Domino theory

Commodities: The slide in commodities this week spells trouble for investors and the global economy alike. It's not that lower prices for raw materials like oil aren't a relief to a world fretting over inflation. It's that gyrating prices can paralyse oil producers and businesses alike. And with so many investors piling into commodities, wild swings like silver's near 29 per cent dive this week can start a wave of selling in other commodities and or seemingly unrelated assets.

Investors are yet to see if further landslides are in store or if the bull run in commodities, having paused, resumes. The Reuters-Jefferies CRB index of commodities prices has climbed 27 per cent in the past year thanks in part to global recovery and demand from China and emerging Asia.

It has also been pushed up by investors borrowing cheap US dollars and using these to pile into commodities to bet on China's growth, inflation and a weakening dollar. High prices for oil and other raw materials pose a persistent drag on profits and economic growth. Companies and consumers can eventually adapt. Wild price swings, on the other hand, cripple the ability of businesses to plan ahead, and so can devastate investment and growth.

Volatility in one commodity may also touch off a financial avalanche like the one that started the global economic crisis. Sharp declines spark a stampede of investors trying to avoid further losses. Falling prices gather momentum by triggering pre-set orders to sell if prices fall below certain thresholds.

This selling can quickly jump to other commodities that are bundled together into exchange-traded funds (ETFs). As the value of one commodity drops, it pulls down the ETF, sparking new avalanches that can spread to the other commodities in the fund. The pressure is most intense for investors using borrowed money. They may start selling other assets to cover their losses and repay their debts.

Brokers and dealers often exacerbate this trend: to reduce their own risks, they require investors to put up more cash. The May 2 rout in silver that spread to gold and then oil was to some extent sparked by an increase in these so-called margin requirements. Those who believe the drop in commodity prices is the answer to their prayers ought to be careful about what they've wished for.