Fitch Ratings has said in a Special Report that, despite the spectacular rally they have enjoyed over Q108, commodity prices are unlikely to escape a demand-led slowdown resulting from the anticipated global economic downturn. Nevertheless, prices probably will not fall by as much as in previous economic slowdowns and are likely to remain elevated relative to historical levels, reflecting robust, albeit moderating demand from emerging markets.

The report notes that in contrast to historical experience when commodity price increases tended to be limited to a select few commodities, over 2003-07 all categories of raw materials have seen a surge in prices. Although the synchronised rise partly reflects the transmission of input costs through the supply chain, the increased correlation between different categories of commodities points to the role of a common demand shock, particularly from rapidly growing emerging markets (EM).

In addition, the remarkable rise in oil and metals demand met constrained production capacity, resulting from weak investment in these sectors during the 1990s. While the tightness in the oil market has been exacerbated by short-term disruptions to non-OPEC supply and OPEC production decisions, the energy and metals sectors have also suffered an increase in input costs from skilled labour shortages. Resource nationalism has also inhibited the development of natural resource extraction capacity.

Meanwhile, food prices have risen due to a structural increase in demand for food grains from the use of bio-fuels as a substitute energy source spurred by environmental concerns, high energy prices and attempts by the developed world to diversify and secure energy supply. Nonetheless, Fitch believes that temporary supply shocks have likely played the larger part in recent food price increases; with food supply typically more elastic in the short-term, this points to the likelihood that high food price inflation will prove less protracted than oil and metals inflation.

Certainly, Fitch sees little justification in terms of the fundamentals for the surge in commodity prices witnessed in Q108. A slowdown in OECD energy demand (60% of the total) is clearly already underway and likely has further to go in 2008, while it is reasonable to expect non-OECD energy supply to recover. A weakening US economy, coupled with the forecast slowdown in Chinese GDP growth to 9.7% from 11.4% in 2007, the slowest in six years, is likely to take a further toll on metals demand. At the same time, investment in the metals sector has responded quite sharply, though the time lags to output are long.

Increased commodity price volatility and rising uncertainty over the outlook clouds prospects for EM terms of trade, which had hitherto been benefiting from large and steady increases over 2004-07. All else being equal, were commodity prices to fall by 10% across the board, they would inflict a decline in total exports of the top 15 commodity exporting EMs, equivalent to 3.2% of GDP on average. Nigeria, Iran, Gabon, Saudi Arabia and Azerbaijan would be among the most severely affected by lower commodity prices.