The world economy is expected to contract for the first time in sixty years with developed economies facing the brunt of the downtrend. As per the latest IMF report, the developed economies are expected to contract by 3-3.5% while developing economies are expected to grow by 1.5- 2%.
In FY 10, advanced economies may just about grow while developing economies will grow faster to 3.5 – 4%. This outlook may be overly pessimistic and we think that growth could surprise positively in the second half of the year an account of several policy initiatives taken across the world which are beginning to take traction.
The actual contraction in demand of several commodities has been relatively modest but erosion in prices has been significant. For instance, oil demand is down by about 3%, but erosion in prices has been over 60%. The same trend has been repeated in almost all commodities. This in turn has resulted in a currency crisis for a few of the commodity exporting countries, which has forced them to export commodities cheaper than ever before on account of devaluing currencies. This has already started in steel exports from Russia which has faced a sharp deterioration in its currency.
There is also a debt crisis brewing in Eastern Europe which has the potential to unsettle European banks resulting in a currency crisis there. Overall, the ripple effect of sub prime originated crisis is being across the world result in several mini crises the world over.
Negative feedback loop flowing from commodity downturn: The sudden sharp decline in the prices has resulted in severe de-stocking creating a further downward spiral. As of now extreme fear rules all commodity markets, as there is no determination on the floor prices. There are, however, signs of an arrest in the downward spiral in commodity prices, giving some legs of stability. This trend has been tenuous and we need to determine if this would last. Incremental demand of commodities is largely from developing economies, and a pickup from these economies will benefit a more stable outlook for commodities which in turn can set a reinforcing process.
Deterioration of prices in commodities will in turn delay a number of expansion projects and result in capital goods companies further pulling back and resulting in job cuts. The pain in China could be higher as the last leg of economic growth was fuelled by growth in demand in China and most of the high cost production is in China.
Hence the make vs. buy decision in China will turn towards ‘Buy’. A lot of capacities could therefore theoretically go out of the system further depressing replacement costs and may be available at salvage costs implying that the book value may lose relevance for a period of time, as is now.
Hence, the feedback loop of lower demand, lower prices, shut downs, lower jobs could continue for a period that is longer than is envisaged.
Breaking the logjam: How can we then break this negative feedback loop? The initial feedback of all producers and consumers has been to cut back production and consumption simultaneously, which has resulted in some of the imbalances being ironed out. The hope is that as consumption comes back on stream, production can also do so.
This concerted action by producers is in a way happening for the first time as there is a greater producer discipline today than earlier, but does this not vitiate the survival of the fittest. In our view there will be capacities in the West, which are higher cost and may get shut permanently and result in partial parity.
In the case of oil, we anticipate oil prices to stabilize as production facilities are declining and new outputs is difficult to come by, and emerging markets improve their standard of living.