Commodities And Yields are declining. This Is Why.

Summary

• A stone thrown in a pond makes smaller and smaller waves.
• Any system subjected to a shock responds irregularly until it reaches equilibrium.
• Any economy subjected to a shock responds with oscillating random waves until it reaches its long-term growth rate.

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A rise in the inventory to sales ratio means inventories are rising faster than demand. The business response is to reduce them. Production needs to be cut. Purchasing of raw materials must be reduced. Hours worked and labor is lowered. Borrowing is also curtailed since less capital is needed to finance operations.

The market response to these decisions is declining commodity prices and interest rates.

The opposite takes place when the inventory to sales ratio declines, reflecting the need to replenish inventories since sales are outstripping inventory growth. Production needs to be raised. Purchasing of raw materials must be increased. Hours worked and employment are expanded. Borrowing is also increased since more capital is needed to finance operations and capacity expansion.

The market response is higher rising commodity prices and interest rates.

Source: St. Louis Fed, The Peter Dag Portfolio Strategy and Management

The above chart shows the change in the inventory to sales ratio of three industrial segments: manufacturers, wholesalers, and total business.

The inventory to sales ratio (April data) has been sinking, reflecting demand outstripping supply by a wide margin. The last time it happened with similar violence was during the great recession of 2008-2009. Businesses will continue to respond by aggressively increasing production. This is the major business activity supporting the economy until inventories are growing at the same pace as sales.

The weakness in commodities and yields will provide an important clue whether inventories are finally outstripping demand and there is an unwanted inventory accumulation. It will take a few more months to find out. Commodity prices, however, being an important leading indicator, will provide important clues on the direction of the business cycle.

This chart shows the percent change on a month-to-month basis of sales, durable goods orders, and autos. The graphs show the growth patterns of these crucial sectors. The economy is oscillating like the waves generated by throwing a stone in the water.

The first big wave was caused by the lockdown of March 2020. The system boomed until May 2020, followed by a slowdown ending in Nov 2020. We experienced another wave which peaked in May 2021. The current decline shows the economy slowing down again. It will eventually reach its growth potential of 1.5%-2.0%.

The economy will have to continue to slow down to a growth rate lower than 2%. The reason is productivity growth is about 1.0% and population growth is 0.4%. The average growth rate of business activity is computed by adding these two numbers. No government program can stop this natural process.

This development is the main reason for the continued decline in commodities and bond yields.

This chart shows percent changes on a month-to-month basis of employment in manufacturing and construction. The employment situation in construction and manufacturing gives mixed pictures. Employment in construction has declined, confirming the weakness in housing and the decline in lumber prices. Manufacturing employment will stay firm thanks to the ongoing manufacturing effort to rebuild inventories.

Shipping activity is still strong. This trend confirms the health of the manufacturing sector. The goods produced to replenish inventories must be shipped, thus causing the index to surge. It also explains the strength in crude oil prices – one of the few commodities resisting the decline.

The above chart shows the trending and gradually slower growth of the economy is confirmed by the broad decline in the major commodities – from soybeans to copper to lumber – except crude oil.

Key takeaways

• The economy is trying to find its equilibrium growth rate which is close to 1.5%-2.0%, down from the current 10+%.
• The various stimulus programs emanating from Washington generate random forces, further creating uncertainties and delaying the healing process of the economy caused by the lockdown of March 2020.
• As the growth rates of the economy decline from the recent absurd 10+% to less than 2.0%, the markets will respond by placing continued downward pressure on commodities and yields.
• Bonds (TLT) will keep appreciating, creating profit opportunities, and providing an attractive hedge to equity portfolios.