"HOW FINANCIAL MARKET VOLATILITY LEADS TO SHARP COMMODITY SLUMPS?"

A number of commodities have seen sharp corrections lower in recent weeks just as financial market volatility has been on the rise.

A new report by Deutsche Bank says that the recent sharp slump in commodities are more financially driven than a reflection of worsening physical demand for commodities.

A number of commodities have seen sharp declines since the end of June including iron ore (-25%), Brent crude oil (-9%), copper (-5%), thermal coal (-4%) in tandem with a selloff in Chinese equities and as the final days of reckoning in the Greek debt crisis approach.

One possible causal link could be the various restrictions against selling Chinese equities which, in DB’s view, mean that commodities can serve as a proxy hedge. Additionally, liquidation of commodity holdings could fund margin calls on the Chinese equity market exposure.

“Financial market volatility will not, at this stage, materially alter our fundamental market balance assumptions, and in this sense commodity markets have suffered an exogenous shock over the past week.”

A more serious concern is whether these events will unfold in such a manner as to deflect economic growth expectations to the downside in the weeks and months ahead.

DB’s China economists believe that the Chinese equity decline, particularly in H-share Hong Kong market, is not supported by fundamentals.

“Although retail investors represent the majority of share turnover, we expect little spillover to the real economy as equity exposure represents a small share of household assets compared to real estate.”

“However, we would view bulk commodities and specifically iron ore and thermal coal, as markets which are structurally weak where any price recoveries are likely to be unsustainable,” DB said.

“Moreover we do not see the decline in oil as changing the fundamentally negative outlook, so any price rebound on a normalization of the financial environment will be limited, in our view. We continue to watch fundamentals of energy names in the US High Yield sector given the broader contagion risks a default cycle in this sector might pose.”