The strongest manufacturing activity since the aftermath of the global financial crisis is slowly draining commodities surpluses, sending prices to a 3-year high as investors pour money into everything from oil to copper.
"Rarely has the outlook for a New Year been as encouraging as it is today," said Holger Schmieding, chief economist at Berenberg Bank in London.
With factories around the world humming, demand for raw materials is fast increasing. The Bloomberg Commodities Spot Index, tracking the price of 22 raw materials, jumped to its highest since December 2014 on Jan. 4. The gauge has risen for a record 14 days in a row.
For the global economy, the pickup in commodities poses a conundrum. It could show how years of ultra-lax monetary policies have finally boosted activity and may even be enough to revive long-dormant inflationary pressures. The risk is inflation reemerges faster than central banks expect, forcing them to raise interest rates more aggressively than they now plan or investors anticipate.
According to a September study by the International Monetary Fund, a 10% gain in the price of oil increases, on average, domestic inflation by about 0.4 percentage points. Such an effect might help push U.S. inflation back towards the Federal Reserve’s 2% target. Research from the central bank published in October found the last plunge in crude had shaved 0.2 percentage point from core inflation, which excludes food and energy prices.
Already this year, Brent crude, the global benchmark, has jumped to nearly $70 a barrel, and palladium, a metal used to reduce cars tailpipe emissions, hit an all-time high.
"The oil market is tightening, and it’s tightening very quickly," said Amrita Sen, chief oil analyst at consultants Energy Aspects Ltd. "We see very strong demand, and it’s really broad-based.”
After years of worrying about deflationary risks, investors are starting to think in the other direction. Byron R. Wien, an executive at Blackstone Group LP, included a rise in U.S. oil prices to $80 a barrel among its top 10 potential surprises for 2018 in global markets.
"The price rises because of continued world growth and unexpected demand from developing markets," he wrote in a note to investors.
How much fallout there is on the economy ultimately depends on whether the rise in commodity prices is driven by increased demand or a decline in supply.
Neil Dutta, head of U.S. economics at Renaissance Macro Research, told clients on Jan. 4 that while oil has been climbing, retail stocks have been doing so too. “The market is basically telling you that the rise in oil prices is probably more about strong demand than a negative supply shock and is not enough to derail the consumer,” he said.
In one of the strongest signs of the rebound in manufacturing activity, Germany, whose economy is underpinned by manufacturing giants like Volkswagen AG and Siemens AG, reported this week that its unemployment rate fell in December to a record low.
Wall Street banks including Goldman Sachs Group Inc. are predicting that the global economy will expand about 4% in 2018, the fastest pace since a post-recession bounce in 2011. If realized, that would mean millions of barrels in extra demand for crude, thousands of tons extra of copper, and more consumption of corn, meat and other foodstuff.
Investors so far are betting heavily the commodity rally will continue, with net bullish bets in West Texas Intermediate and Brent crude at an all-time high.
Some remain unconvinced, warning that economic growth could slow down as the year progresses, turning into a headwind for the commodities sector.
"We think prices are reflecting undue optimism about demand," said Caroline Bain, chief commodities economist at consultant Capital Economics Ltd. "Indeed, weaker demand, as China’s economy slows, should trigger somewhat lower prices this year," she added in a note to investors.
Beyond stronger demand, commodities prices are though also benefiting from less-friendly supply constraints, notably the reduction in oil supply orchestrated by Saudi Arabia and Russia. In copper, investors worry that wage negotiations in Chile, the world’s largest producer of the red metal, could disrupt mining activity. And freezing weather in the U.S., the world’s top producer of agricultural commodities, is helping to increase the price of wheat and other grains.
On the flip side, the rally could sow the seeds of its own destruction as producers such as shale oil companies bringing extra supplies to cash-in higher prices.
“Rising U.S. production on the back of higher prices could keep prices range-bound even though demand for oil is rising,” said Michael McDonough, chief economist at Bloomberg Economics.
By Javier Blas and Steve Matthews
