By SIMON CONSTABLE
Investors in commodities need to watch out.
Fresh data show the U.S. economy is weakening. The economy added a paltry 80,000 jobs in June, not enough to keep up with population growth. Earlier last week, we learned the manufacturing sector contracted in June for the first time since July 2009. Other indicators have been equally uninspiring.
Why does this matter to commodities? The raw-materials sector tends to get hit harder than the rest of the economy in a recession.
The Economic Cycle Research Institute, which claims a perfect recession-forecasting record, says an economic contraction is imminent. "We have not seen a slowdown where year-over-year payroll job growth has dropped this low without a recession," ECRI states in a May report.
If, or when, the U.S. (and/or the global) economy does start to contract, commodity prices will tumble because of three factors:
1. The dollar will most likely appreciate against other currencies.
"In general, when things are really good or if things are really bad, then the dollar will rally," says Marc Chandler, global head of currency strategy at Brown Brothers Harriman in New York. A U.S. recession would be an example of the latter, he explains.
That's bad for commodity prices because they are mostly priced in dollars. For example, if the value of the dollar rose 10%, the price of commodities should drop by 10% if everything else in the world economy stays the same.
2. Consumption of commodities will fall.
"Generally, business investment falls during recessionary periods," says Michael Woolfolk, senior strategist at BNY Mellon in New York.
That means there is less demand for the raw materials that are used to make the things that businesses buy.
On top of that, consumer buying drops during recessions, but the spending pullback tends to be less than it is for the business sector.
When overall demand drops, and the supply remains the same, prices drop.
3. Credit will be less readily available.
"In a normal recession, credit grows at a less rapid rate than in an expansion," says Paul Dales, senior U.S. economist at consulting firm Capital Economics in London.
That constrains consumption of goods, as described above.
It also does something else. Speculation in commodity markets tends to be driven by credit, because easy credit allows bigger bets. So when credit is tight, expect to see reduced activity in the commodities pits and reduced prices.
So what does this mean for investors?
BNY's Woolfolk says the entire commodity supply chain will be hurt.
For the oil market, that's everything from the drillers through refining to gasoline retailers. For mining, it starts with the companies that dig the minerals and goes through to jewelers or other retailers.
So if a recession is imminent, it's time to lighten up not only on commodity futures, but also on companies tied to raw materials.
Investors should steer away from large mining companies such as BHP Billiton (ticker: BHP), Rio Tinto (RIO), and Freeport-McMoRan Copper & Gold (FCX); oil stocks such as ExxonMobil (XOM), BP (BP), and Chevron (CVX); and companies that supply these industries, like Caterpillar (CAT) and Schlumberger (SLB).
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