SHARP MOVE HIGHER IN THE BALTIC DRY INDEX ADDS TO OUR INFLATION THEME

The rally in commodity stocks looks like it has legs!

Prices of raw materials have taken a bit of a dip in the last week, but the Baltic Dry Index (BDI) has suddenly soared. The BDI is issued daily by the Baltic Exchange, based in London, and measures the utilisation of 23 of the world’s largest shipping lanes. The overwhelming majority of commodities are still shipped by sea, so the BDI gives investors a fantastic means of gauging global demand. It also serves as a decent proxy for what is really happening in China.

Yesterday, the BDI closed at 1,478, having risen nearly 50% in the last month;

In itself, this sharp move higher doesn’t necessarily provide a specific trading opportunity, but it says a great deal about improving conditions. And improving conditions are usually supportive of higher prices.

There are several reasons I like the Baltic Dry Index so much, but chief of these is how pure it is. The reported figures are not subject to revision, adjustment or political interference. It is sufficiently broad that it is hard to see how it could ever be in anyone’s interests to attempt to manipulate it. Overall, it is quite dull really, but that should not detract from its usefulness.

This leads to the second main reason I appreciate the BDI, which is how intuitive it is. Buying ships is an extremely expensive and lengthy process; decommissioning them equally so. This means the supply side of the BDI calculation is inelastic i.e. supply stays largely constant. In the event of an economic downturn, shipping companies cannot simply close down ships, as producers would shut factories or mines. Equally, when there is an upturn, shipping companies can’t simply launch new ships to cater for the demand.

The fixing of the supply side of the calculation serves to amplify the effect of demand on the index. An increase or reduction in demand usually exerts a dramatic influence over the value of the BDI. Look at the long term chart below, of the BDI, and you will immediately see how spikey it is;

You can’t have failed to have noticed how low the index has been, since the start of 2012. Compare this chart to most commodity price charts and a consistent picture should start to emerge of what has happened over the last eighteen months!

Since the upturn in commodity prices, I’ve had at the back of my mind “dead cat bounce”. My concern has been that, although prices have been rising, this has not been mirrored by a similar shift in the BDI. Without such a move, I would have had increasing doubts about the sustainability of the commodity rally.

Now, however, this could be about to change.  

In very simple terms, I’d like to see the BDI move above and hold the 1,600 level. Judging by the long-term chart, this has been synonymous with economic growth and confident markets (ignoring the arguments about debt driven growth for the time being). The sharp rally in the last few days suggests 1,600 is in sight. If this threshold is reached, it should give us a degree of assurance that the latest data out of China is reliable (in part at least) and that their economy is starting to move again. The implications of this for everybody else are surely obvious.

With commodities retreating slightly in price over the last week, the BDI could well be telling us that we should be buying into this temporary weakness. Watch this chart closely in the coming weeks. 

Ben Turney