World trade hasn't evaporated

In a broad sense investors have been pre-occupied with negative themes like the stress testing of the European Banks and how many might fail. To be sure more banking failures will be extremely unhelpful for the global economic recovery; but in the background central bankers are working hard to prevent a double dip recession as collateral damage of one or more European banks or countries default on debt payments. This seems increasingly unlikely.

Bubbling in the background there is positive news like the trend in US New Orders for Durable Goods. Industry in the US is investing heavily in capital equipment. It is very interesting that New Orders for Non-ferrous Metals have surged higher at a time when metal prices have softened. This would indicate that the orders measured in terms of volumes of metal are rising. Orders for non-ferrous metals have risen 40% from the low point in 2009.

The very weak U.S. household sector seems to have found a bottom and orders for household durable goods have formed a clear base from which to move higher. We looked at these positive trends in the U.S. in FAT-MIN-231, which included a review of Rio Tinto and BHP Billiton.

It is not all gloom and doom and there is another very important data set to consider; and that is the trend in world trade and more specifically its correlation with commodity prices.

Although it makes perfect sense for trade activity to be correlated with commodity prices the connection between prices and trade seems often over looked. This is strange because over recent years the correlation between the two is undeniably very strong; and so it should be.

The foundation for mineral economics is the flow of basic raw materials and finished goods around the world. Access to free data is becoming increasingly rare but over many decades there is generally a close visual relationship between world trade and the Reuters CRB Index.

A notable period when the relationship didn’t hold was earlier this decade when world trade accelerated sharply higher at a time when real commodity prices were still stuck in a 20-year decline. In hindsight there was a very strong buy signal to wade into the commodity markets in 2002/2003.

For the ease of data collection, the following figure shows the relationship between the Reserve Bank of Australia’s (RBA) Commodity Price Index and World Merchandise Trade.

In the first quarter of 2010 World Merchandise Trade soared 25% on a year ago, a solid recovery in any language. Global trade fell slightly in January, was flattish in February and soared in March. It is no coincidence that the inventories of copper and nickel on the London Metal Exchange are falling daily and the oil price has backed up over US$75 per barrel.

The low point for the world economy was February 2009. The World Trade Organisation’s indexes of global imports and exports collapsed around 42% from cyclical peaks in July 2008. Since February 2009 world trade has rebounded by around 45%.

When global trade collapsed in the face of the GFC some sectors suffered particularly badly. Whilst trade in Manufactures fell 27.6% in 1Q09 on a year ago followed by a fall of 29.8% in 2Q09, trade in iron and steel fell 54.7% in 2Q09 and 55% in 3Q09 on a year ago. Trade in Automotive Products fell 46.9% in 1Q09 on a year ago followed by a fall of 45.6% in 2Q09.

2010 started with a huge surge in trade activity in 1Q10. Let’s start with imports by the BRIC countries. China’s imports in 1Q10 rose 65% on a year ago, closely followed by India with an increase of 55%, Brazil 36% and Russia 18%. North American imports rose 22% and European lagged behind with 16% rise on a year ago. Asian imports for the period were up 45% on 1Q09.

Now let’s turn to some of the recent year on year increases in industrial production. All the changes in industrial production have been sourced from The Economist, July 3^rd 2010.

Singapore still leads the pack with 58.6% for May, with Taiwan in second place with 30.7%. Thailand (17.2%) was in third place in Asia but internal problems cut output in May and now South Korea is in third place with a rise of 21.5%. The world outcast is Venezuela with a fall of 13.3% for March. The simple truth is that world industrial production is in recovery and very few developed countries are showing negative changes on a year ago.

The most recent industrial production for the BRIC countries are: Brazil (April, 17.4%); Russia (May 12.6%); India (April, 17.6%); and China (May, 16.5%).

Closely related to world trade are the prices paid for shipping bulk materials like coal and iron ore. In this regard a lot of attention is being given to the sharp fall in the Baltic Dry Index (BDI). The BDI captures the prices paid to the owners of bulk carriers to ship bulk commodities around the world.

The BDI has fallen around 50% from its May 2010 high. The inference is that the world economy is slowing dramatically and demand for iron ore and coal has plummeted. But could the fall in the BDI be related to the number of bulk carriers bidding for work?

There is no doubt that there has been an increase in inventories of iron ore and steel in China. To make matters worse, China has accelerated production of iron ore from its domestic mines. At this point in time China requires fewer bulk carriers arriving at its ports loaded with iron ore. This certainly does not mean that the world is diving into a double dip recession.

At the start of this decade there was a shortage of bulk carriers to handle the explosive growth in Chinese demand for bulk commodities. With plenty of money available new orders for cape sized bulk carriers soared to many times the historical average. At the time that the GFC hit there were new carriers ready to be delivered.

In terms of running a shipping business some of the forecasts were awful, with predictions that by 2011 the shipping sector would be two times oversupplied. If this situation is close to the truth then it is not surprising that bulk freight rates are low, for the competition for cargoes is high.

It is difficult to tell when the market’s perception of the resources sector will change or what the precise catalyst will be. We are getting nearer a point of change; perhaps it will come from the IMF?

The IMF revised global growth for 2010 from 4.2% to 4.6%. The IMF’s global growth forecast for 2011 is unchanged at 4.3%. If world trade keeps recovering going into 2011 the IMF will revise its estimates higher for 2011. World trade will rise and guess where commodity prices are headed?