The Big Surprise?

Posted by Michael Campbell

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MC horz cropped - 2013

MC horz cropped - 2013It’s been a given that China will grow. Everyone knows that. It’s got to grow to maintain social stability. The catch is that any seasoned investor gets suspicious of things that “everybody knows.”

Chinese demand for commodities has been key to Canada avoiding the economic slump that has gripped much of Europe and the US. Rising commodity prices have had a massive impact on government revenues, employment and general prosperity in many parts of Canada. But what if China is about to go into a more severe correction?

I’ve written and broadcast for several months that China’s domestic credit problems scare the heck out of me. Below you’ll find the conclusions by Barclay’s Bank that China’s economic engine is about to slow down and with it brings the promise of social unrest.

We’ve already seen the impact of slowing demand for commodities on stocks and economic growth in Canada. At the least this is a warning shot across the bow for investors to make sure they are not over exposed in terms of risk. – MC

Demand for Commodities Down

On China – Barclay’s concludes, “In the short run, such rebalancing and deleveraging point to further downside risks for both economic growth and asset prices, including the exchange rate. Based on an increasingly likely downside scenario, we think Chinese growth could experience a temporary ‘hard landing’, which we would define as quarterly growth dropping to 3% or below, within the next three years.

There is a problem with this: as most know, the social stability GDP cut off floor is around 5.5 – 6.5%: anything below that, or the minimum growth rate required to preserve social cohesion and stability, and the riots begin. 3% growth means widespread looting, and millions of angry Chinese roaming the streets, an outcome that the Politburo will stop at all costs.

The Contrary View – JP Morgan and Goldman Sachs are Bullish

Both JP Morgan and Goldman Sachs think that commodity stocks have fallen far enough. I wouldn’t classify either as outright bullish but both feel the decline in the sector is overdone and now may have upside potential.

Of course time will tell which side is right. My own take is that once again it comes down to the central banks. If China’s bank becomes more aggressive in the face of growing social discord then it can push the problem down the road and juice commodities on the shorter term.

Investor must first decide what level of exposure is appropriate in terms of risk and then act accordingly. It’s a lot easier to put a toe in the water if you are under invested given two contrary views but if you are already positioned then you don’t have the leeway in terms of risk to add.


JP Morgan has recommended an underweight position in commodities as an asset class since November, 2011, but now that view has changed. “We move to recommend a net long, overweight exposure for institutional investors (in commodities) for the first time in more than two years,” JP Morgan said.

“Like other global markets, commodity prices are buckling on rising concerns about China and the Federal Reserve. It is important to be specific about what these concerns are. The new fears are not that Chinese growth is slowing or that the US central bank will taper its QE3 asset purchases. Both are inevitable outcomes that have long been embedded in commodity forward curves.

The actual concerns are: (1) the large shadow banking sector in China might soon trigger an unexpected financial crisis, like the one that emerged in Asia in July of 1997, and (2) the FOMC might simultaneously be making a policy mistake in putting its own growth and inflation forecasts ahead of the markets’ fear about Chinese finance and the evidence that disinflation in the real economy is bulldozing inflation expectations in markets. These concerns are legitimate. A sturdily low-vol commodity regime has suddenly been asked to assign probabilities to these two scenarios. Neither is a zero probability. Nor is either likely a baseline outcome in 2013.”

“The last time we recommended moving to overweight was on September 30, 2010, or about a month ahead of the announcement of QE2 on November 3, 2010. In the nine months that followed (we turned neutral in June 2011), the S&P GSCI total return index produced a 16.5% total return against a 14.9% total return for global equities and a 2.5% total return for global bonds.”

“… metals prices have reached levels that are demonstrably forcing involuntary production cuts and fresh demand. Against one-sided sentiment and following 15 months of destocking, Chinese buyers are going to realize very soon this is the opportune moment to back up the truck and to restock supply channels where China is import dependent. A surge in Chinese buying of a metal at a lower price has already been observed in gold. We expect renewed vigor in imports of copper and oil. It is quite obvious what the Chinese should do here in physical markets, in pursuit of China’s long-run economic and social self-interest.”