Baltic Dry Index Points to…?

The chart below - courtesy www.bloomberg.com/apps/quote?ticker=BDIY:IND - shows that freight prices per ton of dry materials such as iron ore have been falling.

Of course, the chart could just as easily rise as it could continue to fall. This is not a chart of something which is the subject of financial speculation. Therefore, it does not lend itself to technical interpretation.

So, because we need to understand the underlying fundamentals, let's have a look at why freight rates have been falling.

Before we do that, it should be born in mind that profits flow from selling something for more than it costs you. Most costs in the shipping industry are fixed. Depreciation is a given. Overheads are a given. The only costs over which management of any business has control in the short term are variable costs - in the shipping industry it will be wages and the price of oil.

From January 2009, the price of oil moved as follows:

Clearly, in the face of rising oil prices, to make a profit in the shipping industry, it was necessary to increase freight rates. The rise in freight rates from January 2009 was consistent with the rise in oil price. Also, since early May, the oil price has been falling; along with freight rates.

Why has the oil price been falling?

Here are a couple of key (selected) quotes from OPEC's monthly report for June 2010 (Source: www.opec.org/opec_web/static_files_project/media/downloads/publications/
MOMR_June_2010.pdf)

• "Commodity prices dropped sharply in May in the middle of the EU public debt crisis and concerns about the impact on demand of China's tightening policy in the property sector. According to the World Bank, the non-energy price index declined by 4.7% m-o-m in May compared to a rise of 8.7% in April while the energy index lost 8.9% compared to 5.1% in the previous month. In the non-energy group, base metals experienced the most severe decrease in May in response to the European debt crisis and the announced end of the stimulus package for the property market in China and the slowdown in private residential construction. Concern also was boosted by the softening of the PMI and slower car sales growth in May." (At page 9)
• "Macroeconomic data will remain the main factor for oil price developments over the coming months. Price movements will largely depend on the evolving Euro-zone sovereign debt crisis. A spread to other countries will likely undermine global economic growth and negatively impact world oil demand. Oversupply from increasing production at a time of already high inventories remains another downward risk for the oil market." (At page 5)

Analyst comment: On page 9 the authors talk about the European debt crisis and the reduced demand from China flowing from a slowing property market and yet this latter important factor was ignored by them in the document summary on page 5.

The following table is also reproduced from OPEC's June 2010 monthly report (at page 14).

World economic growth of 3.8% assumes a higher growth rate in China for 2010 vs 2009!

Now, the following statement is also made in the June OPEC report:

"Chinese economic growth is set to moderate from the very strong 11.9% expansion registered in 1Q10. China may be affected by the fallout from the Euro-zone debt crisis and slower growth in the Euro-zone region as Europe is the most important market for Chinese goods, absorbing around 20% of total Chinese exports."

Hmm? So the 11.9% has been reduced to 9.5% because of the anticipated impact of the EU financial crisis on exports to Europe.

Analyst Question:

This raises a very interesting question: What will be the impact of China's weakening property market on Chinese (and world) GDP growth rate?

Of course, we should not forget about the impact on the world economy of US consumer With regard to the US, here is another quote from page 14:

But later on, at page 15, the following statement is made:

"Thus, while the economic development in the US is continuing its positive trend, it might be still inflated by various government-led support measures. By acknowledging the positive momentum, but also taking into account the challenges for the coming months, the forecast for 2010 has been left unchanged at 2.8%."

Interesting observation. Let's keep that in the back of our minds.

Interim Conclusion

The June OPEC report seems to be biased based on the authors' predisposition to want to prove that the world economy is improving.

To be even handed about it, there are a couple of straws in the wind that "costs' of living may be falling. The following chart implies that gasoline consumption per motor vehicle is falling given that car sales in Europe have been growing but fuel consumption has been flat.

On the other hand, given that world oil supply is still below levels of June 2008, the world will need lower gasoline consumption per vehicle for its economy to keep turning.

This is not necessarily a bad thing. In fairness, it could be argued that there will be more money available for consumption. So this raises the question, what is happening in the minds of consumers? Let's have a look at motor car sales as a possible proxy.

