Commodity Slump to Make Canada Poorer in ‘09

(David Parkinson — Globe & Mail)

LIVE BY SWORD, DIE BY SWORD

A key element to Canada’s economic strength over the past several years has been swelling income, which has primed consumers, businesses and governments with vital fuel to keep domestic demand humming. A key source of that income growth has been the boom in global commodity markets, which has injected considerable wealth into Canada’s resource-rich economy.

But, as Canadians are about to discover, this is a double-edged sword poised to stab deeply at the country’s economy in 2009.

Economists believe the slump in global commodity prices is not yet over, and the continued downturn will weigh particularly heavily on Canada, not just in the resource sector but across the entire economy. The result will be an outright decline in gross domestic income this year, they say, as the nation pays a heavy price for the commodity largesse of the recent past.

“We expect that Canada will, quite simply, be a poorer place in 2009,” said David Wolf, Merrill Lynch’s head Canadian economist and strategist.

TUMBLING TRADE TERMS

In a recent report, Mr. Wolf predicted that Canada’s gross domestic income would fall for the year, while nominal gross domestic product - i.e. GDP before adjusting for inflation - would tumble 2.8 per cent, the first outright contraction since 1933. Much of the blame rest with the commodity slump, which is sharply reversing Canada’s until-recently highly advantageous terms of trade.

“Terms of trade” essentially refers to the difference between the prices a country receives for its exports and what it pays for its imports. Booming commodity prices made Canada’s exports highly valuable, while a strong Canadian dollar helped keep import costs relatively low. That situation has now reversed, with the dollar down significantly and the value of Canada’s commodity exports sliced in half in recent months. Read more here.

Plenty of Incentive to Speculate

(Video: AP/Story: Export Development Canada – Peter G. Hall)

One of the marvels of recent economic developments is the surge in commodity prices. It wasn’t anticipated, but it has persisted, and the debate about its causes rages on. Two key views have emerged: on one side, those who feel it’s mostly about supply and demand fundamentals, and on the other, those who see a heavy speculative element. Does the latter side have a point?

Price movements have been dramatic, and have involved a broad range of goods. Since the summer of 2007, oil prices have more than doubled to $130 a barrel. Base metals have been on a tear since 2005, with copper, nickel, lead, zinc, aluminum and steel now fetching several times their original prices. Food has more recently joined the fray, with wheat, coarse grains and rice prices, up 125% since early 2007, spurring price increases across the agri-food sector.

Is speculation a factor? Human behaviour suggests so. Sudden price spikes are usually spurred by shortages, or at least the perception of shortages. Consider food. A mere rumour that local supplies are running low is enough to trigger a rush on supplies. To the merchant, this looks like a surge in demand, so up go prices as the order book fattens. Does the demand surge reflect fundamentals? Far from it. Worry that the current food distribution system will fail them leads private citizens to buy, not just for current needs, but to build their own personal food inventories.

The mechanism is similar for producers. Rather than let short supplies shut down their production lines, savvy businesses will likewise build up stocks of what they need for the future. As this catches on across the world economy, demand swamps available supplies, putting pressure on the global production system and ultimately, prices. Why? Because global production maintains enough supply to meet day-to-day needs, but is not geared for sudden private inventory building.

The process doesn’t stop here, though. As with any sustained price rise, it is better for producers to buy additional supplies early, and sell at the latest possible point in time, either marking prices up to reflect rising input costs, undercutting competitors who didn’t pre-buy earlier at lower prices, or a combination of the two. Either way, there is a strong incentive to purchase a lot more than current needs dictate, adding further to the perception of a general supply shortage.

And then there are other market players. These have little or no direct connection to the commodity in question, but see large price increases, and want a piece of the action. They have significant clout, given the sizable liquidity generated by robust global growth in the past four years. And data suggest that they are quite active in current commodity transactions. Their incentive is strong. In the past year, major global stock market indexes have fallen on average by 15%. In the same timeframe, commodities in US dollar terms have jumped by almost 50%. What is more, the incentive has been magnified by crisis in other parts of the economy. This activity is enhancing the perception of shortages, but has little relation to demand and supply fundamentals.

The bottom line? Speculative bubbles are almost impossible to fully identify before they burst, but oddly enough, are always a no-brainer in hindsight. Knowing that the incentives to over-invest in commodities are currently very strong suggests that a near term price correction could well occur.