You might find this surprising. Falling commodity prices should mean lower inflation, which might help hold down interest rates. And they mean higher real incomes for households as food and fuel bills fall and lower costs of production for companies which should mean higher demand, output and profits. All this must be good for shares.
However, there are two offsetting factors.
One is simply that a big chunk of the UK market comprises commodity producers who lose from lower prices: oil and gas producers and miners account for 17.2 per cent of the All-Share index.
The other is that falling commodity prices can be a symptom of weaker global economic activity. And this is bad for shares as it reduces earnings expectations and appetite for risk.
Which brings me to the problem. The correlation between commodity and share prices has been increasing over time. In the early 90s, it was negative; falling commodity prices were generally associated with rising equities. From the mid-90s to mid-00s it was around zero implying that the favourable and unfavourable effects of lower commodity prices offset each other. But since the mid-00s it has been positive. More often than not - but not always - falling commodity prices have been bad for shares.
This partly reflects the increasing weight in the index of commodity producers. This itself, though, might be a more significant fact that generally appreciated as it might be yet another sign of secular stagnation: what does it say about the dynamism of UK plc that so many of its most valuable members are holes in the ground?
This, however, is not the full story. If we look at sectors' sensitivity to commodity prices, we can see that it is not just miners and oil stocks that tend to fall when commodities do. So too do several cyclical sectors such as chemicals and engineers. In fact - based upon annual changes since 2000 - only three FTSE sectors are negatively correlated with commodity prices: these are general retailers, pharmaceuticals and non-life insurers and all three correlations are statistically insignificant.
| FTSE sectors' sensitivity to a 10% change in commodity prices | |
| Mining | 8.1 |
| Industrial engineering | 5.1 |
| Chemicals | 4.8 |
| Industrial transport | 3.6 |
| Oil & gas | 3.2 |
| All-share index | 2.4 |
| Utilities | 1.8 |
| Based on average annual changes since January 2000 | |
This fact tells us that, for most sectors, the possibility that falling commodity prices are a sign of weaker global demand outweighs the fact that they cut costs and inflation.
And here's the problem. Stock markets have become increasingly globalised. Their fate increasingly depends not just upon economic conditions in the west, but also upon those in commodity-dependent Asia. It's for this reason that the All-Share index's correlation with commodities has increased over time.
It’s in this context that we should, perhaps, be a little concerned by the recent fall in Chinese share prices. In itself, this is not a huge problem: economists don't expect it to cause the Chinese economy serious trouble and stock markets, as the cliché goes, have predicted nine of the last five recessions. However, this fall might corroborate the message of falling commodity prices - a message which itself is consistent with the slowdown in world trade - that Asian economies might be spluttering.
The best hope for equity investors is not so much that the drop in commodity prices reflects increased supply of them - which would be a good thing - or will reduce inflation, but rather that it prove to be only temporary.
