Credit: Shutterstock photoIt seems strange to me, but these days there are many people that have never heard of the Baltic Dry Index (BDI). I grew up as the son of a City of London shipping manager for whom the BDI was a part of everyday life, and our family dinner table conversations occasionally centered on the fluctuations of the index and their causes.
Then, when I went to work in the forex market, I found that people incorporated the BDI into their long-term predictions for major currencies. The BDI is not perfect a perfect predictor of currencies stocks or any other market, but the logic behind its predictive capabilities is sound, and it can be used to develop a snapshot of global economic strength at any given moment.
The index is calculated by the shipping and insurance hub Lloyd’s of London and reflects the average cost of shipping dry raw materials such as metals, coal and grains around the world. Those are the building blocks of economic activity, so the conventional wisdom is that a rising BDI foreshadows a period of robust economic growth.
On that basis, should we be worried that, after rising significantly in the second half of 2016, the index has been declining since early in December of last year? The short answer is yes, but to fully understand why you must have a better understanding of what the BDI is and what influences it.
The first thing to account for is that the index is a measure of price and is therefore influenced by supply as well as demand. Fluctuations in the index are often the result of changes in shipping capacity, which in turn responds to demand and price.
Obviously, building ships takes time, and in many cases by the time the capacity is increased the demand picture has changed. For example, strong growth and high demand during the early 2000s prompted an expansion of the fleet, but by the time the new ships were launched, we were in the teeth of the recession.
The resultant overcapacity is still affecting freight pricing and is one of the major reasons that stocks in the industry continue to do extremely poorly.
Figure 1: BDI 2003-2017
However, that overcapacity has existed for some time now, so movement in the index can be judged against a fairly stable base and some conclusions about demand for raw materials can be drawn. That is why the first chart that shows the decline this year is so worrying.
The narrative that we hear all the time is that global growth is still on an upswing and that that is a large part of the reason for the optimism that keeps pushing stocks to new highs, even despite things like political turmoil here in the U.S., the threat of a Trump Trade War and the prospect of rising interest rates.
If the BDI is to be believed, however, the high demand for raw materials that inevitably accompanies economic growth has faded this year. When the effects of that begin to show in backward looking data therefore, attention will shift to the bad news and a major correction will result.
That, to me, is an obvious conclusion, but it doesn’t mean that investors should be selling everything right now. One of the advantages of following the BDI is that it is a forward-looking indicator, but it tends to look a long way forward, and other circumstances can change before the implied move in stocks comes about.
It is something to be watched though, and investors should be aware that if the index resumes its decline, and/or trade and GDP data begin to reflect the falling demand suggested, it will represent a fundamental shift in conditions and so will prompt a sharp selloff.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
