Commodities: Puffed-out dragon?
China’s slowing economy - and its longer-term transition away from investment-led growth - is raising questions about ongoing demand for commodities. But Martin Steward suggests that it’s too early to call time on the ‘supercycle’
With the euro-zone in chaos and the US recovery sputtering, it was the last thing anyone needed. China reported a precipitous drop in annual GDP growth, from 8.9% in Q4 2011 to 8.1% in Q1 2012. And it could get worse.
“What we see on the ground at company level is not as high as that 8.1% suggests,” says Frank Yao, senior portfolio manager in Greater China equities at Neuberger Berman. “We hear company owners saying that this is similar to, or even worse than, 2008-09.”
May saw the seventh month of contraction in the HSBC China Manufacturing Purchasing Managers index. Growth in fixed-asset investment was uninspiring, and railways and highways were particularly weak as projects from the 2008-09 stimulus wound up. Manufacturing and railways consume a lot of raw materials. China takes almost 50% of the world’s cement and iron ore and 40% of its steel, lead and copper.
When its economy slows, demand suffers: Q4 was a horror story for China’s cement, aluminium and building materials companies; coal and steel inventories are expanding; importers are deferring deliveries of iron ore and thermal coal. And fears emerged that this cyclical dip could turn secular as China manages the transition from an economy driven by investment in its capital stock, to one driven by manufacturing and consumption.
“We remain concerned about the sustainability of 7% growth later this decade,” says Ole Hansen, senior commodity strategist at Saxo Bank. “We expect a transition towards a more Western-style economy with GDP growth possibly decelerating all the way to the 3-5% range typically associated with Western economies.”
Of course, 5% of China’s GDP growth was worth $67bn back in 2001. Today it is worth $370bn. The same applies to commodity demand. Deutsche Bank estimates China’s copper demand will grow 5-6% per year until it hits peak use in 2025, about half the rate clocked up between 2000 and 2010, but that represents an extra 10m tonnes of metal - two-thirds more, in absolute terms, than during the fast-growth period.
As Neil Gregson, portfolio manager in global natural resources at JPMorgan Asset Management points out, growth numbers miss the bigger story of China going from consuming 10% of those commodities to 50% over that same period: “Slower growth is still significant growth.” And Nathalie Han, co-manager of Craton Capital Management’s Global Resources fund, adds that those numbers don’t even factor in resource depletion and the rising cost of labour: “That provides a strong underpinning for prices.”
Which brings us to the supply side. Some voice concern that the extractive industries invested heavily as China took off and that the resulting projects are coming on-line just as the dragon is running out of puff. Others, like Gregson, point to the low margins for aluminium and nickel producers and argue that, while the low-ball price assumptions that feed into project planning can keep old supply coming in the face of falling demand, they also crimp spending on new supply.
“The consensus long-run view on copper is about $2.50/lb,” he says. “If today’s price of $3.50/lb was taken as the long-run projection a lot of five-to-seven-year projects would be brought online - but we’re not in that position and that additional supply is not being brought on.”
Further complicating the issue is the potential firepower of China’s authorities. There is consensus that the Q1 numbers came as a shock and will be met with a response. Jonathan Blake, head of global energy and materials at Baring Asset Management, notes that Q1 spending on infrastructure was “nowhere near” enough to meet targets and that once policy loosens, that spending will pick up again. “The story is not over, and Q1 is not necessarily a true picture, even for the rest of this year,” he says.
The People’s Bank of China (PBOC) set out its stall immediately, cutting banks’ reserve requirement ratio (RRR) by 0.5%; on 7 June markets were jolted by unexpected 0.25% cuts to the benchmark short rate, and took it as a clear signal that Communist Party leadership is now focused on growth.
China also has fiscal flexibility, but despite Wen Jiabao’s recent pro-growth rhetoric few expect anything like the €500bn 2008-09 stimulus. That made an already inefficient economy worse: the IMF reckons that China needed $5 of investment to generate every $1 of GDP growth since 2001, 40% more than Japan or South Korea in their growth periods. That’s a big problem when investment has gone from 35% of GDP to 50%.
More pertinently, the stimulus led to a great deal of capital misallocation, particularly in residential property, that now sits with banks as depreciating assets. Even if the government wanted to, pushing money into capital stock would be tricky as long as the intermediaries hold those depreciating assets; despite the cut in the RRR, bank lending is sluggish.
“We expect a significant credit loosening event in Q4,” says Jason Lejonvarn, commodities strategist at Hermes Fund Management. “Will that be in the form of more infrastructure, more credit for smaller businesses, more focus on third-tier cities? The banks are still suffering from the last round of stimulus; if there’s another round, are they going to want another piece of it? The key for China is to build stuff like cars and white goods that someone is going to use - otherwise it just sits there depreciating.”
