Com­mod­ity Decline Could Pro­vide a "Tax Cut"

Octo­ber 24, 2011

by Michelle Gib­ley, CFA, Senior Mar­ket Ana­lyst, Schwab Cen­ter for Finan­cial Research

Key points

• The global growth slow­down could offer some pos­i­tive news: a decline in com­mod­ity prices and inflation.
• Domes­ti­cally ori­ented countries—those that rely more on con­sumer or con­struc­tion spending—could ben­e­fit from the con­sump­tion stim­u­lus, while domes­ti­cally ori­ented, emerg­ing mar­ket coun­tries could receive a dual ben­e­fit as mon­e­tary pol­icy pres­sure lessens.
• Com­mod­ity prices may not decline to the same degree as in 2008, because another global reces­sion appears unlikely.

It's hard to cheer on a global eco­nomic slow­down, but there could be some good news for con­sumers amid the pes­simism. As eco­nomic growth slows, the demand for commodities—such as oil, met­als and food—typically slows, result­ing in falling prices. The impact of this could be sim­i­lar to a "tax cut" for con­sumers, giv­ing them more money in their pocketbooks.

The ben­e­fit of this "con­sump­tion stim­u­lus" is most likely to be seen in coun­tries where growth is gen­er­ated domes­ti­cally, either through con­sump­tion or con­struc­tion spend­ing. Exam­ples of devel­oped, domes­ti­cally ori­ented coun­tries include the United States, Japan and the United Kingdom.

In addi­tion to the "con­sump­tion stim­u­lus," emerg­ing mar­ket coun­tries could ben­e­fit from the down­ward pres­sure that falling com­mod­ity prices puts on inflation—reducing the need to hike inter­est rates.

Here, we'll discuss:

• Why might we see a "con­sump­tion stimulus"?
• Why is infla­tion likely peaking?
• Who is likely to ben­e­fit from the "con­sump­tion stimulus"?
• Why are com­mod­ity prices unlikely to decline as much as in 2008?
• What are Schwab's invest­ment resources for inter­na­tional investors?

Why might we see a "con­sump­tion stimulus"?

Com­mod­ity prices tend to fall when eco­nomic growth slows due to reduced demand from both con­sumers and busi­nesses. Con­sumers may cut back on energy use and pur­chase fewer goods and ser­vices to save money. Mean­while, busi­nesses may reduce pro­duc­tion in response to reduced demand.

In addi­tion, most com­modi­ties are priced in US dol­lars. When the dol­lar falls, com­mod­ity prices tend to rise as it takes more dol­lars to pur­chase the same amount of a com­mod­ity. And as we're see­ing now, the inverse is also true; com­mod­ity prices tend to decrease when the dol­lar rises.

While con­sumers pay atten­tion to the prices they pay at the reg­is­ter, investors care more about inflation—and notably, we may have seen the top.

Why is infla­tion likely peaking?

With eco­nomic growth slow­ing, some investors are wor­ried that infla­tion may increase because they may expect the Fed­eral Reserve to pur­sue QE3 (quan­ti­ta­tive eas­ing, or asset pur­chases), which could weaken the dol­lar and raise com­mod­ity prices.

How­ever, the dol­lar may not decline. Thus far, the Fed has done more to stim­u­late growth than the rest of the world. And with global growth slow­ing, other global cen­tral banks may begin to lower rates or pur­sue other stim­u­lus mea­sures in a "catch-up" phase. The impact of rate changes on cur­ren­cies is rel­a­tive. But the net effect of declin­ing rates abroad and poten­tially bet­ter growth prospects in the United States is that the dol­lar may have an upward bias.

Com­mod­ity prices have already started to fall as a result of the eco­nomic slow­down, but infla­tion has not yet shown a notice­able decline. How­ever, tak­ing out the impact of the dol­lar and hold­ing com­mod­ity prices unchanged from the lev­els reached this sum­mer, mea­sures of infla­tion are likely to decline rel­a­tively soon. The rea­son is that infla­tion is mea­sured as a per­cent change from the prior period.

Com­mod­ity prices likely peak­ing near-term

Source: Fact­Set, Com­mod­ity Research Bureau, Dow Jones, NYMEX as of Octo­ber 19, 2011.
* Indexed to 100 = 10/18/2006. 25-day mov­ing average.

Who is likely to ben­e­fit from the "con­sump­tion stimulus"?

