Weekly economic briefing: Commodity prices: losing momentum?

The Weekly Economic Briefing is written by two senior Deloitte Economists, David Rumbens from Deloitte Access Economics in Australia and Ian Stewart Deloitte’s Chief Economist in the UK. They provide a personal view on topical financial and economic issues. Subscribe to receive the Weekly Economic Briefing in your inbox!

In this week’s blog:

Australian economic briefing
UK economic briefing
International economic briefing

Australian economic briefing by David Rumbens

This section of the briefing provides a snapshot of key economic data and issues of relevance to Australia.

Commodity prices: losing momentum?

Financial market reaction to the elevation of Australia’s new Prime Minister last week has been relatively modest, but positive given that Scott Morrison was seen to reflect the ‘status quo’ more so than Peter Dutton.  After losing around 1 cent since the start of the week amid the political uncertainty, the Australian dollar reclaimed around a third of a cent on the news, while the ASX spiked around 25 points higher (or around 0.4%).  All said and done, the dollar is now little changed from where it was at the start of last week.

A more significant movement on financial markets for Australia may come from some global commodity prices starting to ease. Chart 1 shows an index of rural and non-rural commodity prices. Weakness in non-rural commodity prices has been more notable, with the index down by 7.4% since February 2018. By contrast, rural commodity prices have remained largely steady.

 

Chart 1: Commodity prices (rural and non-rural)

 

Source: Reserve Bank of Australia, Deloitte Access Economics

 

Base metal prices have shown notable weakness. For instance, copper prices – often seen as a bellwether of global industrial growth – have fallen 19% since early June of this year, while nickel prices are down by around 20% over the same period. A stronger US dollar is likely contributing to these falls, with most commodity prices quoted in the currency). In addition, base metals are energy-intensive due to the need for refinement and, as a result, the easing in the crude oil price over the same period may have put further downward pressure on prices. Finally, price weakness may be reflecting investor fears about trade policy, the health of emerging markets, and what both might mean for global demand.

To date, the Australian economy has been fairly well insulated from the broader downward pressure on commodity prices. Our dollar has fallen by around 10% against the greenback since earlier in 2018, to around US73c, helping to mitigate the fall in global commodity prices on an Australian dollar basis.

Prices for Australia’s key commodity exports have also been less affected, with the price of our largest export, iron ore, largely range-bound since June, between US$64-70/tonne.

That resilience owes much to the continued strength in the Chinese steel sector, which drives demand for both iron ore and coking coal. While infrastructure investment is cooling in China as policy support eases, investment in the steel-intensive real estate sector has remained robust. Higher Chinese steel prices relative to input costs have boosted profits and incentivised production and, as a result, Chinese steel production is set for a record year in 2018. On the supply-side, Chinese iron ore production has fallen amid a continued environmental crackdown, also supporting prices.

Worth remembering, however, is that China’s economy still has its own risks amid elevated corporate debt, tightening financial conditions and escalating trade tensions with the US. And with world economic growth forecast to gently moderate from 2018, commodity prices could come under more pressure.

That may help Scott Morrison with some energy prices (oil in particular), but will otherwise give the new PM and his equally new Treasurer, a bigger headache through a cut to national income, given that Australia is a significant commodity exporter.

For more information on the Australian brief, please contact co-authors David Rumbens and Andrew Ponsonby.

 

UK economic briefing by Ian Stewart

A personal view from Ian Stewart, Deloitte’s Chief Economist in the UK. Subscribe to and view previous Monday Briefings at: http://blogs.deloitte.co.uk/mondaybriefing/

