BetaShares Market Insights: El Nino risks to the economy and commodity prices | BetaShares

BetaShares Market Insights: El Nino risks to the economy and commodity prices

BY David Bassanese | 27 October 2015
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According to a key climate indicator – the Southern Oscillation Index – the risks of a strong “El-Nino” global weather event are now at their most elevated since 1997-98.  While such an event poses downside risks to the Australian economy – at what is now a particularly inopportune time – it also poses upside risk to global oil and agricultural prices.

El Nino and the Southern Oscillation Index

The Southern Oscillation Index (SOI) is a measure of air pressure differences between Tahiti and Darwin, which in turn is an indicator of temperate and rainfall activity in keys parts of the globe. As seen in the diagram below, in normal climatic conditions high air pressures in areas such as Tahiti relative to Darwin allow “pacific trade winds” to blow west (from South America toward Australia), which in turn produce normal rainfall and temperature levels in Australia.  But when these air pressure differences are much less than normal (i.e. the SOI has a large negative reading), these trade winds do not blow as effectively, causing less rainfall and higher summer temperatures in Australia – a recipe for drought.

tradewinds
Source: see footnote*
By contrast, other parts of the globe – such as South and North America – can experience heavier rains and, in some instances, severe flooding.

El Nino and Australian Non-Farm GDP

As seen in the chart below, the average readings for the SOI in the September quarter was -17.4, which was the most negative quarterly average reading since the -23.7 recorded in the March quarter 1998.  What’s also apparent from the chart is that large negative SOI readings are often – but not always – associated with significant detractions from economic growth by farm gross domestic product (GDP) – principally due to poor rains causing a major slump in the wheat harvest.

Most notably, the very significant negative SOI readings in the early 1980s were associated with a severe drought that caused farm GDP to decline by 35% in year to end-June 1983.  Although farm GDP only accounted for 4% of GDP at the time, this severe slump was sufficient to detract 1.3pp from economic growth over this period.   Given non-farm GDP also declined by 2.2% over this period, the overall economy contracted by a large 3.4% in this particularly wrenching four quarter period.

SOI

Since then, there have been three periods when farm-GDP detracted more than 0.5pp from annual economic growth – in the December quarter 1994, the March quarter 2003 and the December quarter 2006 – and each was associated with negative SOI readings of at least 10.  Farm GDP declined by an average of 29% in each period, detracting 0.7pp from annual economic growth. Thankfully, however, these periods – unlike in the early 1980s – were also associated with solid annual non-farm GDP growth (averaging 3.9% across all three periods), such that the overall economy did not succumb to a recession.   Interestingly, moreover, the negative SOI readings in 1997-98 were not associated with a large negative economic impact as the decline in farm GDP was a (relatively) modest 8.7%.  This highlights that large negative SOI readings are often a necessary but not sufficient indicator of serious drought.

That said, the challenge for the economy heading into 2016 is that the non-farm side of the economy is, at this stage, likely to remain relatively subdued – leaving the overall economy more vulnerable to the negative effects of a drought than at any time since the early 1980s.   Indeed, non-farm GDP growth was only 1.9% in the year ending June 2015.  Notably, the Reserve Bank of Australia’s latest economic forecasts – which assume a pick -up in economic growth to 3 per cent growth in the four quarters ending December 2016 – implicitly assume normal weather conditions.

El-Nino and Commodity Prices

El-Nino events do not just affect Australia – but can have global consequences.  As noted above, rainfall in South and North America, for example, tends to be higher than normal during El-Nino. According to an IMF study*, wetter than normal conditions pose downside risks to copper production in Chile, with associated upward risks to global prices given that country is a key source of supply.  Reduced rainfall in India and Indonesia may also lead to upward pressure on global coal and oil prices as these energy sources are needed to produce electricity in view of reduced output from thermal power plants and hydroelectric dams.  Poor growing conditions in the Asia Pacific (including Australia) can also place upward pressure on global food and agricultural raw material prices.

As seen in the chart below, IMF modelling suggests these impacts are statistically significant in the face of notable change in the SOI.

imfcommod
Impact: Median percentage point change from baseline due to a once standard deviation change in SOI from average. 

 BetaShares Commodity ETFs

BetaShares offers a number of ETFs that provide a simple way to obtain low cost exposure to a range of commodities.

The BetaShares Crude Oil Index ETF -Currrency Hedged (synthetic) (ASX Code OOO), for example, aims to track the performance of the S&P GSCI Crude Oil Index, which provides exposure to the front-month West Texas oil futures contract. The ETF is also currency hedged against movements in the AUD/USD exchange rate.

Similarly, the BetaShares Agriculture ETF – Currency Hedged (Synthetic) (ASX Code QAG) aims to track the performance of a basket of the most significant agricultural commodities (corn, wheat, soybeans & sugar) and also includes a currency hedge against movements in the AUD/USD exchange rate.

For investors seeking broader commodity exposure, there is the BetaShares Commodities Basket ETF – Currency Hedged (Synthetic) (ASX Code QCB) which aims to track the performance of a diversified basket of commodities (including energy, agriculture, industrial metals, livestock and precious metals), with a currency hedge against movements in the AUD/USD exchange rate.

 

*Paul Cashin, Kamiar Mohaddes and Mehdi Raissi (2015). Fair Weather or Foul? The Macroeconomic Effects of El Niño, IMF Working Paper WP/15/89.  

 

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