Don't be tempted to dive into commodities just yet

published 13 October 2014

141013-commodities — Commodities: the moment of truth

Millions of Chinese people are planning to leave China. Why? Where are they going? What do they plan to do? The FT is running a series exploring this (Silk Road Redux). Run your eye down the list of nationalities taking advantage of Europe's 'golden visa' schemes and you will find that the majority of those buying property to apply for residency are Chinese 81% so far in Portugal's scheme.

That might be just about the nice weather in Lisbon, the semi-democracy offered by the EU, and the lower levels of air pollution in the West. But it might also be to do with the fact that China's economy isn't quite what it was.

There have been dire warnings for some time on the nasty ending awaiting what some call 'the Chinese growth miracle' and others call 'the Chinese credit bubble'. But it is now hard for even the most optimistic observer to escape the evidence of a sharp slowdown.

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The China Beige Book, a quarterly analysis modelled on the Federal Reserve's commentary on US economic conditions, aims to get to the bottom of what is happening in China.

It ignores the official data in favour of tracking the fortunes of thousands of companies across the economy. The results from the second quarter of this year made for miserable reading. They showed slowing growth across the board and exceptionally weak capital expenditure(capex) "not one sector showing quarter on quarter improvement".

Given that growth in the Chinese economy has for years been driven by an addiction to over-investment, this weakness has pretty sweeping effects: the "withdrawal symptoms will not be pretty", it says.

The just-released Beige Book for the third quarter doesn't give much room for hope either. Capexgrowth fell again with the "share of firms both applying for and receiving loans stuck at rock bottom levels".

This is not exactly surprising. But it is useful information for those of us who, like me, have been wondering about piling into the commodities that have collapsed in price on the back of falling global demand. It tells us that we might be a bit early.

This brings me on to something boring but important: 'collateral trade' in China. This sounds complicated, and it is. At a financial industry dinner earlier in the week, I asked every person I spoke to if they could explain it. No one could. They might soon wish they had paid more attention.

A paper from chemicals consultancy International eChem gives a good overview of how it works. There are various mind-boggling schemes in use, but the key point is that the trades involve commodities of all types (metals in the past and, more recently, chemicals) being shipped to China and used as collateral via the shadow banking system to finance other investments offering higher returns in particular, property. They have been one of the key drivers of credit creation.

Investors in commodities might have believed that everything imported into China was used for something productive. But Paul Hodges of International eChem says many of the imports have just been stockpiled for financial engineering. Some estimates suggest that 100 million tonnes of iron ore is tied up in finance deals.

That was fine when China was growing fast who cares about the complications when everyone's making money? But with the property bubble deflating, it matters now. Not only can deals fail as property prices and liquidity fall off, but the government has announced it has found some $10bn of fraud in trade finance, and has ordered a tightening of systems.

This, says Hodges, suggests the "moment of truth" for commodities may be near. Falling capital expenditure means that China doesn't need natural resources like it used to, and the "vast stockpiles" it was only ever going to use as financing instruments "may soon be released back on to the open market" too. The unwinding won't be pretty.

Still, if you are a typical modern stockmarket investor, all this talk of moments of truth and the like won't bother you at all. You will simply assume that bad news is good news, and that slow growth, or some kind of financing meltdown, will mean more monetary stimulus from the Chinese authorities, who have form when it comes to credit creation.

That might not be the correct assumption this time around. Not only have the authorities made it fairly clear they aren't planning major stimulus, but the Beige Book for the third quarter also makes the point that there isn't really any excuse for stimulus.

The labour market is fine and wage inflation has eased, "allowing profit margins to grow at the healthiest pace in more than a year". China might be having a nasty secular slowdown, but the employment situation isn't bad enough for the authorities to give global investors the flood of money they would like.

It is also clear that more stimulus in China won't do much for the real economy. For years, the Chinese government has force fed mining and the manufacturing industries on a rich diet of cheap capital.

Excess capacity of 40 to 50% in just about everything is the norm, says Anne Stevenson Yang of J Capital. So, stimulus to these industries "cannot create demand-driven growth". The authors of the Beige Report agree. Supply is there, but as is always the case when bubbles end, demand is not so there is no point in offering more supply.

The clear message from all of this is that we should continue to steer clear of assets that rely on Chinese economic growth, and in particular investment growth, for their success.

This doesn't necessarily include all Chinese equities. However, it does include most commodities. It also includes pretty much anything in Australia which is very reliant on mining and, among other things, the multiple booms in high-end property markets worldwide.

If there isn't as much money to come out of China as there once was, new expats may well head for low-budget Lisbon rather than costly Kensington.

This article was first published in the Financial Times.

Merryn Somerset Webb started her career in Tokyo at public broadcaster NHK before becoming a Japanese equity broker at what was then Warburgs. She went on to work at SBC and UBS without moving from her desk in Kamiyacho (it was the age of mergers).

After five years in Japan she returned to work in the UK at Paribas. This soon became BNP Paribas. Again, no desk move was required. On leaving the City, Merryn helped The Week magazine with its City pages before becoming the launch editor of MoneyWeek in 2000 and taking on columns first in the Sunday Times and then in 2009 in the Financial Times

Twenty years on, MoneyWeek is the best-selling financial magazine in the UK. Merryn was its Editor in Chief until 2022. She is now a senior columnist at Bloomberg and host of the Merryn Talks Money podcast - but still writes for Moneyweek monthly.

Merryn is also is a non executive director of two investment trusts – BlackRock Throgmorton, and the Murray Income Investment Trust.