How Commodities Affect the Economy

How Commodities Affect the Economy

Market movements and price fluctuations are influenced by a number of factors, such as economic reports, large institutional block trades and such like. Of all these factors, one that is often underestimated is the impact of commodity prices. Fluctuating commodity prices not only have a significant impact on business, they also impact the trading markets and the overall economy. Generally, the impact of commodity price fluctuations depends on whether that economy is a net importer or net exporter of commodities.

For economies that are net importers, commodity price increases act almost like trade tariffs. This is because it makes the import of raw materials and sources of energy, required for the everyday functioning of different economic sectors, more expensive.

Economies that are net exporters, on the other hand, benefit from increasing prices, since their income increases with the sale of those commodities. At the same time, a steep rise in prices could reduce the demand for commodities and lead to losses.

Here’s a look at the effects of different commodities on a nation’s economy.

Oil

Oil prices are crucial because they play an important role in power generation, logistics and industry. Oil and its byproducts are vital for the functioning of any industrialised economy. A steep rise in price will increase the price of almost every product, raising the overall inflation of the nation, while reducing demand and productivity.

If the price of oil increases due to higher demand, it is a good sign for the global economy, which will continue to expand, maybe at a fast pace. But it won’t eliminate the chances of recession in individual economies, if the demand for oil increases only in a specific region or country. If the increase in oil prices is driven by a decreased oil supply, it will lead the global economy to contract.

Gold

The price of gold not only impacts jewellers or retailers, who are dependent on the sales of gold-related items. Gold is also used extensively in glass making; aerospace; medical products and other sectors, so fluctuations in gold price can affect the entire market.

The price of gold also reflects changes in the price of the US dollar, in comparison to other currencies. Gold price will increase in countries in which the value of the national currency has declined in comparison to the USD. This reduces demands and brings down the price of gold in dollars. The opposite happens when the value of the dollar declines, making it more attractive for investment and pushing the price of gold upwards.

Gold also signifies the health of an economy. A country with a strong economy will attract more investment in stocks and other financial instruments, rather than precious metals and other commodities. But when the economy weakens, precious commodities are considered stable investment options and attract more investors.

Timber

An ordinary person is unlikely to worry about the price of timber, unless they are building a house. However, timber prices can affect companies involved in the construction sector. Even a small increase in price could affect the cost of a building. Of course, businesses in other sectors would be impacted by timber prices, especially if they are planning to build new premises.

Cotton

Cotton is used in a large number of products. Rising prices can have a negative impact on retailers and manufacturers of apparel and vice versa. Cotton is a key component in furniture, coffee filters and other industries. With rising prices, companies have to increase the prices of their products or absorb the rising cost, which would impact their profits. This will further affect the prices of all dependent firms and their stocks.

Cash Crops

Wheat, Corn, Coffee and others are primary ingredients in many products. The producers of products dependent on these crops will have to increase the prices of their products or have to absorb the losses, which will impact their margins and overall gains.

Commodity Prices and Inflation

Commodity prices are said to be a key indicator of inflation. Commodity prices respond quickly to general economic shocks, such as increase in demand and global economic shocks, such as the political tension in the Middle East. Systemic shocks, such as cyclones and floods that affect the production and supply of agricultural commodities, can drive up the overall cost.

The direct relationship between commodity prices and inflation was strong in the 1970s. In the last 30 years, this dependency has become less important. Globalisation has increased the interdependence of economies around the world. Today, an increase in commodity prices from a strong dollar leads to domestic deflation.

Factors Impacting Commodity Prices in an Economy

There are three main reasons for fluctuations in commodity prices. Here’s a look at them.

  1. Fundamental features of an economy. This deals with the supply and demand generation. If the current supply and inventory of a commodity is more than the demand, it leads to oversupply and decline in prices. On the other hand, if the demand is more than the supply, it drives up prices.
  2. Technical condition of the market. Charts and other technical indicators influence the behaviour of traders, investors and other stakeholders in the market. Since a majority of market participants depend on the same technical indicators, they tend to have similar buying or selling patterns, based on these indicators, thus influencing prices.
  3. Global political and macroeconomic conditions. Any economic, political or natural event can impact commodity prices. For example, conflict in the Gulf region tends to increase oil prices, which affects oil prices worldwide. Similarly, the US-China tariff war raises concerns worldwide and could impact prices of various commodities.

There are a number of factors that impact market movements, of which commodities also have a great impact on stocks, business, portfolios and the overall economy. When you are preparing to invest in a particular sector, analyse the impact of commodities on that sector, it might prove beneficial for your overall investment.

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