China can’t do 2009 again, agrees Adam Wolfe, senior economist for Asia at Roubini Gobal Economics (RGE). “This round of stimulus is more about smoothing out this cycle by bringing forward some projects, rather than raising the overall level investment or abandoning the transition to a more consumption-driven model.”
Sure enough, while important measures are aimed at by-passing banks (such as opening up railway investment to other private capital), current fiscal policy focuses on pro-consumption initiatives - cutting household taxes and subsidising purchases of energy-efficient white goods and cars, for instance. Officialdom is clearly becoming less worried about Chinese savers balking at the negative real deposit rates that subsidised the investment boom.
“People talk of China as a triumph of cheap labour, but in fact it’s a triumph of cheap capital,” says Ewen Cameron Watt, chief investment strategist at the BlackRock Investment Institute.
Steel plants, aluminium smelters, highways, railways and shopping malls get green lights despite low profitability, thanks to the even lower cost of savers’ capital, but also thanks to the fact that local authorities each had their own 8% growth target to meet: a copper smelter does not have to make money when you are booking revenues linked to sky-high copper prices as output. China’s investment ecosystem - in which projects generating monopoly rents for state-owned property, materials and energy enterprises are financed by land sales which see proceeds leak into the pockets of local mandarins - fed the boom, too.
“To shift to consumption, China needs to raise that cost of capital, to take financing to a more market-led system,” says Wolfe at RGE. “That will bankrupt a lot of the companies that have been involved in the investment boom.”
Clearly there are powerful interests resisting this. “Provincial leaders are extremely powerful voices in the Communist Party,” says Wolfe. “It would be tricky to engineer this transition from a pure economics point of view - add the politics and it’s even messier.”
But the tectonic plates are shifting even here. The bizarre headlines around anti-reformist Bo Xilai are the most visible sign, but just as important are Wen’s recent statements about “smashing” bank monopolies and his Deng-like pilgrimage to private-sector boomtown Wenzhou.
“The irony is that Bo Xilai seems to have united two separate wings of the Communist Party around a [pro-reform] consensus,” says Philip Ehrmann, who runs Jupiter Asset Management’s China fund. Cameron Watt agrees that the incident settled “the battle between the technocrats and the princelings”.
Raising the cost of capital for infrastructure and materials businesses would not seem supportive of commodity demand. But again, this picture is not black-and-white. Wealthier consumers put demand on commodities just as construction does - the process is a transition from cement and steel to copper, aluminium, precious metals and grains (see boxes). But that transition will be gradual and must consider interests beyond those of grafting local politicians. Consumers need jobs, so suddenly removing subsidies from industries that still provide a lot of employment would be counter-productive.
“The core processing industries are not necessarily near the manufacturing hubs or the new utility and power infrastructure, so you not only have to deal with migration between industries, but also geographical migration,” says Blake at Barings. “The process will take longer than some think.”
It isn’t growth that motivates Chinese policy-making so much as employment, living standards and social stability, agrees Cameron Watt. Both say that years will pass before we see substantial consolidation in industries like steel production - witness the bloated inventories and the cheap capital that China is taking to Africa, Canada and elsewhere to secure iron ore, copper, bauxite and coking coal inputs for these industries.
Still, while efforts to shut down the smallest (and most polluting) facilities have hit a wall in the past, softening demand is creating some natural wastage. “I used to serve as a member of the financial market expert group for the PBOC, and at our monthly meetings the one thing on everyone’s mind was social stability,” says Yao at Neuberger Berman. “But with demand slowing down, a lot of smaller mills have had to shut down anyway, and some of this capacity might be lost permanently.”
State-owned enterprises accounted for 58% of employment in China in 1998, notes Ehrmann, and today they account for 19%: “China has managed this kind of transition before and I think they will manage it again.” Stephan Wrobel, CEO at Diapason Commodities Management, agrees: “In any economic transition, you see a shift in the workforce from areas of over-capacity to under-capacity. That will happen, it’s just a natural process.”
George Cheveley, base metals sector specialist at Investec Asset Management, reckons that a solid base of Chinese production can make the case for relatively high iron ore prices for the next five years. “But if a company is talking about a great deposit which won’t be developed for five to 10 years, you might be more cautious,” he warns.
Not that this signals the end of industrial commodities. The ‘natural process’ that Wrobel describes is the transition from infrastructure-led processing twinned with low-value, developed market-led manufactures towards high-value, emerging market-led manufactures as a foundation for higher consumption. As processed commodities hit capacity limits at home, China is finding ways to export them.
