Leading indicator of trade, economic growth, and geopolitical instability.

By Larry Kummer, editor of the Fabius Maximus website:

US exports, a problem that even the Fed warned about, depend on the health of other economies that are buying US products. The emerging markets are important customers for US goods, growing as they evolve from exporters to have more balanced trade. Trade figures from emerging markets (EMs) are only somewhat reliable, but imports’ share of EM’s seaborne trade has grown, and equaled that of exports for the first time in 2014.

So falling commodity prices are now a mixed blessing for the US economy. It multiplies exposure to slowing growth in China, the third largest buyer of US exports, with a 7% share of total exports year-to-date (Census, through September) — as China’s slowing continues to depress commodity prices. Several nations that rely on commodity exports are big customers of the US: Canada, Mexico, Brazil, and Australia — totaling 38% of total exports. All are slowing; Brazil might implode.

The other commodities exporters are in aggregate significant to the US, and some of them are hurting, such as Russia and Venezuela.

As a secondary effect, falling commodity prices slow growth throughout the emerging and developing nations. Their GDP grew 6.3% in 2011, slowed to +5.0% in 2013, +4.6% in 2014, and +4.0% this years. Next year will be worse if China continues to slow and commodity prices continue to fall.

That means hard times for much of the world. For example, metals exports are 15% of GDP for Chile and Zambia, 6% for Peru and Niger, and 5% for Australia and Bolivia. Mining (esp. copper) produces one-quarter of GDP in the Democratic Republic of Congo.

While oil began to crash in mid-2014, other commodities began slowing in 2011, a process that has turned into a rout.

It’s not just oil that’s in oversupply. It’s a broad collapse in prices, from the big three metals (iron ore, copper, aluminum) to agricultural products. There’s even a glut in diamonds. Non-fuel commodity prices have fallen also:  down 1% in 2013, -4% in 2014 , and estimated by the IMF to be -17% in 2015. That’s probably optimistic; -20% looks more likely. The 2000-2011 commodity supercycle has died.

Commodity prices are ruled by positive feedback. As prices fall production often increases as extractors increase production to pay their bills. “High-grading” allows them to survive as prices fall (tapping higher grade, more profitable reserves to offset lower prices). Also, lower commodity prices themselves often reduce costs. But this magic works only for a while.

Eventually the “cure for low prices is low prices,” as capital investments are cut — which eventually reduce supply. Glencore has announced cuts in zinc and copper production. Freeport has announced major capex cuts. Eventually everybody will slash capex to survive, with the total drop in capex probably 50%.

“Eventually” means it takes several years for industrial metals production to fall. Oil could react more quickly if OPEC decides to cut production. A big production cut, if it materializes, could hit the oil market like a thunderbolt. The effects of capex cuts last even longer; it takes a decade or two to open a new mine – even after the burns of CFOs’ heal so that they’ll again sign checks for capex.

EM economies are highly cyclical, as their weak governments (both politically and financially) provide few counter-cyclical stabilizers (e.g., the highly effective food stamps and unemployment insurance). Worse, both their private and public sectors often have too much debt, especially at the end of a boom. Falling commodity prices can easily cause recessions in these economies, or worse.

Then conditions worsen. Those with freely-floating currencies (most of them) see a substantial drop in their values vs. those of developed nations. That acts as a natural shock-absorber. But their falling currencies lead to outflows of foreign capital, making it difficult to borrow in their own currencies to either stabilize their economy or maintain capex.

And most have not learned the perils of borrowing in foreign currencies, attested to by a record $9.6 trillion in US-dollar denominated non-US debt outstanding. As their own currencies weaken, their external debts grow larger, and their debts denominated in foreign currencies become more difficult to service [read… World Is Now “More Exposed than Ever” to Explosive Dollar].

All of this means less buying from American companies. If it continues, there will be defaults by corporations and eventually governments, contagion of economic stress to neighbors and trading partners, and political instability. The history of the Middle East, Latin America, and Africa shows how these trends can feed on themselves, and turn ugly quite quickly.

Of course, economists predict an upturn in prices and economic growth in 2016, as they usually do – just as the housing bust was “contained” in early 2008. The magnitude and duration of trends often surprise economists, who tend to have exaggerated faith in systems acting for regression to the mean.

Watch commodity prices as a leading indicator of trade, economic growth, and geopolitical instability. They are among the major risk factors for 2016. By Larry Kummer, Editor of the Fabius Maximus website.

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