You Can’t Gauge the Global Economy Just by Looking at Ships
(Bloomberg Opinion) -- Amid the turmoil of the oil-price bubble and credit crunch in 2008, a few analysts and economists discovered something remarkable. An obscure shipping index compiled in the shadow of London’s “Gherkin” tower had become a sort of daily prophecy about the direction of the global economy.
The Baltic Dry Index could be used as a “Predictor of Global Stock Returns, Commodity Returns, and Global Economic Activity,” to quote the title of one 2011 academic paper. Google searches for the term rose roughly 50-fold from late 2006 to their peak in February 2009. In one highly influential paper published a month before crude oil hit its peak in July 2008, University of Michigan economist Lutz Kilian created a similar home-brew index of ocean freight costs, and argued it could be used to spot turns in the global business cycle.
There’s just one problem with this theory. While Baltic Dry aficionados were able to pat themselves on the back after the index foreshadowed 2008’s precipitous slump in the S&P 500 and subsequent recovery, its record since then has been patchy. The indicator’s sharp pickup in late 2013 wasn’t matched by any great improvement in the global economy; worse, a slump to record lows at the start of 2016 was followed not by a crash, but a bull market that drove the S&P 500 up by nearly one-third in two years.
In an article this week in Vox.eu, University of California San Diego economist James Hamilton argues shipping costs just don’t work as a useful measure of economic activity. Using Kilian-style measures would suggest a downturn pushed the world business cycle “to a far lower level in 2016 than was realized in either the financial crisis of 2008-2009 or the 1974-1975 global recession.” That doesn't pass the smell test. An indicator based on measures of industrial production does a better job of isolating major economic shocks, he wrote.
Think about the shipping industry for a minute and the problem becomes clear. The Baltic Dry doesn’t measure the whole universe of tankers, container ships and car carriers, but only the freight rates on dry-bulk ships used to carry solid commodities like grain, ore and clinker. In practice, about 70% of the index just tracks the Capesize vessels that largely ferry coal and iron ore to China from mines in Indonesia, South Africa, Australia and Brazil, according to Bloomberg Intelligence analyst Rahul Kapoor.
If you think the global business cycle is fundamentally driven by Chinese raw-materials demand, then you might still find the Baltic Dry a useful indicator. But given China’s attempts to shift toward a more consumption-based economy, that doesn’t quite work these days. The Li Keqiang Index, originated by the Chinese premier when he was a senior provincial official in 2007, was a similarly heavy industry-focused proxy for GDP growth. That gauge is now best considered alongside retail sales, industrial output and beefed-up electricity demand data, according to Bloomberg Economics’ Tom Orlik.
There’s another problem. The price of freight on ships isn’t simply determined by trade demand in the global economy, but by the supply of vessels themselves. If you’d been watching the shipping industry in 2016, rather than staring into an economic crystal ball, you’d have known that the container market entered a profound glut just as cargo measures started falling, sparking a wave of mergers, takeovers and scrapping of old ships. For the first time in at least a decade, the tonnage of container ships on the seas barely grew in 2016; bulkers have been seeing a similar slowdown in recent years, with growth rates below 2%.
These measures aren’t entirely useless. Shifts in industrial activity can portend swings in the business cycle, and cargo bookings are a forward-looking indicator. On top of that, without a proper derivatives market for freight rates, there’s no speculative activity in the Baltic Dry to fuzz up the signal it’s giving about activity in the real economy. The predictive power of such measures may even improve in the years ahead, now that the glut of shipping is clearing and leaving indexes more at the mercy of demand-side factors.
Still, it’s a mistake to treat indicators like the Baltic Dry as anything more than another tool for exploring the mystery of what’s happening in the world economy. If all your investing decisions could be made for you by looking at one easily available index, other traders would have already beaten you to the punch.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
David Fickling is a Bloomberg Opinion columnist covering commodities, as well as industrial and consumer companies. He has been a reporter for Bloomberg News, Dow Jones, the Wall Street Journal, the Financial Times and the Guardian.
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