Commodity Decline Could Provide a "Tax Cut"

It's hard to cheer on a global economic slowdown, but there could be some good news for consumers amid the pessimism. As economic growth slows, the demand for commodities—such as oil, metals and food—typically slows, resulting in falling prices. The impact of this could be similar to a "tax cut" for consumers, giving them more money in their pocketbooks.

The benefit of this "consumption stimulus" is most likely to be seen in countries where growth is generated domestically, either through consumption or construction spending. Examples of developed, domestically oriented countries include the United States, Japan and the United Kingdom.

In addition to the "consumption stimulus," emerging market countries could benefit from the downward pressure that falling commodity prices puts on inflation—reducing the need to hike interest rates.

Why might we see a "consumption stimulus"?

Commodity prices tend to fall when economic growth slows due to reduced demand from both consumers and businesses. Consumers may cut back on energy use and purchase fewer goods and services to save money. Meanwhile, businesses may reduce production in response to reduced demand.

In addition, most commodities are priced in US dollars. When the dollar falls, commodity prices tend to rise as it takes more dollars to purchase the same amount of a commodity. And as we're seeing now, the inverse is also true; commodity prices tend to decrease when the dollar rises.

While consumers pay attention to the prices they pay at the register, investors care more about inflation—and notably, we may have seen the top.

Why is inflation likely peaking?

With economic growth slowing, some investors are worried that inflation may increase because they may expect the Federal Reserve to pursue QE3 (quantitative easing, or asset purchases), which could weaken the dollar and raise commodity prices.

However, the dollar may not decline. Thus far, the Fed has done more to stimulate growth than the rest of the world. And with global growth slowing, other global central banks may begin to lower rates or pursue other stimulus measures in a "catch-up" phase. The impact of rate changes on currencies is relative. But the net effect of declining rates abroad and potentially better growth prospects in the United States is that the dollar may have an upward bias.

Commodity prices have already started to fall as a result of the economic slowdown, but inflation has not yet shown a noticeable decline. However, taking out the impact of the dollar and holding commodity prices unchanged from the levels reached this summer, measures of inflation are likely to decline relatively soon. The reason is that inflation is measured as a percent change from the prior period.

Commodity prices likely peaking near-term

Who is likely to benefit from the "consumption stimulus"?

Depending on the type of economy, the "consumption stimulus" can have a different impact:

	Emerging Markets	Developed Markets
Domestically Oriented	Brazil India Mexico	Japan United Kingdom United States
Export-Oriented	South Korea Taiwan Thailand	Germany Singapore Switzerland

Current outlook for select emerging market, domestically oriented countries:

Brazil: the threat of a credit bubble could damage Brazil's growth, where consumer spending grew on the back of excessive lending. Consumers have started to become delinquent on payments, risking the potential for bad bank loans in the future. Fiscal spending needs to be redirected from social programs toward productivity-enhancing investments. The central bank was one of the first to cut rates. However, with inflation still elevated, there's the concern that the rate cut came too early, and inflation could resume upward.
India: persistent inflation forced the central bank to essentially decide to sacrifice growth in the name of fighting upward prices. However, inflation remained above 9% in September, well above the central banks' 4-6% target, and rate hikes may continue. Additionally, the country has longer-term issues with food supply. Available land has shrunk, crop yields have fallen due to flawed farming practices, and only 45% of fields are irrigated, leaving production at the mercy of weather. Other growth pressures include a large fiscal deficit and the need for foreign capital. Foreigner investors have pulled out money, discouraged in part by ongoing corruption allegations and government bureaucracy.
Mexico: growth is typically tied to the United States, as it's the destination for more than 70% of exports. Among developed nations, growth in the United States is attractive relative to the larger probability of a recession in Europe. Meanwhile, Mexico could benefit as auto production comes off the bottom and reaccelerates globally after the slowdown induced by the Japanese catastrophes earlier this year. Relative to other emerging markets, Mexico may have a better potential for growth because many other emerging markets could slow due to reduced growth in China.

Why are commodity prices unlikely to decline as much as in 2008?

While commodity prices fell sharply in 2008, prices may not decline to the same degree this time, because another global recession appears unlikely.

Emerging market incomes have continued to rise, increasing demand for both food and energy. Rising incomes tend to result in improved diets, increasing consumption of protein, which require more grains to produce than basic grain-based diets. This supports underlying demand for agriculture commodities. Additionally, energy consumption has risen in tandem with greater automobile penetration. Emerging markets now outpace developed markets in oil consumption.

Emerging market oil consumption more important than developed markets

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Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost.