28 November 2016

Over the past week Australian shares were 2.8% higher. Shares in developed countries were 1.4% higher with the US market up 1.4%. Shares in emerging markets gained 1.3%. The Australian dollar was 1.4% higher at 74.43 US cents. The 10 year bond yield in Australia was 0.04% higher at 2.76% while in the US, the 10 year bond yield closed the week unchanged at 2.35%. The oil price gained 0.8% to 46.06 US dollars per barrel.

This year the prices of most industrial commodities have surged. Year to date the price of Newcastle coal has risen 105% and iron ore 81%. See charts below. Short term price movements can be difficult to understand: are they due to:

  • supply shortages? – not our belief in this case
  • increases in demand? – some but perhaps just short term demand
  • speculation? – this is possible.

Graph

How do such large, sharp price rises affect company profits and the overall economy?

One may expect that short term price rises flow through directly to higher profits. This is not always the case in the short term. Often companies have agreed price contracts with their customers and sometimes they will hedge their selling price by using derivatives. This protects them from price falls but also means they don’t benefit from price rises. Long term higher prices will flow through to higher profits.

Nonetheless price rises will help struggling businesses and likely slow down the pace of mine closures. It doesn’t necessarily mean new projects or mine openings. These decisions are generally based on strong long term price forecasts backed by fundamental analysis.

Higher coal and iron ore prices are good for the economy. Short term price rises only provide a moderate benefit in the form of higher national revenues and improved terms of trade. Terms of trade is a measurement of the value of a country's exports relative to the value of its imports.

If longer term prices remained at elevated levels then the creation of new mines and projects would have a greater impact on economic growth and employment.

So all up the recent price rises provide some positive messages but it’s sustainably higher prices which flow through to significant profit and economic growth.

Signing off
David Bell

Past performance isn't necessarily an indicator of future performance.
All data sourced from Bloomberg.