“China’s economy has clearly been investment-led,” as Cheveley puts it. “But it’s a bit of a myth that it has also been exports-led. Of the 8-10% growth of recent years only one point has been attributable to the net added value of exports.”
That is changing as the share of consumer goods in China’s exports gives way to more industrial and capital goods - and materials like steel - for other countries building infrastructure. Chinese construction machinery exports grew at a compound annual rate of 40% from 2000 to 2010, according to China research specialists GK Dragonomics.
This is also why the capital stock investment that is being made is about re-tooling for efficiency gains. This includes such things as work on two Baosteel facilities brought forward as part of the new stimulus, but is exemplified in the development of China’s power generation and transmission. “There is a need to move to cleaner energy sources, but to do that China will have to change its entire infrastructure,” says Wrobel.
That could be positive for cement and steel, but whichever energy source comes out on top, it is almost certain to require substantial copper. Against this demand story, on the supply side China’s company-level copper investments have not always been successful, extraction projects of meaningful size with decent grades are few and far between, and a resurgence of resource nationalism is making access more challenging. “China has a pool of capital to deploy, but the timescales we are talking about should not be under-estimated,” says Blake.
If improved transmission of power is a crucial part of China’s economic transition, transmission of people (and goods) is just as crucial. One should not be fooled by the precipitous 42% year-on-year decline in railway investment seen in Q1 2012. The Wenzhou high-speed rail collision of July 2011, together with a high-profile corruption scandal, has put a dampener on things - but as there are no alternatives to rail, things are stirring again. Yao notes that, after falling from CNY1trn (€1.2bn) to CNY400bn last year, the talk is now of investment returning to CNY1trn again this year. High-speed lines are very steel-intensive and require cement for elevation.
Just as headlines about rail accidents can distract us from the big picture, so can headlines about real estate bubbles. Completions grew 39% year-on-year in Q1 - a legacy of the 2008-09 stimulus - and starts growth has been flat-to-negative over Q4 2011 and Q1 2012. Lejonvarn reports that Hermes’ head of emerging markets recently returned from China having seen evidence of unfinished or unoccupied buildings.
But the tide might be turning here, too; GK Dragonomics notes some easing in housing inventories and a significant fall in completions in April, which should clear the way for new projects this year. Moreover, while higher-end residential needs to correct, social housing will certainly constitute an important element of China’s current fiscal stimulus as urbanisation continues.
China is about 50% urbanised today and the aim is to reach 70% within 20 years. There is a big difference between coastal regions (55% urbanised) and central and western regions (40-45%). Coastal highway, airport and railway densities are double or triple those of the interior. There are a lot of Chongqings waiting to be raised - and this can get missed in headline figures or trips to coastal mega-cities.
“Shanghai’s year-on-year fixed-asset investment growth in Q1 was negative for the first time in 32 years,” says Yao. “Heavy industry, as a proportion of its GDP, has fallen from close to 50% to 20-25%. But for the western and central regions the story is completely different.” Ehrmann concurs. “It can be frustrating to read stories knocking China informed by people who never really go beyond Shanghai and Beijing,” he says. “China is still 20 years away from Japan-style roads to nowhere.”
China’s per-capita steel consumption, at 450kg, could still grow 50% before matching Japan’s. And even as it peaks, the US consumed at those 600-700kg levels for 45 years.
“Per-capita consumption of commodities in the highly-populous, urbanising, growing economies like India, Indonesia and China is actually quite low - not just in relation to the developed world but also in relation to the rest of the emerging world,” says Philip Poole, global head of macro & investment strategy at HSBC Global Asset Management. “China has an awful lot more to build, in my opinion, and that will continue to have a considerable impact on demand for infrastructure-related commodities.”
The most important thing to note is that the sources of that demand - social housing, railways, power infrastructure, industrial manufactures - are all necessities in the journey towards a consumption-led economy, not impediments to it. Significant demand for these materials will overlap with growing demand for ‘later stage’ commodities.
That, in itself, represents a strong case for materials. But the macroeconomic implications of all this are considerable, too. For a generation, China has had an inflationary effect on raw materials, offset by its disinflationary effect on labour and goods. Today, some Chinese see wages rising 30% a year. A spike in petroleum prices that causes genuine pain to Western consumers suffering negative real wage growth will barely be noticed by Chinese competitors spending their yuan. They will continue to exert upward pressure on commodity prices while adding it on labour and goods, and the global inflation regime could be transformed. Many have seized upon the slowing Chinese economy as evidence that the commodities ‘supercycle’ is over. Don’t count on it - especially if you’re investing euros, sterling or dollars.