Depend­ing on the type of econ­omy, the "con­sump­tion stim­u­lus" can have a dif­fer­ent impact:

• Domes­ti­cally ori­ented coun­tries, those with big­ger con­sumer sec­tors or reliant on infra­struc­ture spend­ing for growth, would ben­e­fit from lower com­mod­ity prices because a "con­sump­tion stim­u­lus" could result in bet­ter poten­tial for growth to reac­cel­er­ate. The extra money in con­sumers' pock­et­books can be used for dis­cre­tionary spend­ing, and make infra­struc­ture spend­ing more attractive.
• Export-oriented coun­tries tend to suf­fer in a global slow­down, although lower raw mate­ri­als prices can reduce mar­gin pres­sures for com­pa­nies with less pric­ing power.
• In emerg­ing mar­ket coun­tries, food price declines have a large impact on infla­tion, because food accounts for a dis­pro­por­tional share of con­sumer spend­ing. Emerg­ing mar­ket infla­tion has been a prob­lem due to ris­ing com­modi­ties and expec­ta­tions that prices increases would con­tinue. Addi­tion­ally, higher wages, which con­tributed to infla­tion when growth was accel­er­at­ing, are likely to ease along with slow­ing eco­nomic growth. Peak­ing infla­tion could pro­vide the cover for cen­tral banks to pause rate hike cycles, ben­e­fit­ting stocks.
• In devel­oped mar­ket coun­tries, the com­mod­ity that tends to get the most atten­tion is oil. Accord­ing to the Fed­eral Reserve's model, every $1 move in the price of oil equates to a 0.2% change in GDP in the United States. Through Sep­tem­ber 30, the price of Brent crude, the index most closely asso­ci­ated with changes of gaso­line prices at the pump, has fallen $24 from the May peak. And while gas prices at the pump typ­i­cally react a lot faster to spikes in oil prices than to declines, the national aver­age price at the pump has fallen back down to $3.50 a gal­lon on Sep­tem­ber 30 from the $3.96 May peak.

Emerg­ing mar­ket coun­tries with a domes­tic ori­en­ta­tion could receive a dual ben­e­fit from the "con­sump­tion stim­u­lus" and the reduced pres­sure on mon­e­tary policy.

Cur­rent out­look for select emerg­ing mar­ket, domes­ti­cally ori­ented countries:

• Brazil: the threat of a credit bub­ble could dam­age Brazil's growth, where con­sumer spend­ing grew on the back of exces­sive lend­ing. Con­sumers have started to become delin­quent on pay­ments, risk­ing the poten­tial for bad bank loans in the future. Fis­cal spend­ing needs to be redi­rected from social pro­grams toward productivity-enhancing invest­ments. The cen­tral bank was one of the first to cut rates. How­ever, with infla­tion still ele­vated, there's the con­cern that the rate cut came too early, and infla­tion could resume upward.
• India: per­sis­tent infla­tion forced the cen­tral bank to essen­tially decide to sac­ri­fice growth in the name of fight­ing upward prices. How­ever, infla­tion remained above 9% in Sep­tem­ber, well above the cen­tral banks' 4–6% tar­get, and rate hikes may con­tinue. Addi­tion­ally, the coun­try has longer-term issues with food sup­ply. Avail­able land has shrunk, crop yields have fallen due to flawed farm­ing prac­tices, and only 45% of fields are irri­gated, leav­ing pro­duc­tion at the mercy of weather. Other growth pres­sures include a large fis­cal deficit and the need for for­eign cap­i­tal. For­eigner investors have pulled out money, dis­cour­aged in part by ongo­ing cor­rup­tion alle­ga­tions and gov­ern­ment bureaucracy.
• Mex­ico: growth is typ­i­cally tied to the United States, as it's the des­ti­na­tion for more than 70% of exports. Among devel­oped nations, growth in the United States is attrac­tive rel­a­tive to the larger prob­a­bil­ity of a reces­sion in Europe. Mean­while, Mex­ico could ben­e­fit as auto pro­duc­tion comes off the bot­tom and reac­cel­er­ates glob­ally after the slow­down induced by the Japan­ese cat­a­stro­phes ear­lier this year. Rel­a­tive to other emerg­ing mar­kets, Mex­ico may have a bet­ter poten­tial for growth because many other emerg­ing mar­kets could slow due to reduced growth in China.

Why are com­mod­ity prices unlikely to decline as much as in 2008?

While com­mod­ity prices fell sharply in 2008, prices may not decline to the same degree this time, because another global reces­sion appears unlikely.

Emerg­ing mar­ket incomes have con­tin­ued to rise, increas­ing demand for both food and energy. Ris­ing incomes tend to result in improved diets, increas­ing con­sump­tion of pro­tein, which require more grains to pro­duce than basic grain-based diets. This sup­ports under­ly­ing demand for agri­cul­ture com­modi­ties. Addi­tion­ally, energy con­sump­tion has risen in tan­dem with greater auto­mo­bile pen­e­tra­tion. Emerg­ing mar­kets now out­pace devel­oped mar­kets in oil consumption.

Emerg­ing mar­ket oil con­sump­tion more impor­tant than devel­oped markets

Source: Fact­Set, BP Annual Sta­tis­ti­cal Review of World Energy as of Decem­ber 31, 2010.

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