In yesterday's Oil Investment Update we wrote that investors should not expect a reverse of the downward trend in oil prices. One of the reasons for that is the slowing global economic growth. The very recent fall of the Baltic Dry Index (BDI) to the lowest level since 1986 (Figure 1.) confirms our fears about the health of the world economy. Why is the drop in the index a bad sign for the global economy?

Figure 1: The Baltic Dry Index from 1985 to 2015.

Source: zerohedge.com

The BDI is compiled daily by the London-based Baltic Exchange. It measures the cost of shipping freight on various trade routes (around the whole globe, not only around the Baltic Sea) for dry bulk carriers. Why is the indicator from the maritime market considered to be an important gauge of the world’s economic condition?

The reason is that it measures the cost to ship raw materials, like iron ore, steel, cement, coal and so on. The demand for commodities increases when global economies are growing. It also provides an excellent glimpse into the future, because increasing investment activity needs a lot of commodities. This is why the BDI is considered to be a leading indicator, which has a habit of foreshadowing major turns in the economy and the stock market by about 3 to 6 months.

What is important is that the supply of ships is tight and inelastic in the short-term. You can’t build a new cargo ship in a few days. It usually takes two to three years. This implies that, in the short-run, the freight rates tracked by the BDI are very sensitive to demand for vessels, driven by increased global production and demand for raw materials. Moreover, the BDI is considered to be a simple, real-time indicator that is not affected by speculation or manipulation.

OK. So what does the unusually low BDI mean? Low freight rates imply low demand for vessels. It means that global economies are slowing and do not need so much raw materials. Entrepreneurs are contracting their operations (they have less faith in their economic prospects), which will be reflected in the stock market valuations (unless the Fed provides Wall Street fresh liquidity). Please notice that shipping huge quantities of cargo is an energy-intensive activity, so the plunge of the global maritime reflected in the BDI’s collapse may partially explain the decline in oil prices.

Summing up, there are no perfect indicators. The BDI is not free from defects. Many analysts point out that the BDI is decreasing because of ship oversupply (too many ships were ordered in the past), so it does not reflect the demand for shipping raw materials accurately. However, the world trade growth is indeed slowing (Figure 2.), so it seems that the BDI shows a correct direction of the global economy (even if it overestimates the slowdown). Taking under consideration that the BDI predicted the Great Recession (it started falling a few months before Lehman’s collapse), it is not good news for the world. But gold investors should not be worried – gold is the best asset class during slowdowns and it gained after the outbreak of the crisis in 2008 (after the initial decline).

Figure 2: World Trade Growth from 1980 to 2015.

Source: zerohedge.com

Arkadiusz Sieron
Sunshine Profits‘ Market Overview Editor

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