It’s hard to believe, but there was a time when mineral commodities were considered passé and BHP Billiton rarely made broker headlines – but between the early 1980s and 1990s a credit crunch and sovereign debt crisis in Latin America and Russia saw a sharp downturn in commodities prices.
Crises are nothing new and the European debt crisis is yet another blip on the evolutionary path of economic mayhem. A fascinating study by Carmen Reinhart at Paterson Institute for International Economics puts the current crisis into perspective. After analysing data from the mid-fourteen century of Edward III of England to the subprime crisis in the US, she says that the current financial crisis is nothing new. ‘Capital flow/default cycles have been around since at least 1800-if not before. Technology has changed, the height of humans has changed, and fashions have changed. Yet the ability of governments and investors to delude themselves, giving rise to periodic bouts of euphoria that usually end in tears, seems to have remained a constant,’ she writes.
The chart below details the percentage of countries in default or restructuring for the years 1800 to 2006 (the database covers 36 countries). The chart shows that repeated sovereign debt default is the norm throughout nearly every region in the world, including Asia and Europe. The data shows that country defaults tend to come in clusters, including especially the period of the Great Depression, when much of the world went into default,
the 1980s debt crisis, and also the 1990s debt crisis.
There are five pronounced peaks or default cycles – the first during the Napoleonic War to the emerging market debt crises of the 1980s and 1990s. Reinhart argues that the years of early 2000 were simply a lull before the next crisis hit in 2008.
Interestingly, the study shows that over the period 1800 to 2006, peaks and troughs in commodity price cycles appear to be leading indicators of peaks and troughs in the capital flow cycle.
The charts below illustrates the pre and post war periods and suggest that spikes in commodity prices are almost invariably followed by waves of new sovereign debt defaults. ‘Favorable trends in countries’ terms of trade (meaning typically, high prices for primary commodities) typically lead to a ramp-up of borrowing that collapses into defaults when prices drop,’ she writes.
Reinhart singles out emerging markets as a potential sore spot over coming years: over the last decade emerging markets have benefited from low international interest rates, buoyant world commodity prices and solid growth in the US and elsewhere. “If things can’t get better, the odds are that they will get worse,” she notes.
“Weaker growth in the US and other advanced economies soften growth prospects for export-dependent emerging Asia and elsewhere; inflation is on the rise.” Already this is apparent in Australia’s important trading partners, India and China, where India’s inflation currently sits at 9.04%, notwithstanding its Reserve Bank hiking interest rates 13 times since early 2010. China’s annual consumer inflation rate sits at 4.2% for November, down from 5.5% in October.
A regularity discovered in the analysis is that countries that experience large capital inflows – such as emerging markets did following the global financial crisis in 2008 – are at high risk of a debt crisis. “Default is likely to be accompanied by a currency crash and a spurt of inflation.”
Many investors are plagued by the thought of the commodities boom coming to an abrupt end, which would impact returns from not just miners, explorers and its servicing industry, but to banks, construction and property companies. The memory of the sovereign debt defaults in Latin America and the credit crunch of the Savings and Loans crisis in the US, has haunting similarities to today. Will this current financial crisis spell the end of our once-in-a-century commodities boom?
There is one marked difference between the two periods. Back then interest rates were sky high, with the US federal funds rate reaching 21.5% by June 1982. In contrast, the benchmark interest rate in the US currently stands at 0.25%.
According to Jeffrey Frankel, professor of economics at Harvard Kennedy School, real interest rates are an important determinant of real commodity prices. He notes that low interest rates lower the cost of carrying inventories, and hence raise commodity prices. “Monetary policy news and real interest rates, along with other factors, do appear to be significant determinants of real commodity prices historically,” he adds, hence explaining why commodity prices flew skyward as the sub-prime crisis played out and global growth slowed.
Interest rates aside, demand from China – the world’s largest consumer of commodities – will continue to be the crucial ingredient in the outlook for commodities.
Chinese demand governs prices for iron ore and coal, our largest export markets. While most agree that the China surge that we’ve witnessed over the past ten years is unlikely to be repeated, the government still has plenty of ammunition to keep investment ticking along for the time being.
BHP and Rio Tinto are certainly not acting as though a China slowdown is imminent, with multi-billion dollar mine expansions in full swing. Last month Rio Tinto increased its iron ore expansion target by 20 million tonnes to 353 million tonnes a year by the first half of 2015, from roughly 240 million tonnes a year currently. Brazil’s Vale is also citing its intention to raise its yearly iron ore output to 469 million tonnes by 2015 from 308 million tonnes today. BHP and Fortescue Metals have also earmarked output expansions.
Australia’s monthly trade surplus narrowed by more than expected in October to its smallest since March, as demand for commodities from China slowed. The Bureau of Resources and Energy Economics in Australia is far from worried, however. It forecasts a 15% rise in mineral and energy export earnings coming from iron ore, coal, oil, gas and gold in 2011-12.
The first serious setback for Aussie miners, particularly BHP and Rio, was the 30% plunge in the price of iron ore to around $US120 a tonne back in October. Iron ore prices are back up to $US137, but it was a demand scare that’s ever present for commodity investors as we move into 2012. Over the past two weeks offer prices from China have reflected restrained buying from steel producers.
Exports to China are declining – down 19% for hard coking coal, 50% for semi-soft coal and 25% for thermal coal. Although volumes are up in most cases, lower commodity prices are to blame for lower export values – which basically means falling mining profits, and weaker share prices.
Gold too is acting strangely lately; it’s off its highs of $US1921 an ounce three months ago, and lately has been seen to droop in lure with sold off sharemarkets, which is raising eyebrows. Traditionally, gold is the safe haven investment, the fall back option, when shares and bonds look too risky, but investors have been turning to gold for decades now, creating something of a bubble. Nevertheless, there are plenty of gold bulls still roaring, including Deutsche Bank with a forecast of $2,100 a troy ounce on the precious metal, and $44 on silver.
The point to remember here is that commodity prices move in cycles and are not a one-way road to higher ground. If Reinhart is on the money here, we should expect lower commodity prices next year as clusters of sovereign debt defaults and restructuring become the next blip on our economic map. Time will tell.