As commodities have been getting smacked around the last two weeks, we’ve been very keen to observer the vast outperformance by equities, even on days that they’re down as well.
Quite simply: Paper is beating rock.
Can that outperformance continue is a question that’s surely worth trillions of dollars to investors, and it’s the subject of the latest Viewpoints letter from Goldman Sachs’ Jim O’Neill.
Many market participants appear to have forgotten the days of the 1980’s and 1990’s where economic strength was not symbolized through rising commodity prices. During that time, we had two decades of declining commodity prices and, while there were periods of recession, we experienced two decades of global economic expansion. Could such days ever return?
He then jots down three quick observations, which we’ll summarize:
- First, the sharp spike in commodities that has coincided with this latest round of global growth has created instability-causing inflation. It’s very plausible that recent weakness in some economies could be attributed to high oil and food prices.
- Goldman’s own proprietary measure of Chinese economic strength has been flagging, and historically it’s lined up with commodity prices well, and at this point suggests further commodity downside.
- If China’s 5-year plan is to be believed, the country’s oil consumption “will not grow even close” to the level that was projected for it back in 2004.
O’Neill concludes an equity rally sans-commodities is highly plausible:
As it relates to the directional trend of equity markets, however, the last week’s events do draw me to a conclusion that if equities are to develop another leg into higher prices, it probably won’t be sustained if it is simply the result of commodity prices recovering. If commodity prices go straight back up, it will add renewed pressure to headline consumer prices in China and elsewhere, probably resulting in additional monetary tightening.
If commodity prices don’t move back up, one of the beneficial consequences is that it will make it probable that a number of central banks won’t need to tighten as much as otherwise, possibly not at all, including China and maybe also the ECB. It is interesting that ECB President Trichet didn’t utter the magical phrase “strong vigilance “at this week’s press conference.
Can equity markets rally without leadership of commodity companies and prices? Of course they can, but I shall leave the sectors most likely to all of you to ponder.
Meanwhile, for a totally opposite view, see Jeremy Grantham’s latest letter on the “paradigm shift” in commodity prices.