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Thursday, June 04, 2015

Is the Shanghai stock market a risk for wool prices?

By Andrew Woods, ICS  |  Source: Dow Jones, SSE, RBA, AWEX, ICS

Key points

  • Share and wool prices generally have little correlation.
  • A major financial crisis, such as in 2008-2009, tends to push asset and commodity prices downwards thereby introducing some positive correlation.
  • Will a correction in the Chinese share market dampen demand for wool? Only if it is dampened by a tightening credit cycle in China.
  • The Chinese government would be reluctant to penalise the greater economy to dampen the equity market.

2015-06-04 Wool And Equity Prices FIG 1

2015-06-04 Wool And Equity Prices FIG 2

2015-06-04 Wool And Equity Prices FIG 3

A regular Mecardo reader has asked, “What risk does the Shanghai stock market pose to the Australian wool market?” So what is the relationship between equity and wool prices during the past 25 years? And are there any correlations that may prompt further investigation?

Given the Chinese economy and share market have developed in importance over the past three decades, figure 1 compares the Dow Jones Industrial Average and the median micron merino price (in US dollar terms) from 1991 onwards. The US equity market remains the largest and most liquid in the world, so if there is a general relationship between wool and equity prices it should show up between wool and US equity prices.

Before carrying out any statistical analysis it pays to look at the data, in this case at the correlations. In the years leading up to 2008 there is, if anything, a negative correlation between the wool price and the Dow Jones average. In 2008, the equity and wool prices reacted in the same manner to the general financial crisis, and from 2011 onwards the two series are again negatively correlated.

Figure 2 substitutes the Dow Jones average with the Shanghai Stock Exchange Composite Index (SSE Composite). Like the Dow Jones average, there was little correlation between the SSE Composite and wool prices in the lead up to 2007. Between 2007 and 2010 the two series were strongly correlated and then the correlation melted away.

Figure 3 shows the same as figure 2, but with wool prices in Australian dollar terms. This introduces the exchange rate as a variable in the relationship between the Chinese equity index and wool prices. The relationship between the two series is similar to that seen in figure 2.

What can we take away from this simple “eyeballing” of equity indices and wool prices? Equity and wool prices cycles, generally, are not correlated. It takes a major crisis (such as 2008-2009) to bring them together, along with other financial and commodity markets.

Within China, credit cycles are anecdotally acknowledged as major drivers of demand for commodities. If the Chinese government tightens access to credit, this impacts on trading firms which includes wool traders and processors. This then limits demand for raw wool. Will the Chinese government introduce a tightening credit cycle to control its share market? The Chinese government would penalise the entire economy by doing this. Instead, it can use other tools such as controls on margin lending to target the equity market, without damaging the greater economy.

What does this mean?

Equity (share) markets run to the sound of different drum to the wool markets. As such, equity and wool prices have little correlation, except when a major external financial crisis drives them lower. The question that remains is whether or not the Chinese government would introduce a tightening credit cycle to dampen the Shanghai equity market. This seems unlikely when there are other ways to take the steam out of that market, without dampening the greater economy.

Mecardo information is provided to assist in your marketing decisions. It contains a range of data and views on the current market. It is not intended to constitute advice for a specific purpose. Before taking any action in relation to information contained within this report, you should seek advice from a qualified professional. The information is obtained from a variety of sources and neither Mecardo nor Ag Concepts Advisory will be held liable for any loss or damage whatsoever that may arise from the use of information or for any error or mis-statement contained in this report. 


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