Feb 22
China's Commodity Bear Trap PDF Print E-mail

By David Fickling

Imagine a country -- let's call it the Kingdom of Centralia -- that's been ruled for decades by a single party. Elections in Centralia are a sham, but the government is paranoid about dissent and wants the next poll in October to go off without a hitch to help consolidate Queen Sophia's power. Cracks are starting to show, however: Exiled former members of the elite are publicizing all sorts of wild rumors about official corruption, and there are signs the normally powerhouse economy might be juddering to a halt. While the government controls the central bank and has wide scope in managing economic demand, many merchants trading with Centralia are becoming convinced that a collapse is looming, and have started pulling back in response.

That's a useful framework for thinking about the signs of an economic slowdown in China, and the rout in commodities prices that it's sparked. Dalian-traded iron ore is down 30 percent over the past two months, while Zhengzhou thermal coal is off 13 percent, the Asia-focused Oman-Dubai crude benchmark has lost 8 percent, and Shanghai copper has slipped 4.4 percent. The Shanghai Composite Index of stocks, meanwhile, has slumped 6.6 percent from its April peak, with its Shenzhen counterpart dropping even more.

If the wheels have finally come off China's growth story, those declines will be just the start of the pain. But anyone betting that Beijing won't try to put its thumb on the scales to make things look a little brighter in time for the Communist Party's National Congress later this year had better watch out for a bear trap.

Back in the days when official interest rates in rich countries bounced around the 2-to-4 percent range, a counterintuitive investment rule was to go long equities when bad economic data came out. If the economy was really slowing, the logic went, the central bank was bound to cut rates -- which in turn would spur a jump in stock prices.

China can certainly take that type of action. If anything, the array of policy tools available to the People's Bank is far wider than its Western counterparts enjoy.

More important, though, is the vast role of the public sector in China's economic activity. State-owned enterprises account for about a third of fixed-asset investments, and when private spending starts to slow, the government is more than willing to pick up the slack.

Markets saw that most dramatically early last year when, after a sharp slowdown in industrial activity, plans to rebalance the economy toward consumption were dumped in favor of an old-style bout of demand-side stimulus. That sent prices of metals, and the miners that dig them up, soaring.


State of Play

The share of China's fixed-asset investment coming from the state jumped in 2016 Source: National Bureau of Statistics of China, Bloomberg, Gadfly calculations

Note: State share calculated as state and state-owned holdings as a percentage of state/state-owned plus private.

State fixed-asset investments in the June quarter of 2016 totaled 6.2 trillion yuan ($898 billion), a 38 percent or 1.7 trillion yuan jump over the average of the previous three years. On an annualized basis, the change in investment alone was equivalent to adding the gross domestic product of Mexico.

With China still experiencing a seasonal lull in construction activity, it's quite possible that investors have simply failed to notice the pickup that typically feeds into the data over the next few months. So far we only have March figures for monthly cement output, for instance -- but the series has increased by an average of about 22 percent between March and May over the past decade. If that pattern plays out again, China will make almost as much cement this month as the U.S. has produced since 2013.

Crumbling Concrete

There's no guarantee that Beijing will ride to the rescue, of course. If anything, much of the latest rout in commodities prices has come from signs that the government has finally grown serious about reducing the mountain of debt that fueled the 2016 spending boom, as well as cutting overcapacity that's plagued industries from steel to coal to aluminum to oil refining. To date, there's been no hint that Zhongnanhai is about to reverse those policies for another round of pump-priming.

Still, those betting on no change to the downward momentum need to recognize the tightrope they're walking. If demand-side stimulus still works in China, investors need to explain why the Communist Party is going to stand by and let the economy crack up on the eve of its national congress. If it doesn't work and China has truly reached a 1970s moment in its economic development, a whole bunch of assets -- such as the S&P 500, which hit another record high Monday -- should be experiencing the pain being suffered in commodities markets.

Long Time Coming

China's debt problems are worrying, but in the short term the country's willingness to borrow should be giving commodity investors comfort, at least until the congress is over. These days, Beijing's wish for its state finances is similar to Saint Augustine's prayer: "Lord, make me pure -- but not yet."