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As a resource driven economy, Australians are justifiably concerned when commodities of all stripes take a dramatic turn southward.  While the price of iron ore is of greatest concern here, experts have long maintained that the base metals – copper, zinc, and aluminum – play the role of canary in the coal mine.  Of these, copper is perhaps the most widely followed.

On 20 October 2011, the price of copper dropped to its lowest level in more than a year.  The price of aluminum and zinc experienced similar drops.  The COMEX or Commodities Exchange is the division of the New York Mercantile Exchange where futures contracts on base metals trade.  Here is a 2 month chart for the price of Copper:

You can clearly see the decline began in early August right around the time the US default crisis was resolved with an agreement no one liked and which paved the way for future disagreement.  This was followed by a downgrading of the US credit rating and daily news on troubles in Europe; not only with the Greek default, but also with potential trouble in Italy and Spain.  

Just after the new 52 week low was set in the copper price, note the upward spike – on Friday copper rallied a whopping 6.5%.  What happened?  Newcomers to share market investing who still believe in the fairy tale of a rational market driven by fundamentals might have assumed China or India or somebody announced something that would require large quantities of copper. Instead, it was more likely that it was speculators pushing the price up. The real question to ask is whether commodity prices being driven down by a markets focusing on negative news, or are there genuine fundamental concerns about global growth?

The picture is far from crystal clear, but analysts from well-respected institutions like Morgan Stanley are introducing a new term to the equation – global synchronous recession.  Adam Parker, the head of US Equity Strategy at Morgan is warning investors of a minimum 10% chance the entire world will plunge into recession at the same time.

However, as is almost always the case in times of fear and uncertainty, many investors will ignore the 10% chance warning and instead assume the worst.  Panic is contagious, especially when there are several macroeconomic conditions at play, some of which have more than just a grain of truth to them.

Putting analyst opinion aside for the moment, here are four common sense issues contributing to the decline in commodity prices.

1.    Forced Liquidation

2.    Eurozone Debt Crisis

3.    US Recession and Budget Negotiations

4.    Slowing Pace of Economic Activity in China

Forced Liquidation

This is the only issue of the four that has nothing to do with fundamentals.  Retail investors who have been in the share market for awhile know what margin trading is and what margin calls can do to their investment portfolio.  However, this is only one example of forced liquidation, and it is the least consequential.  

The price of commodities is no longer determined solely by the commodity producers and the end users.  Futures contracts to hedge against price fluctuation began centuries ago between producers and users.  Once futures contracts attracted the attention of speculative investors, a new demand element entered the price equation – a demand not for the commodity itself, but rather for the investment vehicle derived from it.  Fortunes have been made and lost by the big players trading these instruments.  

Today’s players are hedge funds and other institutional investors.  However, most trade with other people’s money and when the investors for whom they trade get scared and want their money back, the funds and investment houses are forced to liquidate their positions to raise the cash needed to repay their investors.

While the initial panic selling may well be a function of fundamental concerns, forced liquidation can make the situation appear worse than it is as this kind of selling drives already dropping prices to even lower levels.

Eurozone Debt Crisis

The Eurozone debt crisis is very real.  Truth be told, no one knows with certainty what will happen if Greece defaults and no one knows the full exposure of the European banks in the event of a default.

What is readily observable and fundamentally troubling is the inability of the leaders of the European countries to agree on a policy solution.  For well over a year, investors world wide have been subject to what seems to be a never-ending series of “constructive talks” that never seem to lead to a resolution.

There are a small number of financial experts who actually predict a break up of the European Union itself.  As you know, Europe is a large importer of Chinese manufactured goods.

US Recession and Budget Negotiations

The United States is still the world’s largest economy and China’s best customer.  While a few economists believe the US is already in a new recession, the majority feel it can be avoided.  One wonders if they have read the details of the political deal reached to avoid a US default.  It calls for a group of politicians who have already demonstrated their inability to agree on anything, to agree on putting the US on a budget diet to bring down their debt.

What many seem to be ignoring is what will happen if they cannot agree on a policy solution.  In that case, automatic budget cuts will kick in, with a large bite taken out of the US defense budget.  While there is no question of the long term need for the US to cut spending, those kinds of massive cuts that could begin in 2012 would almost certainly push the country into recession.

Slowing Economic Activity in China

To most investors this is the most troubling issue.  China weathered the GFC very well and without their economic growth it is likely the impact would have been far worse.  Australians are particularly nervous about the pace of economic activity in China, as they are the principal driver of our resources boom.

The most recent bit of news out of China that sent shivers around the world was the drop in the non-manufacturing purchasing managers index (PMI) for the month of August.  As you know, a reading below 50 means economic activity is contracting and readings above 50 signal expansion.

In April of 2011 the non-manufacturing PMI was at its high for the year – 62.5.  The reading dropped to 57% in June and rose to 59.6% in July.  In August it dropped to 57.6%, still well within expansion territory.  

The China Federation of Logistics and Purchasing (CFLP) said that investments on railways have fallen and the impact of slowing growth of infrastructure investments in some sectors has started to show.  Slowing construction activity in August was one of the main factors contributing to the lower non-manufacturing PMI reading.

In addition, China has said it would suspend new railway project approvals in light of heightened public concern after two high speed trains collided in July, resulting in the deaths of 40 people.

In summary, the principal driver in the fall of commodities appears to be a growing concern of economic slowdowns of varying severity in the world’s two largest economies – the United States and China, – and in the European Union where the world’s fourth, fifth, and eighth largest economies reside (Germany, France, and Italy.)

Australians might find a glimmer of light in the fact many economists believe public policy could stave off a global recession.  While the governments of the European Union, and the government of the United States have yet to demonstrate an ability to agree upon and implement such policies, China has done the opposite.  Despite repeated warnings in recent times of impending doom in the land of the dragon, they have managed to prevail.

More articles from this week’s newsletter 

18 Share Tips – 24 October 2011

Three vulnerable sectors: Banks, Retail & REITs

The Stockies – Vote for the no.1 broker

Can I hold just one share so that I can be included in future share purchase plans?

The Utility Of Trendlines

ASX rolling 52-week highs

ASX rolling 52-week lows

Top 10 shorted stocks on the ASX

Breaking News – all the latest Australian stockmarket news

Market Data: Check out TheBull’s market data for charts, quotes and company information

 

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