Commodity Decline Could Provide a "Tax Cut" (Gibley)

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.