Sunday, March 22, 2009

How can you tell where the economy and the market are heading?

Many of us have never heard of "The Baltic Dry Index" but we should know about it, especially if we’re concerned about the economy and try to gage when it will turn around. Of all the leading indicators The Baltic Dry Index is the most honest and not subject to manipulation or speculation because it is fact-driven.

The Baltic Dry Index is an index that tracks the average cost of carrying dry cargo such as iron ore, grains, finished steel and coal. This can be a good indicator of the activity in the global economy because it allows one to measure the demand for raw goods, which is further indicative of future industrial activity. As countries resume creating products for eventual export, they'll need the raw materials. After those products are finished, they'll once again ship them to where they're needed.

Economist Susan Lee gives the following reasons why the Index is important:
  • The index captures activity at the beginning of the production process
  • It looks at ocean shipping, which focuses on international trade, the critical driver of global growth
  • The shipping business is highly dependent on credit, so the Index indicates if the credit markets are tight or loose

Since The Baltic Dry Index is a daily average of prices to ship raw materials, it represents the cost paid by an end customer to have a shipping company transport raw materials across seas on the Baltic Exchange which is the global marketplace for brokering shipping contracts. The prices are determined by the buyers and sellers.

The Baltic Exchange is similar to the New York Mercantile in that it is a medium for buyers and sellers of contracts and forward agreements (futures) for delivery of dry bulk cargo. The Baltic is owned and operated by the member buyers and sellers. The exchange maintains prices on several routes for different cargoes and then publishes its own index, the BDI, as a summary of the entire dry bulk shipping market. This index can be used as an overall economic indicator because it shows where end prices are heading for items that use the raw materials that are shipped in dry bulk.

The BDI is one of the purest leading indicators of economic since it measures the demand to move raw materials and precursors to production, as well as the supply of ships available to move this cargo. Consumer spending and other economic indicators are backward looking in that they examine what has already occurred. The BDI offers a real time glimpse at global raw material and infrastructure demand. Unlike stock and commodities markets, the Baltic Dry Index is totally devoid of speculative players. The trading is limited only to the member companies, and the only relevant parties securing contracts are those who have actual cargo to move and those who have the ships to move it.

As the BDI increases, so does the cost of raw materials. Because this is the cost of buying and transporting materials used in production of goods, the cost must be passed along the value chain by producers and refiners. Eventually consumers will pay higher costs in the higher prices they pay for goods produced from these raw materials. For example, when a coffee company like Maxwell House pays an extra $10/ton to import coffee beans, they will pass along this increased procurement cost to consumers to maintain margins.

The Baltic Exchange has the following interesting example:

"As China transformed from coal exporter to importer, they began buying coal from nations such as Russia, Brazil, and Australia. The coal from the latter two must be shipped using dry bulk carriers. As the rates for the BDI went up in 2007, so did the cost of coal to China. Since coal is used for 70-80% of China's energy generation, overhead costs for factories increased with the price of coal. As the overhead costs increase, so must the price of the end good to maintain the margin of profit. As this end price increased, an American paid more for a t-shirt or toy at Wal-Mart."

When the BDI increases, dry bulk shippers win. The increase in the index directly increases their margins and revenues. When the BDI decreases, every other consumer/producer in the global value chain wins. Since the BDI measures procurement costs, when these costs go down, producers benefit from increased margins, and consumers benefit from lower prices for finished products. However, a lower BDI means that the general economy is trending downward.

Here is how the BDI works.

Every working day, the Baltic Exchange canvasses brokers around the world and asks how much it would cost to book various cargoes of raw materials on various routes (e.g. 100,000 tons of iron ore from San Francisco to Hong Kong, or 1,000,000 metric tons of rice from Bangkok to Tokyo). The index is made up of an average of the Baltic Supramax, Panamax, and Capesize indices. These indices are based on professional assessments made by a panel of international ship broking companies. The BDI factors in the four different sizes of oceangoing dry bulk transport vessels.

For the reasons described, the BDI is considered a leading economic indicator because it predicts future economic activity.

Other leading economic indicators may serve as a basis for important political and economic decisions but they are often massaged to serve narrow interests and are subjected to adjustments or revisions. Payroll or employment numbers are often estimates; consumer confidence appears to measure nothing more than sentiment, often with no link to actual consumer behavior; gross national product figures are consistently revised, and so forth. Unlike stock and bond markets, the BDI "is totally devoid of speculative content," says Howard Simons, an economist and columnist at "People don't book freighters unless they have cargo to move."

Changes in the Baltic Index tend to precede movements in global stock markets. But the index also tends to predict higher interest rates. When more stuff is being shipped around the world, it needs to be financed. And that creates a greater demand for credit.

The index can be accessed on a subscription basis directly from the Baltic Exchange as well as from major financial information and news services such as Thomson Reuters and Bloomberg L.P.. Most economists and stock brokers read it because the index measures the demand for shipping capacity versus the supply of dry bulk carriers. The demand for shipping varies with the amount of cargo that is being traded or moved in various markets (supply and demand).

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