1. China:
   1. China overtook the United States as the world's largest car market in 2009, selling close to 13.6 million vehicles against the US's 10.4 million. (Source: www.caradvice.com.au/64905/china-overtakes-us-as-worlds-largest-car-market/)
   2. "New car registration hit high growth [in China] in April" (OPEC June report)
2. India: Indian car sales are at their highest point in six years with the fiscal year result, ending March 31 [2010], showing a 25 per cent increase over last year's figures. (Source:www.caradvice.com.au/65007/indias-car-sales-up-25-this-year-biggest-gain-since-2004/) According to data issued by the Society of Indian Automobile Manufacturers (SIAM), Indians purchased 1.53 million cars over the last fiscal year, up from 1.22 million units the year prior. (Source: Ibid)
3. Russia: Russia vehicle sales totaled 183,518 units for June 2010, up 46.4% vs. June 2009. The government's continuing scrappage program led to this increase. (Source:http://wardsauto.com/home/russia_vehicle_sales_100708/)
4. UK: Car sales rise 20% in 2010 June's near-11% rise in new car registrations marks 12th monthly increase in a row, despite the end of the government's scrappage scheme (source:www.guardian.co.uk/business/2010/jul/06/car-sales-rise-20-per-cent
5. Australia: New vehicle sales reached 108,722 units in June, up 5.7 per cent on a year ago, the Federal Chamber of Automotive Industries (FCAI) said today. (source: www.news.com.au/business/breaking-news/new-car-sales-hit-record-high-in-june/story-e6frfkur-1225887996703)
6. USA: (YOY June Statistics fore Light Vehicles): 14.4% growth (source: http://online.wsj.com/mdc/public/page/2_3022-autosales.html#autosalesA)
7. Europe: European markets experienced its first monthly decline in ten months, falling seven per cent to 1.17 million vehicles in April as European government's begin to phase out incentives. (source:http://www.caradvice.com.au/68729/europes-first-sales-slump-in-ten-months/)

Interim Conclusion

Whilst, world-wide over the recent past new car sales have been booming, this might well have been a result of government stimulus programs. The Chart above of new vehicle registrations for Europe appears to be up to date to March. Sales in April showed their first decline. With economic stimulus programs coming to and end it seems that, on balance, world economic growth - going forward - will be dependent on:

• Continuing economic growth within China and India (Seemingly dependent on a combination of European economic health - which may be in decline, and an orderly decline in the Chinese property market - which has high associated risks)
• Consumers within the US continuing to consume.

Chinese Property Market

Some relevant quotes:

• In May [2010] , property prices in 70 of China's largest and medium-sized cities rose by more than 12 per cent from a year earlier. That was the 12th straight month on increase. (source:www.channelnewsasia.com/stories/eastasia/view/1067689/1/.html)
• The nationwide average ratio of housing price to household income in China was 9.1 in 2009, compared with 4.74 for the UK and 3.09 for the U.S., said Yao, citing statistics from a research on China's property market he conducted in 2009. (Source: www.chinapost.com.tw/business/asia/b-china/2010/06/01/258931/Economist-sees.htm)
• Although China has taken a new policy to stabilize housing prices, the country's housing prices are still expected to grow 5 to 8 percent this year, and Beijing's growth rate may exceed 8 percent, Professor Dong said. (Source: www.china-window.com/china_market/china_real_estate/beijing-housing-price-fac.shtml)
• According to some market watchers, they expect the national average property price in China to fall by 10 to 20 per cent over the next 12 to 18 months. (www.channelnewsasia.com/stories/eastasia/view/1067689/1/.html)