Turkish lessons

  • Emerging market economies have been the main losers from US protectionism and higher US interest rates.
  • Capital has flooded out of emerging economies to the US to benefit from rising interest rates. This has meant less liquidity and has sent some emerging economy currencies through the floor. Emerging market governments or businesses which borrowed in dollars, and many have, are having to cope with rising financing costs and a heavier local currency debt burden.
  • US protectionism has added to the headwinds. Uncertainty and tariffs are the direct problem. Commodity-producing economies are also at risk from a Chinese slowdown exacerbated by US protectionism.
  • Events in Turkey illustrate how US monetary tightening has interacted with structural weaknesses, poor policy and a diplomatic row to create a full blown crisis.
  • The latest phase of that crisis reflect tensions over Turkey’s imprisonment of an American pastor, Andrew Brunson. After a deal to release Mr Brunson collapsed, the Trump administration imposed sanctions on Turkey and doubled tariffs on Turkish steel and aluminium imports to the US.
  • Underlying this spat is a story all too familiar from earlier emerging market crises. Turkey has a high-risk mix of a sizeable current account deficit, heavy overseas borrowing by businesses and rising inflation. Exacerbating these problems, and specific to Turkey, is the reluctance of the central bank to raise interest rates.
  • Turkey runs a current account deficit of around 5% of GDP and needs inflows of foreign capital to finance imports. A significant proportion of this funding takes the form of foreign purchases of Turkish equities and bonds. This capital is footloose and sensitive to investors’ changing appraisal of prospects for Turkish assets and returns elsewhere. A deteriorating outlook in Turkey and rising US interest rates have caused capital to flow out of the country in recent months.
  • Neither the Turkish government nor the country’s businesses run particularly high levels of debt by emerging markets standards. What makes the corporate sector vulnerable is that around half of its debt is denominated in foreign currencies. Companies borrowed heavily in dollars and euros during Turkey’s construction boom. A 40% fall in the Turkish lira since the start of the year and rising US interest rates have sharply raising financing costs for business.
  • Lira weakness has also pushed up import prices, helping propel inflation to almost 16% in July.
  • The natural policy response to rampant inflation would to raise interest rates. Yet Turkey’s central bank has raised interest rates only once in the last two years. Investors’ faith in the management of the economy has been further tested by President Erdogan’s claim to exclusive authority over appointments to the Central Bank and the elevation of his son-in-law to head of economic policy. In an inversion of conventional wisdom Mr Erdogan appears hostile to the use of interest rates to combat inflation. After his recent election victory he called interest rates “the mother of all evil”, urged citizens to convert dollars into lira and told them not to worry, saying that while overseas investors had dollars, Turks had Allah.
  • With foreign currency becoming scarcer Turkey is drawing-down on its finite reserves of foreign currency. This is not sustainable.
  • Turkey may be able to secure loans from the International Monetary Fund (IMF) or from one or more countries, possibly in the Middle East. But those loans are unlikely to come without strings attached. To ensure they get their money back any creditor is likely to require major changes in policy, just as the IMF and the EU did in Greece. The path that follows, and one that many emerging economies have been down, involves a squeeze on credit and living standards, less spending on imports and slower growth.
  • These are serious challenges for the Turkish economy, but do they pose a risk to global growth?
  • The Turkish economy is relatively small, somewhat smaller than the Netherlands. Losses on holdings of Turkish assets by non-nationals provides an obvious channel for transmitting the crisis around the world. But the size value of such holdings is not of a scale to suggest that losses would trigger a wider, global crisis.
  • The real meaning of what is happening in Turkey is different. It illustrates how frailties which are largely invisible in the good times can be cruelly exposed as interest rates rise. Countries with high levels of overseas debt and a dependence on foreign capital are particularly vulnerable.
  • Bad government policy can turn a problem into crisis, a truth powerfully illustrated by the plight of Venezuela. Geopolitical tensions, which for Russia, Iran and Turkey have resulted in the imposition of US sanctions, add to the challenges.
  • Each emerging crisis is different. Turkey’s current problems illustrate how geopolitics, changes in US monetary policy and market dynamics can quickly turn an economy’s fortunes. Weakness in other emerging market currencies and equity markets testifies to potential vulnerabilities elsewhere. With US rates on a rising path, and protectionism on the rise, the challenges facing emerging market economies are likely to mount.

 

International economic briefing by Ian Stewart

Our review of last week’s news

The FTSE 100 ended the week up 0.7% at 7,583.

