Darren Kugler
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7 underlying issues causing problems for commodities

High debt and low interest rates have created pain for companies as demand weakens

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Fanfares of trumpets do not announce turning points in securities markets.

Since mid-year, financial markets have been volatile. Moves of plus or minus 1% to 2% a day and even larger intraday moves have been common. Equity markets have lost around $10 trillion in value, equivalent to around 15% of global gross domestic product, during this period.

Pundits have offered multiple explanations for the gyrations: commodity prices, overleveraged commodity-trading firms, China, uncertainty about U.S. interest rates and computerized trading. The reality is that no one really knows. There is no clear single factor that appears to have triggered the price falls. Perhaps the market simply ran out of momentum and investors lost confidence.

Commodity concerns

A key area of concern has been the downturn in commodity markets.

The large run-up in commodity prices and mining activity was driven by a number of factors. There was significant underinvestment in mining assets and infrastructure in the 1990s, reflecting low real prices for many commodities. The combination of supply constraints and unexpected increases in demand, especially from China and India, led to a sharp increase in price levels. The industry responded by massive investments to increase production, assuming continued demand and high prices.

The current correction is part of a familiar cycle, driven by large amounts of supply coming on-stream coinciding with a slowdown in demand.

Real concerns

The problems in commodity markets are significant but primarily as symptoms of several real underlying issues.

First, growth has not recovered to pre-financial crisis levels despite seven years of emergency interest rate levels and central bank intervention.

Importantly, growth in emerging markets has slowed sharply. China finds itself facing problems of rising debt. India seems unable to overcome infrastructure deficiencies. Commodity producers, like Brazil, Russia and South Africa, are affected by low commodity prices. Institutional failures, corruption, lack of competitiveness and an inability to reform, which were ignored, now limit future prospects.

Second, there has been a slowdown in global trade. In recent decades, global trade has grown by roughly double economic growth. The World Trade Organization expects growth in trade to be slow and perhaps contract. It is not clear whether this signals structural changes in trading patterns or presages slower growth.

Third, there is the excessive dependence on the strong performance of China. The Middle Kingdom has contributed between a third to half of total global growth directly or indirectly in recent years. While China has 20% of the world’s population and accounts for around 13% of global GDP, it consumes 60% of the global production of concrete, 48% of copper, 49% of coal, 54% of aluminium, 46% of steel and 50% of nickel. Given the mounting problems of China, the dangers of this dependence have been increasingly exposed.

Fourth, disinflationary and deflationary pressures are proving persistent. Assets, like commodities, which act as a hedge against rising prices, have become less attractive.

Fifth, there was significant mal-investment, driven by the low cost of capital. Many projects are not economic in the absence of strong growth and high prices, and will be unable to repay debt and generate adequate returns for shareholders. Money, frequently borrowed, financed mergers and acquisitions or returning capital to shareholders in the form of share buybacks or higher dividends.

Sixth, financial strategies amplified the risks.

A significant proportion of investment was debt-financed. The mining industry, in common with other businesses, significantly increased leverage to expand production. Large commodity-trading firms, such as Glencore GLNCY, +14.13%Noble Group NOBGY, +2.87% Trafigura, et al., have significant borrowings and also extensive positions in derivatives. The problem is compounded by the fact that the buyers as well as key infrastructure providers, such as transport and logistics firms, also used leverage against assumed assured revenue streams, which were all commodity-price dependent.

Low rates also encouraged investment in commodities, as investors chased returns. This includes exposure to mining firms to capitalize on the growth in the sector. It also took the form of direct investment in commodities. Some of those investments used leverage to increase returns.

The continuously neglected fact remains that the major cause of the financial crisis — unsustainable debt — has not been addressed. Low rates and abundant liquidity have allowed these debt levels to be maintained and even increase.

Seventh, asset markets are reliant on the continuation of existing unconventional monetary policies. Increases in U.S. interest rates and reduced liquidity support would destabilize the status quo. It would make high debt levels difficult to maintain. It would also adversely impact already insipid levels of economic activity. It might also result in the withdrawal of funds from risky investments, forcing price adjustments.

The problems in commodity markets are signaling stresses. It is important that markets and policy makers interpret the informational content correctly.

Satyajit Das is a former banker and author whose latest book, “A Banquet of Consequence,” will be released internationally in February 2016.

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