Commodity Prices Signal More Tough Times Ahead

The signers of the Declaration of Independence pledged their "lives, fortunes and sacred honor" to the cause. We're all probably a little more aware of the value and fragility of life than we were just a few weeks ago, and most of us, alas, are now a little lighter in the fortune department.

Sacred honor is not as irretrievable as life, but once lost, it's difficult to recover. This struck me while reviewing a piece I wrote in April on the negative macroeconomic implications emanating from the base metal complex, which includes copper, aluminum, zinc, nickel, tin and lead.

At the time, various members of the Federal Open Market Committee were traversing the countryside to defend their lower-than-hoped-for rate cut of 50 basis points on March 20. I noted then that the "recent spate of comments from various members of the Federal Reserve telling us things aren't all that bad in the face of a steady stream of evidence to the contrary risks a long-term loss of credibility for that suddenly embattled institution."

We needed, then as always, to hear the bad news. President Bush has benefited from leveling with us on how difficult the war on terrorism will be. Pollyannaish Treasury Secretary Paul O'Neill and those brokerage-house analysts and strategists -- many still predicting unlikely massive rallies between now and the end of the year -- need to take note. You can't promise your audience that you'll be right, but you can and must promise them that you'll be honest. I'm tired of writing downbeat assessments and yearn to bear good news, but I can't let that impulse color my analysis.

The Good

The conclusion reached both in my April piece and in one written just before the March low was that the deflation in commodity prices produced by the slowing economy would have some benefits. Lower commodity prices generally precede a drop in long-term interest rates; this leading relationship was distorted over the past three years by artificial price supports in energy from OPEC and from last winter's natural gas price surge.

Commodities and Interest Rates

Source: Bloomberg

The recent drop in energy prices will act as a massive tax cut for the economy. Because we import nearly 12.5 million barrels a day of crude oil and refined products, the recent plunge of nearly $4 per barrel is equivalent to an annual tax cut of $18 billion. The even larger drop in natural gas prices since last winter represents a domestic wealth transfer to consumers from producers of about another $16 billion. (Stray thought: Are consumers gouging producers?) Therefore, both average consumers and noncommodity-producing businesses should benefit from the expected drops in interest rates and energy prices.

The Bad

Real commodity prices should trend lower over time to reflect increased production efficiencies. A striking, but hardly unique example of this, is the 85% drop in real wheat prices since 1946. (Over the same duration, the world's population grew from 2.5 billion to 6.1 billion.) Commodity-price spikes, such as the recent one in energy, are self-correcting as they stimulate both demand conservation and new production.

However, commodity-price deflation caused by macroeconomic recession reflects an unwelcome set of circumstances. Let's update a chart from last April, one comparing London Metals Exchange prices for three-month forward copper and the S&P 500; the date when I said metals prices were still headed lower is marked on the chart. While copper is used in this example, the same story would be told by aluminum, nickel and zinc -- but not by lead or tin -- prices.

Parallel Bear Markets

Source: Bloomberg

Copper prices never took the bait of an expected economic recovery in the third quarter of 2001 the way stock prices did last spring; after all, we can express hope and confidence for the future with our equity investments, but copper buyers have no room for such sentimentality. The demand is either there or not. During last week's relief rally in stocks, nickel prices hit a new low for the year, and both copper and aluminum approached theirs. If there's a global recovery in manufacturing demand, it's news to metals buyers.

The Ugly

My previous column on metals prices offered three ways to tell whether commodity prices have bottomed:

1. Have prices fallen below the marginal cost of production?

2. Has the forward curve of futures prices moved toward a deep carry, wherein the prices of distant futures are well above near-month futures?

3. Are the stocks of primary producers rising faster than the market as a whole?

Of these, the third method is the most reliable. Let's take a look at the six-member Bloomberg U.S. Mining Index in comparison to the S&P 500. The index includes Apex Silver (SIL Quote), Brush Engineered Materials (BW Quote), Kaiser Aluminum (KLU Quote), Phelps Dodge (PD Quote), RTI International (RTI Quote) and Titanium Metals (TIE Quote).

Relative Performance: Mining Index vs. S&P 500

Source: Bloomberg

The picture is discouraging, to say the least. The mining index took the bait even more than the S&P 500 did in the spring rally on hopes of a macroeconomic recovery, but its recent descent has been far sharper and deeper than the broad market's. If metals prices are sensitive leading indicators of economic growth, and if the equity market is doing its job of discounting future earnings properly, we've still got a rough road ahead.