Should surging commodities challenge hawkish central banks?

In the latest instalment of Simply put, where we make macro calls with a multi-asset perspective, we consider whether the significant and broad rise in commodities will prompt central banks to reconsider their planned hawkish actions.

The risks of rising commodities

The war in Ukraine has dispelled a story that long drove the financial news agenda: the Federal Reserve (Fed) being too slow in tightening monetary policy.

Inflation is far from having moderated, but most market participants can feel the tide is turning – primarily by assessing commodity markets. Natural gas prices are again on their way up – and fast – but this is far from being all: the rise in commodity prices is much broader than that being suggested at first glance.

Commodities have risen to the point where they pose a substantial risk to both consumption and earnings. Here is our take on what is happening and the market consequences.

Oil: almost double its ‘fair’ price

Every cycle tends to end in a commodity bull market. All multi-asset investors know this: late cycle demand saturates production capacity, which subsequently triggers energy and demand-driven inflation. That is when investors should diversify the most obvious diversifier – bonds – with other portfolio building blocks: commodities and inflation breakevens.

We have probably not yet reached this terminal point, given the fact that the recovery is still young, but commodity markets are rising and participation is broad. Over the past 12 months, oil has experienced a stellar rise, which has then been convoyed by the whole energy complex. Figure 1 illustrates the relative evolution of oil prices versus a fundamental valuation indicator that encompasses production costs, industrial demand for oil and oil inventories. All these combined elements suggest a ‘fair’ price of about USD 61 per barrel, taking into account the 60 million barrels of released strategic reserves.

All these factors point upwards: production costs are progressing as demand intensifies, incentivising less-efficient players to produce more, and inventories are clearly declining while industrial production has undergone robust growth. With West Texas Intermediate (WTI) front-end contracts trading at about USD 110 or more, the model suggests an overvaluation of about 75%. While the exact fair value could be debated for a long time, the chart highlights – and importantly so – that when an overvaluation breaches 50% for a long enough period, a recession will follow.

This reminds us of the old Hamilton vs Kilian academics debate. In 2009, James Hamilton wrote: “had there been no oil shock, we would have described the US economy in 2007 Q4 – 2008 Q3 as growing slowly, but not in recession”. This latest oil spike is recent and initially reflected strong demand (benefitting earnings over the past 12 months) and latterly the consequences of rising geopolitical risk.

FIG 1. Fundamental overvaluation of oil prices (WTI) with respect to production costs, demand and inventories

Reading note: grey shaded area represents US recessions
Source: Bloomberg, LOIM as at March 2022

Oil is not rallying alone

This oil price acceleration has not come alone. Figure 2 presents the evolution of prices for all commodities included in the BCOM index in year-over-year terms. From these highly traded commodities, two key messages have recently emerged:

1. Commodities are surging. Over a year, the median progression of commodity prices is +116%. During the past 30 years, we have never seen such a strong and fast increase: 50% of commodities in the index have gained by more than that number, which is remarkable.
2. Could the inflationary pressure lead to stagflation? Worryingly, among the 23 commodity futures in the index, 73% of them have risen over the past six months and this number is still growing. Again, we haven’t seen such a broad-based and fast progression of commodity prices since 1991. This could have two major consequences: first, the recent energy-price acceleration could add about 150 bps to inflation in Europe, which is already at 5%. Second, the 110%+ progression of commodity prices over the past 12 months – if durable – could wipe out about 1.5% of world GDP growth in the year to come. In a nutshell, a stagflation scenario has gained traction in recent weeks.

FIG 2. Median year-over-year return on the BCOM components (left) and percentage of rising components in the BCOM index (right)

Source: Bloomberg, LOIM as at March 2022.

Where to from here?

Surging commodity prices pose a new threat to markets. Previously, hawkish central banks increased the risk of interest-rate movements. Now, the rise in commodities – if sustained – could put pressure on consumption and earnings in the months to come. Whether the shock is transitory, and for how long it persists, will once more be essential in assessing the ultimate market impact.

A second factor could bring things into balance: a significant reaction from central banks that acknowledges the fact that we are now facing a supply rather than a demand shock. In this case, a less-hawkish stance from the Fed and a postponement of the European Central Bank’s rate-hike agenda could help stabilise markets. If not, downside risk could be more important than initially expected and cash could be king once more, with diversification suffering from cross-asset weakness.

Weekly macro recap

Despite the negative momentum in markets, the macro news flow remains positive:

• In the US, the manufacturing ISM published on 1 March indicated that the US is set to keep growing at a solid pace. Its ‘new order’ component – the most forward-looking element of the survey – even showed an improvement: it was expected to be 56,  down from 58 last month, but actually neared 62 in February. This strong reading is consistent with an indicator preceding the Ukraine conflict: that rising commodity prices signalled strong demand.
• The US economy is set to continue growing rapidly and the Fed is likely to keep an eye on the pace of this expansion. This data point has been released early enough to be included in the Fed’s projections, which will be released this week. Our nowcasting indicators (see below) are broadly consistent with the very low probability of a recession taking place in the quarter to come.
• Potential good news for the Fed is the ‘price paid’ component of the manufacturing ISM survey that showed a moderation of the cost pressures US corporates have seen recently. With the recent commodity price action, this cost moderation will need more time. Consistent with that positive message, the job-creation report posted very strong gains and a moderation of earnings growth. The reopening of services is now evident in the numbers and has been so over the past three months.
• In Europe, inflation numbers are still strong and are probably set to keep on progressing as the commodities rally goes on. Producer Price Inflation numbers have now surpassed 30% growth on a yearly basis while consumer inflation sits at more than 5%. Inflation is even more of a situation in Europe as wage growth remains limited. This could turn the current wage inflation into a significant downside risk.
• In China, ISMs show signs of improvement. The ISM surveys are progressing marginally but are not fully echoed in the Caixin survey. The Caixin manufacturing index displays a limited progression while sanitary measures weigh on its service component.

Nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary policy surprises are designed to keep track of the latest macro drivers making markets tick. These indicators currently point to:

• Solid growth worldwide, with stronger momentum in the Eurozone, while China lags. Our US indicator recently progressed, mainly driven by the strong ISM report.
• Inflation surprises should remain positive as per our nowcasting indicator. Both in China and in the Eurozone, cost progressions explain a recent progression for both indicators.
• Monetary policy is set to remain on the hawkish side, except in China. The necessity for hawkish monetary policy retreated in January but has progressed again since then as commodity prices surge and wage growth improves.

World Growth Nowcaster: Long-Term (left) and Recent Evolution (right)

World Inflation Nowcaster: Long-Term (left) and Recent Evolution (right)

World Monetary Policy Nowcaster: Long-Term(left) and Recent Evolution (right)

Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The Nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).

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