Commodities are sending a distressing signal

OIL markets are sending a powerful message. After reaching a four-year high in early October, the price of crude has collapsed by more than 25 per cent. This move is about more than just the ups and down of global supplies and whether Opec and other producers can adjust. More importantly, it seems to speak to waning demand, which is worrisome.

These developments suggest the synchronised growth that the global economy has enjoyed in recent years is likely to be replaced by a generalised slowdown. Just take a look at the data out of Japan and Germany this week, which showed the world's third and fourth largest economies contracted in the third quarter.

The message of weakening demand on the oil front was reinforced by the falling price of copper. The base metal is often referred to as "Dr Copper" on its presumed ability to forecast the peaks and troughs of business cycles since it is used in different areas of the economy such as homes, factories and electricity generation. Copper has served as a leading indicator of both recessions and economic booms.

While lower oil prices reflect concerns regarding a drop in demand, the behaviour of copper prices portends trouble on the supply front. It suggests that the weakness in US housing already evident in the sharp decline in homebuilding in September could be followed by an eventual slowdown in factory output.

Weaker commodity prices are a result of two related factors. Economies other than the US have lost the vibrancy they exhibited in 2017. This, for example, is the case with slower growth in the eurozone this year, and a weaker German business sentiment index in October. There is little expectation that the pace of European economic growth will pick up significantly next year.

Lower commodity prices are also a response to the dollar's relentless march upward as the Federal Reserve increased interest rates eight times since December 2015. By contrast, the European Central Bank has maintained crisis-level, low interest rates. The Bank of Japan not only has a short-term interest rate target of minus 0.1 per cent, but is also continuing asset purchases, boosting its balance sheet assets to more than 100 per cent of gross domestic product.

In pushing down prices, commodity traders realise that such a divergence of monetary policies across the industrialised countries is likely to continue. This has resulted in the Bloomberg Dollar Spot Index rising as much as 8.60 per cent since mid-April. Further dollar strength during the coming year would add pressure on oil and copper prices.

Two recent developments may have accentuated pressure on oil and other commodity prices, and suggest worsened prospects for the economy. The switch to a Democrat-controlled House of Representatives could increase the US conflict in trade with China. The party has generally been more protectionist than Republicans, and is expected to support President Donald Trump's position that China ought to be punished for its alleged theft of intellectual property.

A heightened trade war, with many of the increased tariffs going into effect in January, would increase uncertainty for investors, slow capital spending, and reduce the pace of economic growth. The steep drop in oil prices appears to incorporate the rising probability of such a development.

Also last week, the Fed released a hawkish statement indicating that it would continue increasing interest rates even though inflation has remained at manageable levels. Higher borrowing costs resulting from Fed tightening would increase the cost of holding inventories of copper and oil, prompting supplies to shrink.

Investors should heed the message being provided by Dr Copper and Professor Oil rather than go with the optimism expressed by the Trump administration and the Fed. While the US officials appear to be reacting to the faster economic growth that has already occurred, the commodity prices are a better indicator of future market behaviour.

The prudent move for investors would be to reallocate assets from equities - which are likely to be hit by a slowing economy - to high-grade fixed income securities that would provide safety during a market correction. BLOOMBERG