From the Economist's Chair: Markets re-embrace inflationary narrative

Author David Fyfe, Argus Chief Economist

Commodity prices have eased from early-2022 peaks but generally remain elevated compared to pre-invasion norms. Premature optimism in early-2023 that the worst of broader inflationary pressures and interest rate hikes had passed has now subsided, amid the realisation of more muted expectations for advanced economy growth. Nonetheless, even historically modest Chinese growth at or below 5% this year should be enough to provide a floor for commodity prices, while an ebb and flow of bullish supply-side rumour around the Russia-Ukraine conflict will likely add a dose of volatility too.

Commodity prices converged in February, somewhat ironically highlighting the divergent 2023 prospects for China’s economy on the one hand, and for much of the rest of the world on the other.

Is commodity volatility now embedded?

Iron ore and base metals remained strong, as Chinese re-opening progresses and zero-Covid policies in place since 2020 are dismantled. A major infrastructure investment programme, a renewed injection of financial liquidity for the real-estate sector and ongoing renewable power generation capacity build-out will likely sustain demand for industrial metals. Broader optimism for bulk commodity markets is also reflected in the Baltic Dry Index, which fell by 70% between October and mid-February but has subsequently doubled on the potential resurgence of Chinese demand after the Lunar New Year holiday. China’s February manufacturing PMI indices moved strongly into expansion, with the official gauge hitting 52.6 – its highest in a decade, while services PMI data pushed even higher towards 56. All told, China’s GDP growth this year is assumed by Argus to rebound to +4.5% from +3% last year, notwithstanding an official target set this last weekend by China’s Parliament at “around 5%”. Precise growth uncertainty aside, a substantial portion of the expected +1.7 mb/d of global oil demand growth this year will be centred on China. Major commodity imports which declined nearly 5% in 2022 are similarly likely to return to growth, with iron ore, crude oil, coal and copper prominent.

International grain prices have also retained support, with market jitters over renewal of the UN-brokered Black Sea Grain export deal that expires on 18 March, and also following recent loading delays at Ukraine’s ports. There are hopes the grain shipment deal could be extended for one year, also expanding the number of ports covered. However, Russia has sown doubts around the accord’s renewal, with repeated complaints about restrictions on its own agriculture and fertilizer exports due to sanctions.

In contrast, energy prices receded further in February, dragging fertilizer prices down with them. Crude oil marker prices largely stabilised month-on-month, as the market digested anticipated Russian production cuts in March and the initial impact of a European diesel embargo and price cap initiated on 5 February. But coal and gas prices fell by between 20-25% each, partly due to benign Northern Hemisphere weather, but also with a sudden, more bearish shift in market sentiment around inflation and the likely degree and duration of central bank interest rate rises.

A narrative developed during January and early-February suggesting that inflation had peaked, with some observers even suggesting that central banks in the Atlantic Basin would reduce interest rates before the end of 2023. This followed an upgrade to the IMF’s World Economic Outlook, notably its projections for India and China, although the Fund also predicted that major Advanced Economies might also avoid recession in 2023. But buoyant US January retail sales data released at mid-February and subsequent stronger-than-expected inflation data both there and in Europe have seen a marked change in expectations, easing supply-chain pressures notwithstanding. With US unit labour costs coming in at +6.5% for 2022 as a whole and after substantial upgrades to the 4Q22 figure, a more hawkish expectation for central bank behaviour in 2023 has again taken hold. Energy price inflation may be receding, but it is being replaced by tightness in labour markets that risks perpetuating broader Atlantic Basin inflation in the months ahead.

Both the US Federal Reserve and the ECB are now expected to enact a further three rate rises this year, pushing US terminal rates into a 5.5% to 6% range, with the ECB potentially going as high as 3.75% to 4%. A loosening in monetary policy now looks increasingly unlikely in 2023. The US Dollar Index, in retreat between October and January, has regained over 3% in value in the last month. In addition, US Treasury yields now resemble those just ahead of the Great Financial Crisis in 2007, with steeply inverted yield curves implying a US recession is increasingly likely during the next three to six months.

None of this implies a dramatic shift in our own expectations for global economic growth and oil demand over the next 12 months. Rather, we have stuck to our guns while others took a bullish detour in the last 4-6 weeks, before then deciding that inflationary pressures do indeed seem more entrenched for 2023 after all. A comparatively shallow Advanced Economy downturn during the next six months remains our base case assumption, but global oil demand will likely be cushioned by healthy Chinese demand growth and continued recovery in jet-kerosene demand. More generally, commodity price volatility will likely remain entrenched, given ongoing uncertainties surrounding Russian commodity exports and the vagaries around inflation and economic growth.

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