Interim Conclusion

The most reasonable justification for anyone to buy a house priced at 9.1 times your household income is if you believe there is a higher probability of selling the house at a profit than of living in it for the longer term. At face value, the rise in Chinese real estate prices has been driven, primarily, by a "trading" or "flipping" orientation - identical to that which prevailed in the US before the real estate market imploded following the subprime crisis. Given the Chinese Government's move to cool the property market in that country, it is reasonable to expect that a slowdown in the rate of price rises will likely cause the ratio of house prices to household incomes to fall in line with other countries. (Note: In Australia, the ratio of 6.3 is amongst the highest in the world - see www.dailyreckoning.com.au/australian-house-prices-are-severely-and-seriously-unaffordable/2009/01/27/ )

Let's take a closer look at China and the possible impact of Real Estate prices on its economy:

• The economy of the People's Republic of China is the third largest in the world, after the United States and Japan with a nominal GDP of $4.99 trillion in 2009.[2] It is the second largest after the U.S. with an economy worth $8.77 trillion when measured in purchasing power parity. China is the world's fastest-growing major economy, with an average growth rate of 10% for the past 30 years. The country's per capita income is at $3,677 (nominal, 97th), and $6,567 (PPP, 98th). China is the second largest trading nation in the world and the largest exporter and second largest importer of goods. (Source:http://en.wikipedia.org/wiki/Economy_of_the_People's_Republic_of_China)
• In addition to quarterly GDP, China released a batch of figures for March that were strong and close to expectations. Retail sales rose 18.0 percent from a year earlier, factory output grew 18.1 percent, and urban investment in fixed assets like roads and factories rose 26.4 percent in the first quarter. (Source: www.reuters.com/article/idUSTRE63E0CB20100415)
• The statistics bureau said that investment in property leapt 35.1 percent in the first quarter from the period a year earlier, the fastest growth rate in more than two years. And on Wednesday, the government said housing prices were up a record 11.7 percent year over year in March. (source: www.nytimes.com/2010/04/16/business/global/16yuan.html)

Analyst Comment: The "wealth effect" is when people consume more because they "feel" richer because the value of the equity in their homes is rising. This begs the question as to what will happen to consumption within China if/when property prices begin to fall?

One "straw in the wind" may be the behaviour of the Chinese stock market, which can be seen from the chart below: (http://au.finance.yahoo.com/q/bc?s=000001.SS&t=my&l=on&z=m&q=l&c=)

Perhaps just as important to the future direction of the world economy, the statistics on Consumer Sentiment within the USA are telling a story. Not only are they low, the year on year change is still in negative territory and the actual number for June was 52.9 against a consensus expectation of 63.3.

Source: http://fidweek.econoday.com/byshoweventfull.asp?fid=442647&cust=mam&year=2010#top

There are four proximate reasons why US consumer confidence may have contracted:

1. The European debt crisis
2. Although unemployment "statistics" have recently shown a fall in unemployment, this flows, primarily, from more people leaving the workforce and less people looking for work who would otherwise do so. Arguably, if the roughly 600,000 people who stopped looking for work had not stopped, unemployment within the USA would have risen.
3. The catastrophe in the Mexican Gulf
4. The fact that the US Stock market has now given a serious sell signal - as can be seen from the chart below. Note the crossover of the 50 day Moving Average below the 200 day Moving Average (chart courtesy stockcharts.com) (And, of course, the public as a whole is not watching this type of indicator. What is being referred to here are "coincident" indicators.

Overall Conclusion

A cooling real estate market in China (and the resulting slowing of associated construction activity) may be the primary reason for the weakness being shown on the chart of the Baltic Dry Goods Index. This cooling is likely to have flow-on effects within the Chinese economy- because, based on what happened in the USA post September 2008, the wealth effect within that country will likely go away. With this in mind the forecast growth rate of 9.5% in the Chinese economy for 2010 seems optimistic. From this analysts' perspective, much of the optimism in the investment world is based on the foundational assumption that the Chinese economy will "drive" the world out of recession. Whilst world markets in general improved and motor car sales in particular clearly boomed as a result of government stimulus programs across the globe, the recent slow down in car sales in Europe and the collapse of consumer confidence in the USA may be Early Warning signs of things to come. We are living in volatile times. All rationalization aside, it is arguable that the weakness of the Baltic Dry Goods index may be pointing towards a generalized slowing of the world economy.