Wells Capital Management

Perspective

Economic and Market

Bringing you national and global economic trends for more than 30 years

August 25, 2015

A Commodity Conundrum
James W. Paulsen, Ph.D
Chief Investment Strategist,
Wells Capital Management, Inc.

A collapse in commodity prices that commenced last summer

and paused briefly earlier this year, has recently reignited.
Combined with the current aggressive decline in global stock
markets, this has fueled widespread fears of a potential global
recession and a deflationary spiral. Most perceive the significant
weakness in commodity prices as highly unusual in the middle
of an economic recovery and more than a bit spooky.
However, commodity prices have suffered significant declines
in three of the previous four U.S. recoveries dating back over
the last 40 years. In each of these cases, rather than signaling
an impending recession, the pace of economic growth
accelerated, the core inflation rate rose and bond yields
increased within months of a bottom in commodity prices. In
contrast with current concerns, traditionally, recessions have
most often followed a surge in commodity prices whereas falling
commodity prices have usually been a precursor to improved
economic growth.

Chart 1 shows the S&P GSCI Spot Commodity Price Index since
1970. In three of the last four recoveries (i.e., late 1970s, 1980s
and 1990s recoveries), commodity prices suffered a severe
decline during an ongoing economic recovery. Moreover,
in each of these cases, the economic recovery persisted well
beyond the bottom in commodity prices. In the late 1970s
recovery, commodity prices bottomed in July 1977 and the
recovery did not end until January 1980. Similarly, commodity
prices bottomed in July 1986 but the economic recovery
continued until July 1990. Even during the 1990s recovery, while
commodity prices bottomed in February 1999, the recovery did
not peak until March 2001.
Falling commodity prices have not proved a good leading
indicator of a pending recession. Moreover, as Charts 2 and 3
illustrate, faster economic growth, accelerating inflation and
higher yields have often quickly followed commodity price
collapses. In the three previous recoveries highlighted, the
annual core consumer price inflation rate actually accelerated
within four to six months and the 10-year Treasury bond yield
rose almost coincidently with the final low in commodity prices.
Consequently, despite the severity of the current collapse the in
commodity market, once it bottoms, inflation and interest-rate
pressures could emerge much more quickly and much more
aggressively than most now appreciate.

Economic and Market Perspective | August 25, 2015

Chart 1
S&P GSCI Spot Commodity Price Index
Natural log scale

Chart 2
Annual core consumer price inflation rate

Chart 3
U.S. 10-year Treasury bond yield

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Economic and Market Perspective | August 25, 2015

Summary and conclusions

The recent collapse in commodity prices combined with a

route in the global stock markets has many believing the world
economy may be on the precipice of a deflationary spiral.
However, as the enclosed charts illustrate, significant declines
in commodity prices are not at all uncommon during economic
recoveries. Indeed, rather than signal economic malaise,
economic growth has often accelerated after a period of
commodity price weakness. With synchronized policy stimulus
introduced around the globe in the last year, economic
momentum seems more likely to bounce than to fail. Since the
U.S. economy is nearing full employment and given the past
history of commodity price collapses during recoveries, once
commodity markets finally bottom, investors should expect
that U.S. inflation and interest-rate pressures may surface more
quickly and more aggressively than appreciated.

We have been concerned for some time about several

vulnerabilities facing the stock market. Currently, stocks are in
the grip of an emotional collapse. Perhaps, the current selloff
will refresh valuations and adjust investor sentiment enough to
eventually resume this bull market.
Many believe the financial market morass reflects a significant
slowdown if not a potential contraction in the global economic
recovery. However, similar to past mid recovery declines in
commodity prices, our guess is once commodity prices bottom,
both the U.S. and global economic recoveries are more likely
to accelerate. Massive economic stimulus has been introduced
around the globe in the last year and it will most likely improve
the pace of economic growth.
Chinese economic growth has been slowing for the last four
years, but for three of those years, officials were attempting
to moderate their recovery. Only in the last year have
economic policies turned accommodative in China. Similarly,
eurozone officials only earlier this year finally began to
practice quantitative easing. Overall, for the first time in this
recovery, global economic stimulus has been synchronized.
Economies everywhere have been given the equivalent of a
massive global tax cut in the form of lower energy prices (and
other commodity price declines). Sovereign bond yields have
declined significantly around the globe and most economies
(outside of the U.S.) have experienced considerable currency
weakness. While many currently fear the global recovery is
at risk, economic policies employed in the last year suggest
global economic growth will more likely accelerate.
What about the U.S. economy? Undoubtedly, the
manufacturing sector has been weak primarily because of
a contraction in the U.S. energy industry. But outside of this
sector, the U.S. economy appears quite healthy. Jobs are being
created at a pace which is twice as fast as growth in the labor
supply causing the unemployment rate to decline about 1% a
year. Housing activity has strengthened significantly this year,
auto sales are almost at an all-time record high near a 17 million
annual rate, and the U.S. services sector ISM survey recently
spiked to one of its highest levels in a decade above 60.

Written by James W. Paulsen, Ph.D.

An investment management industry professional since 1983, Jim is
nationally recognized for his views on the economy and frequently
appears on several CNBC and Bloomberg Television programs, including
regular appearances as a guest host on CNBC. BusinessWeek named him
Top Economic Forecaster, and BondWeek twice named him Interest Rate
Forecaster of the Year. For more than 30 years, Jim has published his
own commentary assessing economic and market trends through his
newsletter, Economic and Market Perspective, which was named one of
101 Things Every Investor Should Know by Money magazine.

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Economic and Market Perspective | August 25, 2015

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