China and Commodities - The End of the Beginning

I suspect the market is wrong about China, and wrong about its likely appetite for industrial commodities in the coming year - most likely the bottom has already been and gone.

To start with two things which should be obvious: the Caixin manufacturing PMI for August, which apparently managed to panic markets when it fell by 1.7pts to 47.1, is produced by Markit.  China’s industrial data is insufficiently consistent to allow the tests, but where one can measure - Europe, UK and the US - there not the slightest scintilla of meaningful correlation between movements in Markit’s PMIs and movements in industrial output. I do not doubt these indexes power to move markets, but their information content is right up there with astrology: they are not even wrong.

The second thing which I think is obvious is that China’s willingness to devalue the Rmb is a correction of a quite serious monetary policy mistake made last year, and was a necessary precondition to re-liquefying the economy. There are clear signs that PBOC is now grasping the opportunity, adding 150bn yuan in open market interventions this week, the largest since Chinese New Year’s temporary 205bn yuan injection, and compared with the average weekly rise of just 6bn yuan during the last three months.  On top of that, the week has seen PBOC extend 110bn yuan in medium-term loans to 14 financial institutions, and also pump $48bn into China Development Bank and US$45bn into China Exim Bank.

China has finally granted itself the conditions under which it can reflate the economy, and it looks like the central bank is finally making an attempt.  If it succeeds, then the track record suggests that eased monetary conditions will be able to restore momentum in both the industrial sector and in domestic demand.

If so, this is the end of the beginning of China’s cycle, rather than the beginning of the end.

In which case, the current panic in commodity markets looks misplaced, since Chinese demand for industrial commodities is more likely to stabilize and/or rise during the coming year than to disappear.  In fact, that trajectory may already be emerging in the relevant data, such as  imports and inventories. 

The place to start is with the volume of China’s imports of industrial commodities. For those commodities which are no longer growing, imports topped out early in 2014, since when they have been either stagnant or falling. But by July, that peak is beginning to pass out of the base of comparison, with the result that yoy falls are beginning to moderate and will continue to do so, even if the recent signs of modest growth disappear.  In July, imports of four out of the six major industrial commodities showed a yoy rise in volume terms.  

1. Crude Oil: up 29.3% yoy, and up 10.4% ytd
2. Refined products: up 28.5% in July, and up 0.9% ytd
3. Iron ore: up 4.3% yoy in July, and down 0.1% ytd 
4. Copper: up 2.9% yoy in July, and down 9.4% ytd
5. Coal:  down 7.7% yoy in July, and down 34.1% ytd
6. Steel Products: down 13.9% yoy and down 8.9% ytd

We can also get some clues from Australia’s trade patterns: during June exports to China rose 3.4% yoy, although in the year to June exports to China were down 17.7% ytd. Now, looking at commodities: in A$ value terms: 

1. Iron ore down 10.9% yoy in June and down 32.1% ytd
2. Coal: up 13.7% yoy in June and up 1.7% ytd
3. Copper: down 21.4% yoy in June and down 24.2% ytd

The message is similar: although the market is soft, the later data suggests things are moderating, not getting worse.

There’s more to this moderation than simply a base of comparison effect. In addition, the inadvertent tightening of monetary conditions during 2H14 and early 2015 squeezed working capital hard enough to make China’s companies in turn squeeze their supply chains (hence the toll on Northeast Asian suppliers) and cut inventory holdings. There are a variety of measures of China’s inventories, but most agree that commodities inventories have fallen, quite sharply. Of the three separate measures of iron ore inventories, two find them down 26.8% yoy in July, and one finds them down 29.5%. Rebar inventories are down 3.4% yoy, and hot rolled coil inventories are down 8.2%. Coal inventories at China’s ports are also down 10.9%.

It is more difficult to construct wider inventory totals, but producer goods seem to have been falling steadily and consistently since 2008. That fall has moderated significantly over the last year, but still, by June, inventories of producer goods were down 7.5% yoy.  It is even more difficult to reconstruct an inventory series for durable goods generally, but my attempt suggests inventories of durable goods peaked in September 2014, have fallen 18% since then and were down 0.3%yoy in June.

This combination of falling import demand and falling inventory holdings of industrial commodities is consistent with what one would expect after a prolonged period of unusual monetary discipline. What would be consistent with a relaxation of that discipline would be, at the least, a willingness to stabilize inventory holdings, which with even steady underlying domestic demand, would result in a resumption of rising demand for industrial commodities. 

Which is perhaps what is also signalled by freight rates. The Baltic Dry index ended July at 1,131, up 50% yoy, and slightly more than double the Feb 2015 low.  Since the end of July, it has dropped to 1,014: the average price since 2011 is 1128, and the current price is 0.3SDs below that average.  Interpretation? The index was anticipating some pick-up in demand, and still is, although it now has slight doubts. Perhaps it too places its faith in Markit’s PMIs.