As the global cycle gains traction, commodity prices are close to levels seen in 2008; some like copper are actually higher. Trends on industrial prices have triggered concerns that they might have the same impact on retail prices as those already seen in emerging countries…
Author: Pierre Ciret
Economist Edmond de Rothschild Asset Management
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As they are ahead in the recovery curve, emerging countries are the most exposed to rising commodity prices. And as they are now driving growth in demand, they are behind the fi rst wave of higher industrial commodity prices. In 2010, other factors, like weather conditions which reduced supply, played a decisive role in the momentum driving agricultural product prices. Lastly, a low interest rate environment has encouraged investors to anticipate demand either directly or through ETFs, thereby adding to physical demand.
Whatever the origins of this infl ation and even if it is slowing, the rise in commodity prices has been suffi ciently strong and broad-based over recent months to make investors wonder about the consequences. A second leg to the phenomenon might come from wage increases which could trigger a very dangerous upward spiral if the infl ationary periods seen in recent decades are a good indication.
Developed countries feel largely unconcerned by these trends as worries over defl ation have not entirely evaporated. And yet the price index in the euro zone rose 2.4% last year to a two year high. This begs the question of how long prices can continue to rise at such a moderate pace.
Where exactly do we stand? The question is not merely theoretical as an upsurge in infl ation would inevitably end in central banks tightening interest rates and liquidity. Banking systems have not yet been entirely repaired so higher benchmark rates would put the economy at risk.
Similarly, any investor distrust of government bonds with current yields so low would make it trickier for governments to fi nance their defi cits.
IS THE GREAT MODERATION COMING TO AN END?
Since the beginning of the 1980s, the global economy has generally seen particularly moderate trends in infl ation. With the notable exception of 2008-2009, fl uctuations have also narrowed. After the second oil shock in 1979, three factors came into play.
Orthodox monetary policies, which were initiated when Paul Volcker was chairman of the Fed and adhered to by the ECB from its beginnings, have played a major role even if they have been applied with varying degrees of rigour. Disinfl ation was also associated with rapid gains in productivity and effi ciency due to technological progress and not only advances in IT. The third driver of disinfl ation was the rising importance of China, and the emerging world in general, as a key player in global trade.
Very low costs were amplifi ed by the undervalued Renminbi, helping to weigh on prices of goods sold in the developed world. Moreover, China itself has made productivity gains which have helped it maintain prices despite regular wage increases. Widespread rises in industrial, energy and agricultural commodity prices in 2010 coupled with sporadic bursts in countries like the UK (annualised infl ation was running at 3.7% in December 2010) and more systematic infl ation in emerging countries particularly China, have all set investors wondering if the trend in prices might now revert to the upside.
The changing shape of the global economy represents a risk for the current system. How can the emerging zone remain a key driver of disinfl ation when its sheer size and high growth rates are driving price rises and its cost structures are coming under pressure? Emerging country currencies are appreciating against developed country currencies and aggravating the impact on the price of imported goods.
THE ORIGINS OF INFLATION
Infl ation is above all a monetary phenomenon. As money essentially acts as the counterparty of a debt, credit is historically the principal source. Could the exceptionally abundant liquidity created by central banks to offset the impact of the crisis lead to higher prices? The question is frequently asked but as long as this liquidity is not transformed into credit, it does not feed the infl ationary monetary creation which would drive growth and trigger tensions on both costs and prices.
In this respect, and despite the ballooning of central bank balance sheets, there has been no impact on monetary aggregates. In the US and despite the Fed’s bond purchases, M2 grew by an annualised 3.4% in December. The picture in Europe is similar as M3 rose by an annualised 1.9% in December. In both cases, credit expansion has been very slow due to persistently anaemic corporate and household demand.
There has been no risk to prices from monetary developments.
PRODUCTIVITY
Apart from monetary issues, infl ation depends on changing costs incurred in making goods. Changes in labour productivity, i.e. the number of articles produced in each hour, are an essential factor but productivity in industrial processes is also important. Reducing consumption of a product which is becoming much more expensive, or switching to a less expensive product, changes the impact of cost trends. Companies are well-versed in this exercise and have been doing it successfully for years. But the extent of price tensions can mean it sometimes takes longer to adjust. That can create temporary diffi culties.
Productivity in service industries is also an important issue as the sector can represent 70% or more of a developed country’s economy. It can be diffi cult to defi ne and measure but that does not mean productivity is not improving. Low cost airlines are a good example of a steep price drop in a service due to an organisational approach that broke with traditional models. Another example is the cost of making a phone call which has fallen because of technological innovation.
PRICE TRENDS IN THE DEVELOPED WORLD
For reasons of economic structure, there are two major differences in developed zone price momentum compared to emerging countries. Developed zone companies add more value relative to commodity costs -i.e. their products are more sophisticated – and consumer price indices in the zone are less sensitive to food prices. They also have only modest weightings in energy. Even more fundamentally, future household and government deleveraging will put a brake on loan growth which means the risk of monetary infl ation currently looks rather limited. Rising commodity prices may or may not be tempered by exchange rages outside the dollar zone but will depend on company reactions. Will they, for example, choose to pass on higher costs to customers? If so, by how much? The answer has more to do with strategy than accounting since it depends on productivity gains, the company’s pricing power and its market positioning. Not raising prices could be an attempt to keep clients or win more market share even if margins suffer. In any case, buyers are not necessarily motivated by pricing considerations alone. Depending on the product or the service, other factors like quality, distinctiveness and innovation come into play, leaving a company with signifi cant room to manoeuvre.
