with the central banks that sound dovish today. The commodity bubble is one manifestation of the inflationary pressure from the very high monetary stock in the global economy. The inflationary effect of the abundant money supply was suppressed by global deflation shocks. Instead, the liquidity caused asset inflation. As deflation shocks end, asset inflation is causing consumer price inflation.

Central banks have tightened substantially already, and this is now causing the global property cycle to turn down. Central banks are worried about the effect of this downturn on demand and do not want to tighten much more to risk a recession. However, the current level of tightening is not sufficient to stop commodity speculation, in my view. This essentially puts central bankers in a box — if they focus on achieving a soft landing, they run the risk of letting inflation get out of control.

The risk of a global hard landing rises

Central bankers may not be focusing enough on the big picture, but instead could be becoming too ‘data dependent’. The big picture is that they have pumped too much money into the global economy. As deflation shocks suppressed the inflationary effect of this, money supply stimulated demand growth through asset inflation. Global conditions seemed ideal — too much money but no inflation — over the past few years.

However, the inflationary pressure was simply warehoused in asset markets; as deflation shocks end, their inflationary effect pours into the real economy. The right policy for price stability is to target asset prices, in particular commodity prices, in my view. If central banks react to consumer prices, they merely delay containing the inflationary pressure from asset inflation and make inflation more intractable. Inflation would peak out much higher than in a forward-looking policy approach. When upward inflationary pressure is delayed, central banks could well overreact and cause a global hard landing.


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