Friday, July 24, 2015

Commodity prices in perspective

Consider this post a public service announcement. The objective is to put recent commodity price trends into a long-term, historical perspective. I think that what it shows is that despite significant declines in the past few years, commodity prices are still holding up quite well relative to where they've been in the past.

We start the review with "Dr. Copper." Copper prices have been extraordinarily volatile in recent decades. Copper has declined 40% from its early 2011 all-time high, but it is still 290% above its 2001 low.

The CRB Raw Industrials index is my favorite commodity index. It doesn't include any energy or precious metals. It includes mostly just basic commodities of the sort that don't lend themselves to speculation or stockpiling. This index has fallen almost 30% from its 2011 high, but it is still almost 110% above its 2001 low.

The chart above shows the inflation-adjusted value (in today's dollars) of the CRB Raw Industrials index. Here we see that despite the huge increase in commodity prices since their all-time lows of 2001, prices today are still about 30% below their early 1980s level in inflation-adjusted terms. I don't include prices going back to 1970 because the composition of the index changed, but most commodity indices show almost no change in real terms from 1970 to 1980. Similarly, commodity prices in the 1960s were largely unchanged in real terms. In the end, what becomes apparent is that commodities tend to become cheaper over long periods. Presumably that is because of technological advances in exploration and extraction techniques. This vindicates the late Julian Simon's view that the only scarcity that exists in the world is human ingenuity. There has demonstrably been no scarcity of commodities.

The CRB Spot Commodity index consists of the Raw Industrials index featured above, plus the CRB Foodstuffs index. After adding in notoriously volatile food prices, the picture remains essentially the same.

The chart above extends the CRB Spot index back to 1970. Note that commodity prices were relatively stable from 1980 through 2000, then they surged from 2001 to 2011.

The chart above converts the index from nominal to real terms. Note that prices in the 1970s were volatile, but ended the decade relatively unchanged.

Finally, the chart above compares the price of gold to the CRB Raw Industrials index. Note how closely they move, but also note how much more volatile gold prices are than most other commodity prices. Both are in a weakening trend.

Are lower commodity prices bad? Are they symptomatic of the onset of deflationary conditions? Do they reflect a weakening of the global economy? Or do they simply reflect more abundant supplies and reversals of the very strong commodity prices that we saw in the years leading up to 2011? I tend towards the latter explanation. After, all, as the saying goes, "the best cure for higher commodity prices is higher prices." Higher prices elicit more supply. We know that for sure is the case with oil:

Are lower oil prices really a problem?

The market is still jittery. Stocks are off their recent highs, and it looks to be mainly due to falling oil prices, because they threaten the profits of the oil industry and they also increase the risk of bond defaults. But the positive side to this is lower expected inflation, and for consumers and businesses, lower energy costs. Bad for some, but probably good for most.

The Vix/10-yr ratio has moved up a bit in recent days, and stocks have moved down, as the chart above shows. This inverse correlation is what I call "climbing walls of worry." Stocks fall because the market gets nervous, not because of any fundamental deterioration in the economic outlook. Once the worries pass, stocks move back up.

Lower energy prices increase the risk of default on bonds issued by energy-related businesses. This can be seen in rising credit spreads for high-yield energy bonds in the above chart. The market undoubtedly worries that rising defaults in this sector could spread via "contagion" to other sectors. 

While it's not possible to rule out more widespread defaults, 2-year swap spreads today are trading at very normal levels, both here and in the Eurozone. At these levels, swap spreads are telling us that systemic risk is low and markets have plenty of liquidity. These are very important fundamentals that work to limit the contagion risk of the energy sector.

One reason for the latest bout of market anxiety is falling oil prices, which today have almost returned to their low of last March. Crude oil today is less than half what it was a year ago. As the chart above suggests, the decline in oil prices has been closely matched by a corresponding decline in inflation expectations (blue line). I've calculated those inflation expectations by subtracting the real yield on 5-yr TIPS from the nominal yield on 5-yr Treasuries.

The chart above shows the data used for my calculation of inflation expectations. For the next 5 years, the bond market is expecting the CPI to average about 1.4% a year, which is near the low end of historical experience.

As inflation expectations have declined, the demand for TIPS has also declined; that is reflected in the rising yield on 5-yr TIPS (blue line in the above chart). And it's not surprising that the demand for gold has declined as well (red line). The prices of gold and TIPS (using the inverse of their real yield as a proxy for their price) have in fact moved together quite closely for the past 8 years or so. Inflation expectations and concerns have been in part responsible for this, especially in the past year, but another factor is at play as well: a gradual return of confidence in the outlook for economic growth and stability. I wrote in greater detail about the latter in a recent post, "Descending the Great Wall of Worry."

No one can say for sure whether oil prices will continue to decline. The almost 60% decline in the past 10 months in the number of active drilling rigs in the U.S. suggests that U.S. oil supplies are going to be increasing at a much slower rate going forward. But if the deal with Iran goes through, Iran is going to be slowly ramping up its production over the next year at a time when OPEC is producing at fairly high levels. Meanwhile, it's reasonable to think that oil demand has increased, and in that regard I note that miles driven in the U.S. have increased almost 3% in the past year, whereas they were flat for the previous 10 years. Chinese growth has slowed down, but their oil consumption continues to rise at a relatively fast clip: per capita oil consumption in China rose over 30% in the past 5 years, according to the BP Statistical Review and IMF.

In the meantime, sensitive market-based indicators of systemic risk (e.g., swap spreads) are not showing any signs of concern. This is a good sign that the latest bout of worries is likely to pass.

Wednesday, July 22, 2015

Commercial real estate still booming

The commercial real estate market is doing very well, with prices of existing properties rising at strong double digit rates and a pickup in Architecture Billings pointing to stronger growth in commercial construction spending over the next year.

According to the CoStar Group activity in the commercial real estate market is very strong. Prices are rising at a 12-14% pace. Space absorption was the strongest in the current recovery. Leasing activity is robust. Investment activity is surging. This is a very strong indicator that the U.S. economy is doing just fine, and that growth could be picking up.

Architecture Billings are a good leading indicator of commercial construction activity, and the June reading was the strongest in the current recovery. See more details at Calculated Risk.

Very impressive.