Commodity market rout shows how Chinese growth determines prices

The recent global rout in commodity markets re-emphasised the relationship between Chinese growth and commodity prices.

It is a well-known fact that China is the largest importer and consumer of many commodities, but its commodity traders are also among the most leveraged.

The Chinese manufacturing boom started a couple of decades ago serving the needs of the western world for cheaper manufacturing.

But over the last decade much of its growth has been supported by the rise in domestic consumption driven by the vast middle-class on the back of rising incomes and asset prices.

Cheaper financing lured many investors into stocking commodities and rising cheap money to encash on the asset bubbles in real estate.

But the sub-prime crisis in the US followed by PIGS problem in Europe has slowed global consumption cycle leading to a fall in demand causing inventory pile-up.

At the same time, the rising real estate prices were curtailed by the Chinese central bank tightening funding norms and overall saturation in the market.

Now China faces three major problems: slowing global growth creating idle capacities, falling domestic incomes leading to dip in domestic demand which has lead the mighty dragon to lose its altitude of growth.

The economists’ community across the world is widely divided on whether it will be able to manage a soft landing or not.

Meanwhile, the commodity markets were hit by two major developments – the first one is the success of United States in its shale endeavours causing an oil glut and the second one is the strengthening dollar partly supported by growth in US and partly by the weakness of other currencies.

The dollar has risen by more than 20 per cent over the last 12 months causing the dollar-denominated commodities to remain under pressure.

Hit by tepid global growth, stronger dollar and a global glut, the prices for most of the commodities are trading at multi-year lows with very few exceptions.

Commodities such as copper and nickel, which were extensively used for rising cheaper finance and facilitate carry trade into higher returning assets like equities and real estate, have formed the core of speculative financing.

The recent interest rate cuts have made this trade non-lucrative as the financing charges have come down eroding the arbitrage opportunities.

The recent Chinese equity market crash has provided the much needed catalyst for a fresh round of sell-off in commodities driven by margin calls and selling of commodities in order to rise cash to finance the losses.

Added to this, the shale boom triggered an environment of a sustained weakness in crude oil prices as the supply side continues out weigh the demand on the back of shale oil companies and rising supplies from countries such as Libya and Iraq.

Further to this, if the talks of Iran with western powers end this week with any possible relaxation of sanctions the oil prices could see further selling pressure.

The cheaper crude makes mining and smelting costs lower which, in turn, lowers cost of production of many commodities.

On a fundamental basis, the commodity bear cycle doesn’t seem to turn the corner any time soon, but certainly the markets seem to have over reacted to the Chinese mishap in equities and have fairly discounted a potential interest rate hike by US Fed in the coming September meet.

The commodity prices may recover from the current panic sell-off in the coming weeks, but for the cycle to turn around we need to see more evidence of US growth and signs of recovery in Europe along with Japan.

Until then any recovery in commodities is seen a selling opportunity by traders.

The writer is Associate Director Head - Commodity & Currency, Motilal Oswal Commodities. Views are personal.

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