Economics and business

  • Emerging market economies have been the main losers from US protectionism and higher US interest rates.
  • Capital has flooded out of emerging economies to the US to benefit from rising interest rates. This has meant less liquidity and has sent some emerging economy currencies through the floor. Emerging market governments or businesses which borrowed in dollars, and many have, are having to cope with rising financing costs and a heavier local currency debt burden.
  • US protectionism has added to the headwinds. Uncertainty and tariffs are the direct problem. Commodity-producing economies are also at risk from a Chinese slowdown exacerbated by US protectionism.
  • Events in Turkey illustrate how US monetary tightening has interacted with structural weaknesses, poor policy and a diplomatic row to create a full blown crisis.
  • The latest phase of that crisis reflect tensions over Turkey’s imprisonment of an American pastor, Andrew Brunson. After a deal to release Mr Brunson collapsed, the Trump administration imposed sanctions on Turkey and doubled tariffs on Turkish steel and aluminium imports to the US.
  • Underlying this spat is a story all too familiar from earlier emerging market crises. Turkey has a high-risk mix of a sizeable current account deficit, heavy overseas borrowing by businesses and rising inflation. Exacerbating these problems, and specific to Turkey, is the reluctance of the central bank to raise interest rates.
  • Turkey runs a current account deficit of around 5% of GDP and needs inflows of foreign capital to finance imports. A significant proportion of this funding takes the form of foreign purchases of Turkish equities and bonds. This capital is footloose and sensitive to investors’ changing appraisal of prospects for Turkish assets and returns elsewhere. A deteriorating outlook in Turkey and rising US interest rates have caused capital to flow out of the country in recent months.
  • Neither the Turkish government nor the country’s businesses run particularly high levels of debt by emerging markets standards. What makes the corporate sector vulnerable is that around half of its debt is denominated in foreign currencies. Companies borrowed heavily in dollars and euros during Turkey’s construction boom. A 40% fall in the Turkish lira since the start of the year and rising US interest rates have sharply raising financing costs for business.
  • Lira weakness has also pushed up import prices, helping propel inflation to almost 16% in July.
  • The natural policy response to rampant inflation would to raise interest rates. Yet Turkey’s central bank has raised interest rates only once in the last two years. Investors’ faith in the management of the economy has been further tested by President Erdogan’s claim to exclusive authority over appointments to the Central Bank and the elevation of his son-in-law to head of economic policy. In an inversion of conventional wisdom Mr Erdogan appears hostile to the use of interest rates to combat inflation. After his recent election victory he called interest rates “the mother of all evil”, urged citizens to convert dollars into lira and told them not to worry, saying that while overseas investors had dollars, Turks had Allah.
  • With foreign currency becoming scarcer Turkey is drawing-down on its finite reserves of foreign currency. This is not sustainable.
  • Turkey may be able to secure loans from the International Monetary Fund (IMF) or from one or more countries, possibly in the Middle East. But those loans are unlikely to come without strings attached. To ensure they get their money back any creditor is likely to require major changes in policy, just as the IMF and the EU did in Greece. The path that follows, and one that many emerging economies have been down, involves a squeeze on credit and living standards, less spending on imports and slower growth.
  • These are serious challenges for the Turkish economy, but do they pose a risk to global growth?
  • The Turkish economy is relatively small, somewhat smaller than the Netherlands. Losses on holdings of Turkish assets by non-nationals provides an obvious channel for transmitting the crisis around the world. But the size value of such holdings is not of a scale to suggest that losses would trigger a wider, global crisis.
  • The real meaning of what is happening in Turkey is different. It illustrates how frailties which are largely invisible in the good times can be cruelly exposed as interest rates rise. Countries with high levels of overseas debt and a dependence on foreign capital are particularly vulnerable.
  • Bad government policy can turn a problem into crisis, a truth powerfully illustrated by the plight of Venezuela. Geopolitical tensions, which for Russia, Iran and Turkey have resulted in the imposition of US sanctions, add to the challenges.
  • Each emerging crisis is different. Turkey’s current problems illustrate how geopolitics, changes in US monetary policy and market dynamics can quickly turn an economy’s fortunes. Weakness in other emerging market currencies and equity markets testifies to potential vulnerabilities elsewhere. With US rates on a rising path, and protectionism on the rise, the challenges facing emerging market economies are likely to mount.

 

Brexit and European politics

  • The UK government released guidance for businesses, citizens and public bodies on how to prepare for the possibility of a no deal Brexit
  • Britain’s Brexit secretary, Dominic Raab, said the UK leaving the EU without a deal is “unlikely”
  • EU chief Brexit negotiator, Michel Barnier, suggested that the deadline for agreement in Brexit negotiations has shifted to “the beginning of November”
  • EU commissioner, Valdis Dombrovskis, said the UK’s proposal to build on existing equivalence arrangements for UK-EU financial services trade was a “more realistic way forward” than previous proposals for mutual recognition
  • Dominic Raab said that EU citizens residing in the UK will be allowed to remain on the same terms even if the UK and EU fail to reach a deal
  • An ICM poll found that the UK Conservative party would not have a better chance of winning the next general election if prime minister Theresa May were replaced by another candidate
  • Labour shadow Brexit Secretary, Kier Starmer, suggested his party was open to keeping the option of a second referendum “on the table”
  • Nearly two-thirds of asset managers are preparing for a ‘hard Brexit’, according to research from the trading venue Liquidnet

And finally…

  • Venezuela pulled the TV show ‘Who Wants to Be a Millionaire?’ after runaway inflation, which the IMF predicted will hit one million percent this year, has effectively made the top prize meaningless with supermarket chickens already costing over 15m bolivars – game over

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