Industrial commodities stand on a deflationary cliff edge
Written September 19, 2019
China’s quasi-capitalist system, where the communist party still retains a degree of control over the economy, leaves the true state of affairs subject to a certain amount of suspicion. Is the economic data accurate or is it just what they want us to see?
Which is why many investors rely heavily on proxies for Chinese activity to more accurately determine the state of play in their economy. Base metals widely used in construction and manufacturing, such as copper, steel and iron ore have well-deserved reputations as gauges of economic trends. They are also all freely traded on financial exchanges, where price discovery and transparency allow them to be used as a check against official statistics put out by the state.
With the exception of oil and gas, China is the world’s largest consumer of most commodities. According to data compiled by The Visual Capitalist’s Jeff Desjardins, China imports half or more of the world’s production of nickel, copper, and steel (as well as cement and coal), so any changes in behavior in China will have a meaningful impact on prices of those commodities. See https://bit.ly/2KPz9nZ.
Chinese growth has been steadily declining for the past year and a half. The latest GDP reading for the second quarter of 2019 at 6.2% was the weakest result in twenty-seven years. For experienced China watchers, 6% has long been considered something of a line in the sand as a minimum level of growth required to keep a sufficient number of people employed and to avoid any dissent against the government from taking root. Two events this past week suggest that point may soon be at hand.
Underscoring the urgency of the situation, Chinese premier Li Keqiang admitted that it is becoming “very difficult” for China to maintain that crucial 6% growth rate. See https://reut.rs/2lTmjvV. He must have been tipped off because just 24 hours later it was revealed that in August China’s industrial output fell to a rate of only 4.4%, its weakest showing in 17 years. And that was before the latest round of trade tariffs were imposed. See https://bit.ly/2lVzL2g.
Not surprisingly, this slowing in growth is weighing on prices in the base metals sector as well as across the commodities complex in general. One look at a chart of either copper or the broader CRB index shows that like the Chinese economy, commodities are approaching cliff edges of their own (see below).
Legendary trader Raoul Pal calls the current price pattern of the CRB index the most dangerous chart in the world, worrying that a break lower would be a sign of complete deflationary breakdown. China might be the center of this storm but it will have global implications for consumers and policymakers alike. A dire prediction for sure. As forward-looking indicators of this possibility, investors ignore the action in the base metal sector at their peril.