By Brendan Lowney, Vice President, Pulp & Paper Information, RISI
ATLANTA, May 14, 2008 - The current boom in commodity prices has certainly made the lives of the world's producers of basic materials, as well as its central bankers, much more interesting. While the former are struggling to deal with skyrocketing input costs, the latter are trying to combat the inflationary effects of high commodity prices while simultaneously coping with the reality of slower economic growth on the near horizon. Meanwhile commodity producers are whistling on their way to the bank and hoping that the good times will continue. We at RISI expect the whistling to stop before the end of 2008.
For those who earn and spend in US dollars or in currencies that are closely linked to the greenback, the commodity boom has been massive in both scale and scope. In dollar terms, the Commodity Research Board's Spot index (which excludes energy) has more than doubled since 2002 and has increased by more than 60% since early 2006.
Not unprecedented
The current boom is certainly not unprecedented. We saw a much bigger run-up in prices in the 1970s as well as three minibooms between the early 1980s and the mid-1990s. Inelastic supply and demand curves mean that commodities will always be susceptible to wide swings in prices. Translation: producers and consumers are almost always slow and often unable to respond to changes in prices. Capacity investments in commodity industries tend to be complex and expensive. And it is often the case that new capacity comes on line after prices have peaked. That new capacity does not go away when prices start to decline; instead it tends to amplify the decline.
What are the root causes of the current boom? For starters, the US dollar has been in secular decline since early 2002 with the trade-weighted and inflation-adjusted dollar declining by about 25% over that time. Second, the supply-side responses have been particularly slow as memories of the late 1990s - when commodities prices reached an all-time low in real terms - continues to inhibit capacity investments well after prices started to rise. Most importantly, rapid demand growth on a global basis and supercharged demand growth in China have been the primary driver of the commodity boom.
Global GDP expanded at an average rate of 5% since 2002 compared with an average growth rate of 3.5% over the previous 20 years. During that time, Chinese real GDP growth has averaged an astounding 10.3%. Since 2005 more than two-thirds of Chinese real GDP growth has come from the export sector and about half of the commodities that China imports are processed into exports. Fixed asset investment is the other key growth driver in China, and many of the commodities that are not processed into exports are used in the massive modernization of China's infrastructure.
Going in reverse
The most important factors that have driven the boom will soon start to reverse direction, if they haven't already. We think that the US dollar will soon find a bottom as interest rate and growth rate differentials between the US and most of the other advanced economies start to narrow. The Fed will likely stop lowering rates in the spring, while the ECB and others are likely to start cutting rates in the second half of the year. The US is already in recession, while the economies of Europe and Japan will lose momentum over the course of 2008. A dollar appreciation, however slight, will dampen commodity price increases.
Declining economic growth will do more to undermine commodity prices than a stronger US dollar. RISI's forecast shows global real GDP growth declining from 5.2% in 2007 to 4.3% in 2008 and 4.6% in 2009.
We expect Chinese policymakers to tighten monetary and fiscal policy substantially to combat the steep rise in inflation. Since we don’t expect those efforts to begin in earnest until after the Olympics, Chinese real GDP growth will still expand by a robust 10.5% in 2008 as a whole. But the Chinese economy will exit 2008 with a lot less momentum than it entered the year with and our forecast shows real GDP growth dropping to 8.5% in 2009.
The prospect of a stronger dollar and a deteriorating global growth environment support our contention that the commodity price boom is running on fumes and the historical record further supports this contention. Real commodity prices have been trending downward for hundreds of years and we are highly skeptical that the recent evidence represents a turn in that trend.
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