The defl ationary impact of the recession is now waning. In the US for example, rents have started rising again. This means that price indices excluding energy and food will start to see bigger rises in 2011 than in 2010 when they rose 0.8% in the US and 1.1% in the euro zone. This acceleration will be very moderate and is not expected to mark the beginning of an infl ationary cycle. Economies are running below full potential so it is unlikely serious price tensions will develop even if commodity prices are rising. The UK is a case apart and the situation there refl ects the impact of sterling’s depreciation.
Nevertheless, composite price indices are set to accelerate more than underlying prices due to rising energy and food prices which in the US represent 10% and 15.7% respectively of the index. We should, however, bear in mind that the direct cost of commodities is only a fraction of the fi nal product. For large groups, it represents 12% on average. This means that commodities are only a small part of cost structures in developed economies; the real problem in the zone can be the cost of labour which represents between 70-80% of a company’s costs For the time being unit wage costs are stable -they fell 0.6% in Q4 2010 in the US- and the likelihood they will stoke infl ation looks very limited.
EMERGING COUNTRIES: HOW TO MAINTAIN GROWTH WHILE KEEPING PRICES STEADY?
Strong growth tends to generate price distortions. All emerging countries are faced with this problem but to varying degrees. As in 2010, their monetary authorities will try to show how determined they are to avoid the consequences of infl ationary pressure. Moreover, now that growth is on a sound footing, there is no reason to prolong accommodating monetary policies. A combination of factors is driving price infl ation. Food counts for 30-40% in price indices and so represents a major factor but the impact depends on whether or not a country is a producer. Wages can easily cause prices to rise if a country has full employment as in Brazil, especially if the government’s budget policy is not rigorous enough.
Are we close to overheating? Strong loan growth and the emergence of property bubbles in China and also Hong Kong
required some reaction from the relevant monetary authorities. Central banks responded by starting to shift monetary conditions back to normal. At the same time, they are seeking to neutralise the impact of capital infl ows on their currencies. A higher currency is very useful in limiting imported infl ation but export companies pay the price. A balanced approach is diffi cult to defi ne and implement and it also means taking budget policy into account. In 2010, China’s infl ation was 4.6% but 2.1% excluding food and energy. Strong productivity gains have helped absorb most of the price rises in industrial commodities and increased labour costs.
Only low value added sectors like textiles and toys are struggling. The textile sector has been hit by cotton doubling in price in only a few months. In addition, productivity will continue to rise rapidly as Chinese companies are stepping up investment in automation. China’s central bank, the PBoC, has raised benchmark rates several times after declaring more than a year ago that it intended to normalise its monetary policy.
INFLATIONARY EXPECTATIONS
Central banks keep a close watch on infl ationary expectations as they dictate in part how consumers and companies behave. Bond markets provide an initial gauge of these expectations through price movements on infl ation-linked bonds. These expectations have inevitably risen from abnormally low levels but are still moderate. Household perception is monitored though regular surveys carried out by central banks. Countries like Sweden have recently seen an increase in these household expectations.
CONCLUSION: HIGHER PRICES DO NOT AUTOMATICALLY MEAN INFLATION BUT CENTRAL BANKS SHOULD BE ON THEIR GUARD
Occasional spikes in commodity prices can be absorbed especially if they result from a temporary problem of supply. What worries central banks most is the arrival of structural infl ation where price and wages feed off each other. This can be diffi cult to halt unless governments introduce restrictive monetary measures which then tend to choke off growth.
Deleveraging, persistently high underemployment and surplus industrial capacity in the developed world are not conducive to higher infl ation. The global economy has emerged from the most defl ationary period of the 2008-2009 crisis so it is only logical for price rises to move closer to their long term mean. However, today’s world is behaving in a different way than over the last 30 years and China could become a source of infl ation. China’s growth is driving commodity prices all the more because of favourable liquidity conditions and because its expanding market share means its infl uence has grown.
If the Great Moderation is really to end, excessively accommodating policies would have to be extended despite accelerating loan growth. Although liquidity injections are not a direct cause of monetary expansion, they can nevertheless push real asset prices like commodities higher but the real issue is how central banks react. As evidenced in the ECB chairman’s recent statement, central banks are ready to defend their credibility and move towards normal monetary conditions by reducing excess liquidity and raising benchmark rates.
All in all, these factors balance each other out: defl ationary pressures may have abated but monetary policy will make the necessary adjustments.
Disclaimer: The data, comments and analysis in this bulletin refl ect the opinion of the Edmond de Rothschild Group and its affi liates with respect to the markets and their trends, regulation and tax issues, on the basis of its own expertise, economic analysis and information currently known to it. However, they shall not under any circumstances be construed as comprising any sort of undertaking or guarantee whatsoever on the part of the Edmond de Rothschild Group or its affi liates. All potential investors should consult their service provider or advisor and exercise their own judgement on the risks inherent to each fund and its suitability to their own personal and fi nancial circumstances. To this end, investors must acquaint themselves with the simplifi ed prospectus that is provided before any subscription and available at www.edram.fr or from the head offi ce of Edmond de Rothschild Asset Management. Data in this document is not contractual nor has it been certifi ed by the auditors. This document is for information only. Figures refer to previous years. Past performance is not necessarily a guide to future performance.
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