Weather forecasters are predicting a major El Niño event in 2015/2016. If realized, this could have far-reaching effects on economic growth and global markets, particularly commodities.
El Niño is a weather event that occurs when the surface temperature of the Pacific Ocean around the equator rises above the norm, disrupting weather patterns around the world. This unpredictable climate phenomenon occurs every two to seven years and can last several months or up to a year. Its name means "little boy" or "Christ child" and dates back to Peruvian fishermen who centuries ago noticed that sometimes around December a warmer current in the waters harmed marine life and depleted fish stock.
El Niño occurs when the normal trade winds over the Pacific weaken, such that the warm waters in the eastern side of the Pacific do not shift westward. The result can be very severe climate changes. On the eastern side of the ocean, the warmer water can lead to significant rainfall and even flooding in South America and the southwestern part of the United States. Meanwhile, on its western side, particularly near Indonesia and Australia, El Niño can result in warm, dry weather and droughts, potentially leading to disrupted water supplies and threatened crop production.
El Niño, in a Nutshell
Source: Neuberger Berman (commentary), Google (map).
The National Oceanic and Atmospheric Administration (NOAA) produces a measure called the Oceanic Niño Index, which is widely used to gauge and record El Niño events. A reading above 0.5 o C indicates that the surface temperature of the Pacific Ocean is warm enough to trigger El Niño, while a reading below 0.5 o C leads to a "La Niña" event, whereby the trade winds intensify, as opposed to weaken, as is the case with El Niño.
Warming in the Pacific Seems Likely
Oceanic Niño Index
NOAA. Actual data through June 2015, forecast through 2016. The Oceanic Niño Index has become the de facto standard that NOAA uses for identifying El Niño (warm) and La Niña (cool) events in the tropical Pacific. It is the running three-month mean sea surface temperature ( SST ) anomaly for the Niño 3.4 region (i.e., 5 o N-5 o S, 120 o -170 o W). Events are defined as five consecutive months at or above the +0.5 o anomaly for warm (El Niño) events and at or below the -0.5 o anomaly for cold (La Niña) events.
The NOAA said on August 13 that there is a 90% chance of an El Niño in the winter of 2015 and spring of 2016. On September 1, the Australian Government Bureau of Meteorology stated that this upcoming event "is now the strongest El Niño since 1997-98," putting governments and farmers on alert in high impact areas. In early July, Peru declared a state of emergency in 14 regions and set aside $70 million in preparation for potential devastation, while in Chile and Argentina several people have already been killed due to El Niño-related flooding and mudslides.
Landfall: The Global Markets
In today's interconnected global economy, El Niño can have a significant effect on markets, not to mention the human toll. Focusing specifically on a subset of market impacts in commodities, El Niño's effects can be similarly varied, wide-reaching and impactful. For example, in an El Niño event, agricultural commodities in the U.S. grain belt tend to grow well given favorable precipitation, while in areas like Brazil, soft commodities like wheat, coffee and sugar may be at higher risk of supply disruptions from flooding. The International Cocoa Organization has said that El Niño typically reduces global output by 2.4%. 1
Industrial metals may also be impacted by El Niño. For example excessive rainfall in South America may negatively affect mining and transportation of commodities such as zinc and copper, while extremely dry conditions have been known to damage Australian wheat and limit Indonesia's nickel production, which heavily relies on hydropower.
In the U.S., El Niño typically produces a milder winter, resulting in lower demand for energy commodities like natural gas. Sectors such as livestock could be indirectly affected by changes in feed costs of corn and soy. Precious metals, which are often used as an inflation hedge, may become valuable to investors in an environment of inflationary pressure.
A 2014 study by the IMF and University of Cambridge found that "Australia, Chile, Indonesia, India, Japan, New Zealand and South Africa face a short-lived fall in economic activity in response to an El Niño shock" while other regions such as the U.S. and Europe tend to experience a "growth-enhancing effect." The study also noted that most countries saw "short-run inflationary pressures as both energy and non-fuel commodity prices increase." 2
What does the data say? Taking a closer look at the performance of S&P GSCI commodity indices in the 12-month period following the last five El Niño events, most commodities posted positive returns, on average. From a sector perspective, industrial metals such as copper and lead saw the largest increase while agricultural commodities including wheat and soybeans also posted gains. Livestock was the only sector that on average declined in the 12-month period following the last five El Niño events. Natural gas posted the largest decline during El Niño periods, potentially due to a lack of demand in milder winters.
El Niño Can Be Good for Commodities
S&P GSCI Commodity Indices: Average 12-Month Return After El Niño Events
Source: Bloomberg, NOAA. Average 12-month return after last five El Nino events, January 1997 - June 2015.
Forecast for Volatility
It is important to emphasize that commodities are affected by a range of factors and that no two El Niños are the same. Weather patterns are notoriously difficult to predict and, in fact, last year's early concerns about a 2014/2015 El Niño event fizzled by July. However, if the forecasters prove to be correct in their strong prediction this time around, we can expect some volatility in a range of markets, particularly commodities.
1 The Economist, June 2015.
2 Paul Cashin, Kamiar Mohaddes and Mehdi Raissi, "Fair Weather or Foul? The Macroeconomic Effects of El Niño," June 27, 2014.
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