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Transformation in emerging markets and implications for commodities
Emerging markets growth slowdown is certainly behind the fall in metal prices. Does it in any way explain the downward slide in gold prices? How might it affect global oil prices?
The end of the supercycle
The downward movement in industrial metal prices can be attributed to the growth slowdown in China and, with it, to the end of the so-called commodity supercycle. Indeed, the slowdown in China is not only quantitative but, above all, qualitative. In fact, it’s not just China’s aggregate demand that is coming down, it’s the commodity-intensity of its demand that is coming down, specifically the industrial metals demand. There might be other lower-income countries, plausibly India, Indonesia or in Africa, that will pick-up the baton of “manufacturer of the world”. These countries could thus still substitute for China’s hitherto voracious demand for raw materials. Yet, I don’t see this happening in the near future and I actually doubt other countries will exactly replicate the Chinese industrial model.
GOLD AND OIL
The apparent gold conundrum and the “oh-so” benign increases in the oil price
If it is fair to say that industrial metal prices are heavily affected by emerging markets’ growth, the implications for oil and gold are less clear cut. In fact, demand growth for these “commodities” is less predominantly coming from emerging markets. Gold, unlike industrial metals, is also often considered to be a global currency, as well as safe haven asset. Oil, unlike industrial metals, is still the world’s main transportation energy source and as such its demand is positively correlated to income (in the sense that people with higher income can afford more freedom of movement).
Why, many gold bugs think, has gold come so significantly down in spite of the Federal Reserve’s reluctance to disembark from QE, Japan’s QE on steroids combined with massive fiscal expansion, lingering concerns about the security of bank deposits in Europe, and continuing geopolitical tensions from Syria to Iran? Why is the oil price staying so low in spite of global GDP being at least 15 % higher than the pre-crisis level while global oil production has remained stagnant. What about the 500 million Chinese entering the middle class over the next decade, and certainly all wanting to own and drive a car?
Gold, global deleveraging and emerging markets demand transformation
Of course, it is very difficult to predict the gold price. Gold might be a safe haven, but it certainly is a very volatile one. Gold typically does well when central banks enact inflationary policies and bond yields are relatively low. This, I think, is a very interesting point because the 2013 correction of the gold price could thus be nothing less than the anticipation of QE tapering and the concomitant raise in bond yields. Add to this a general return to the “risk on” mood, and the picture is more or less complete. It carries, however, the implication that with the recent resurgence of monetary policy uncertainty (arguably the type of uncertainty markets most hate), and downward pressure on yields, gold should pick up again.
In my view the main argument against this thesis is that the global economy is currently going through a secular deleveraging trend that has few historical precedents. This deleveraging trend originates in advanced economies but has led to a gradual erosion of emerging markets’ hitherto impressive growth rates as well as their current account surpluses. As far as emerging markets are concerned, such development is arguably welcome as they rebalance their economies away from exports towards more domestically driven consumer demand. Yet over the last decade the bulk of the increase of demand for gold has come from China and India. Thus, all other things equal, the transformation of emerging markets demand (and in particular the reduction of the current account surplus) is more likely to have a negative rather than a positive impact on gold.
Oil, emerging demand transformation and global supply boost
Oil, like gold, is another pretty wild card. Why has it remained so remarkably range bound in spite of continuous tensions with Iran, and the recent flare-up of tensions with Syria? Should we expect a downward movement now that the Syrian crisis appears to have been brought under control, and even Iran seems to be heading towards a better understanding with the West?
Many, including the International Energy Agency, argue that oil demand is still bound to remain strong because of the increasing number of emerging market middle-class consumers (especially Chinese) acquiring cars. It is difficult to deny that the growth of per capita income in emerging markets will be an important positive factor for oil prices. Yet, one should be cautious to extrapolate from the strong oil demand which occurred in the 60s and the 70s in the United States and Europe, when more and more families could allow themselves to buy a car. Emerging market consumers will not buy the same inefficient gas-guzzlers of the 60s and 70s. As virtually all major car producers are now focusing on hybrids and electric cars, they are even likely to bypass the relatively more efficient cars most of us are currently driving.
Even before efficiency (supply-side) considerations will kick-in, global deleveraging (demand-side) considerations will exercise – also in emerging markets – a negative impact on oil prices. In fact, the shift from an export-driven investment economy to a domestic demand-driven consumption economy is, initially, not without pain.
The reduction in the current account surplus implies an initial reduction in national income. Part of this is simply due to the fact that export demand (from the West) is coming down, rather than the result of a clear redistribution away from companies to households (which will take more time). This is clearly the case for China where the reduction in wage growth has gone hand in hand with the reduction in aggregate growth. And, for the moment, with it will the demand for oil.
Incidentally, it is not only the global economy that is transforming emerging markets. Emerging markets are transforming – through the provision of cheap labor – advanced economies too. Even before the Lehman crisis, median incomes had been coming down in advanced economies. And they have continued doing so in spite of aggregate growth picking up again. Here too, oil demand has simply followed suit.
Finally, and leaving aside all potential other supply-side issues (increased efficiency, utilization of alternative resources, countries imitating the US shale revolution), there is another way by which the transformation of emerging markets might put further downward pressure on oil prices. As emerging markets shift from export-driven low-income economies to more consumption-driven middle-income economies, their output will become less complementary and more substitutive vis-à-vis advanced economies. The latter will therefore increasingly see them as competitors. The creation of regional free-trade agreements by advanced economies, such as the TTIP (Transatlantic Trade and Investment Partnership) and the TPP (Trans-Pacific Partnership) are clearly, although it is not officially admitted, responses to this development. The United States is part to both agreements, encompassing together more than half of the global economy. So far the United States has had a rather restrictive energy export policy, in the sense that all exports require an ad hoc authorization from the Congress. As soon as the TTIP and the TPP will be operational, the US – which by that time might reach a daily oil production equal to Saudi Arabia and Russia – will be “forced” to allow for free oil exports to all partners to these agreements, determining a dramatic upward shift in global oil supply.
In conclusion, as with the “true gold”, also with the “black gold”, that is to say oil, it is far from clear cut that emerging markets will continue to exercise upward price pressure.
Dr. Luciano Jannelli