"It is a truth universally acknowledged, that a single man in possession of a good fortune must be in want of a wife." The opening sentence of Pride and Prejudice, by Jane Austen, is one of the most famous opening lines in British literature. It is justly famous precisely because we suspect that this so-called truth, as with so many others that are "universally acknowledged", is nothing of the sort. Even in 1813, Austen knew her audience would understand that consensus does not bestow veracity.
In 1999, for example, it was a truth universally acknowledged that, as the internet would irrevocably alter our lives, dotcom stocks could defy previous rules of value. Today, it is a truth universally acknowledged that voracious import demand from China is sucking in raw materials and is driving commodity prices through the roof in the process. As Philip Coggan writes in the FT: "China's economy is growing at 10% a year and its influence as a huge consumer of commodities, pushing prices substantially higher, is seen all over the world."
Take steel. China's demand for the metal has sky-rocketed. According to Asian data provider CEIC, net steel imports (total steel imports minus total steel exports) were not worth much more than $200m a month in the early part of 2000. Five years later and they had soared tenfold. This change hassent both Asian and global steel prices through the roof, and has kept producers all over the world running at full capacity.
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How the steel cycle works
When they're working at full capacity, steel companies make fantastic profits. The costs of running their huge plants are high, but as these are largely fixed, they have massive operational gearing: relatively small changes in the prices for finished steel have a huge impact on the bottom line. The other big swing factor for all basic commodity manufacturers is volume. Steel companies, for example, need to run their blast furnaces continuously. This makes it veryhard to deal with a slowing market - they can't trim back production, it'sall or nothing. The upshot is that in times of rampant demand (such aswe've seen in the last few years) they get the double benefit of running atfull volume and realising constantly higher prices. However, when demand falls the opposite is true.
China gets its own steel
China hasn't just spent the last five years sucking in basic commodities. She's also been importing the plant and the expertise necessary to build her own production facilities. The result? In early 2004 that new capacity started coming online: figures from CEIC show a dramatic leap in the value of steel exports from China from a fairly consistent ten-year range of $500m-$700m to nearer $2,500m - and all in the space of a few months. In the latter half of the year, steel imports also dropped as domestic supply began to satisfy domestic demand. China had suddenly become a net exporter of steel.
China as an exporter is not a new story. "China has overtaken Japan," says Kate Burgess in the FT, "as the world's third-largest exporter." The crucial issue is that, although, on balance, China is a net importer, the China story is an inflationary one for commodity prices. As products are drawn in from around the world, prices rise across the globe and so does the demand for quality. Last year, high-quality European steel product prices doubled. This is despite the fact that the demand for steel came mainly from China, half a world away, and was for low-end, construction steel.
What does this mean for prices?
The dynamics of all this will change as China's new capacity comes on stream. Global steel production rose an extraordinary 9% last year and is slated to increase a further 4.7% this year, and almost all of it is from China. In Europe, where the experienced have seen commodity booms come to grief on excessive capacity increases before, the mood is glum. Production is actually planned to be cut in Europe this year and last week, Lakshmi Mittal, owner of Mittal Steel, warned that second-quarter production and spot prices would be down, while raw material costs continued to rise. Mittal Steel fell 6.3% on the news. If, instead of buying up everyone's steel stocks, China starts to flood the Asian markets with her own steel exports, then prices will inevitably fall.
Rationalists and optimists alike will argue that only the low-end products that the Chinese foundries are producing will suffer price competition, and only in local Asian markets at that. But that is not the way these things work. There aren't two types of steel, high-end and low-end. There are hundreds of varying grades and shapes, and price moves, up or down, knock-on through all products like a contagion; a true domino effect. Besides, the plain truth is that the entire global boom in steel was caused by Chinese demand for almost exclusively fairly low-end steel, so why shouldn't the whole process go into reverse once that demand is taken away?
What next for the steel cycle?
Since the start of the year, Chinese imports again rebounded and, on the most recent numbers, China is back as a net importer of steel again, albeit at a vastly reduced level. However, there's another wave of new capacity coming on stream throughout the year, so this may be a partial relief. And the fact that the level of imports is already substantially reduced is reverberating through global markets. Consider the shipping industry. Prices for freight rates on Lloyd's List are plummeting. The benchmark Baltic Dry freight index, for example, dropped by nearly 20% in a week earlier this month. These indices can be volatile, but that's still serious. There's a case to be made for saying that the long bull market in shipping rates is over.
But what, you may ask, about all the raw materials the new Chinese plants are going to require to produce steel (iron ore and coking coal)? Surely they will need shipping in and that, along with China's new export trade, will compensate for any lost import flow? Well, yes and no. Firstly, the value of all of this cargo will be lower than the imports it's replacing, which alone will put downward pressure on freight rates. Secondly, raw materials' prices are largely set by contract. Even if demand, in volume terms, keeps rising, prices could come under pressure if final product prices are seen to be collapsing: we can't be certain that raw shipping prices and material prices can stay high even as steel prices fall.
The return of global deflation?
However, there is a bigger concern, one that goes to the heart of the medium-term future for the global economy. As China becomes a net exporter of more commodity products, will the whole balance of commodity pricing turn south? And if commodity prices do fall, will that usher in the deflationary environment that America's Fed has been so wary about for the last few years?
If commodity prices (on which "so many emerging markets rely", as Kate Burgess point out) do face a cyclical turnaround - as opposed to the once-in-a-lifetime huge secular boom many think is underway - then expect emerging markets to do the same. They always promise much, what with their dynamic growth rates, but they don't deliver. "Over the ten years to 1 March," writes Coggan, "the average global emerging markets unit trust returned 40.2%, less than money markets." The average UK equity fund return over that time? 113%.
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