Where to Next for Commodities?

Good Evening: U.S. stocks took a bit of a breather today after seeing little to dislike in Friday’s nonfarm payrolls report. The slight trimming to Friday’s gains came on light volume, and then only after another series of afternoon upticks. The weakest performers on Monday (and, actually, for much of the past week) were the economically sensitive names like materials and industrials. If the green shoots are indeed sprouting into something more substantial right before our very eyes, then why are these companies underperforming? As has so often been the case in recent years, the answer may lie with potential policy changes in China.

Friday’s employment figures were indeed better than had been expected, even as the U.S. lost more than another quarter million jobs in July. -274K didn’t beat the “whisper number” estimates for -250K or less, but it did beat the average prognostication, and the revisions were positive to boot. The unemployment rate actually dropped (though mostly a statistical quirk), the work week expanded, and average hourly earnings rose. Losing fewer jobs isn’t exactly the stuff that makes for economic growth, but it was a solid report for this point in the cycle. Stocks went out at their best levels of the year on Friday, despite some late profit taking as investors headed out to the beach.

Wall Street’s celebration spilled over into Asian trading overnight, but not so with Europe this morning. U.S. stocks thus opened a 0.5% lower on Monday before clawing back most of those losses within 90 minutes. Risk aversion made a small comeback in the early afternoon, though, as stocks weakened while Treasurys and the dollar rallied. The S&P gave back almost 1% and tested the 1000 level, but, holding firm at this millennial mark, the S&P and the other averages then rallied into the close. The final tally left the indexes down between 0.1% (Russell 2000) and 1% (Dow Transports). Treasurys found buyers ahead of this week’s large refunding, and yields fell 6 to 8 bps in the process. The greenback added 0.3% to Friday’s strong showing, and most commodities finished mixed. With only the precious metals sporting noteworthy declines (gold and silver were off 1.5% and 2% respectively), the CRB index still managed to finish unchanged on Monday.

On a day with little news flow and even less volume, it is tempting for a writer to ascribe “signal” to what is mostly just noise. I will take that risk tonight by wondering what lies in store for commodities and their associated equities. Those of us domiciled here in the U.S. tend to view global economic activity through an American-centric lens. But when it comes to commodities, the most important marginal buyers are in Asia. We all know the 40% of one ton gorilla is China when it comes to raw materials, so in thinking where commodities might be headed, we have to look at what the Cadres in that country might be up to before registering any potentially useful guesses.

Easily distracted readers will want to skip to the final paragraph, but some history probably is in order. Since no matter how capitalistic many individuals and businesses have endeavored to become in the decades since China began to open up, it is important to remember that China is still a centrally planned, command economy (with emphasis on the second to last word). As its needs for grain, oil, copper, and other consumables rose during the ’70’s, ’80’s, and 90’s, it fell to the functionaries in Beijing to direct the buying. It seemed that whenever the sharpies in the global commodities markets had China’s buying patterns figured out, the purchasing commanders in that nation found a way to game the system that tried to game them.

Suddenly plentiful grain harvests would be announced, or new coal mines in the interior would be found, and the resulting price drops in various commodities could be brutal when China supposedly didn’t need as much as had been forecast. In the run up to the 2008 Olympic games, for example, commodity longs came to count on Chinese demand for just about anything that could be grown, drilled, or dug from the ground. Once the Olympics went off without a hitch, Chinese demand just stopped — cold. Tanker shipping rates collapsed and commodity prices were decimated in the wake of the Chinese demand drought. The credit crisis in most Western nations then exacerbated the problem.

Upon seeing the prices of raw materials fall between 50% and 80%, China announced a stimulus package over the winter and went on a restocking binge. Even when global equities hit bottom in March, global commodity prices never again reached their 2008 lows. China, courtesy of the generous bank lending instigated by the powers that be, was back. The Fed and other central banks may have lent an unwitting hand to China’s commodity appetite in the first half of 2009 with their wanton efforts to reflate. After all, commodities are real goods priced in nominal dollars, so what better way for China to hedge against Western monetary debasement than to stock up while prices were at WalMart levels? So strong was the demand for commodities during the opening two quarters of 2009 that green shoots were sighted, shipping rates shot up, and commentators openly worried about a bubble in China (see below). Andy Xie, Morgan Stanley’s former expert on China, is bearish; others, including Templeton’s Mark Mobius, are cautious but don’t see a bubble (see below).

Fast forward to today, and worries about Chinese demand have resurfaced. Shipping rates have started to fall again, and commodity prices are just now starting to wobble. Whether they fall may depend on what happens to Chinese economic activity, which, in turn, depends upon what the mandarins have decided to do about reining in bank lending. If lending is in fact set to drop, then commodity prices will likely again feel the effects of gravity.

But take a look at the Rio Tinto story before jumping to the conclusion that Chinese demand will soon be back in hibernation. Iron ore rates are up for renegotiation, and Rio Tinto is a primary supplier to Beijing. So what shall we make of the arrest of Rio Tinto employees? Is industrial espionage truly at work, or is China hoping for Rio, BHP, and the others to cry “Uncle” once again on pricing? The rumors of a drop in Chinese bank lending support China’s negotiating stance, too, so the stories may not be just a coincidence.

Like everyone else outside the Forbidden City, though, I really have no idea what China is up to these days. The evidence can be interpreted in whichever way a commodity bull or bear would like. I do know this, however. The FOMC is unlikely to do anything more than just talk about exit strategies when it meets this week. Promises, as opposed to action, will probably continue well into next year, too. Chairman Bernanke will do everything in his power to avoid having a “D” (for deflation) show up on his report card. So rather than deciphering the inscrutable maneuverings in China, all we have to remember is that the Fed looks set to keep right on printing fresh greenbacks. Over any short period, commodities can literally go anywhere, just as they both skyrocketed and crashed during calendar 2008. Long term, however, they will be moving higher. Not even China’s best gamesmanship can prevent it.

— Jack McHugh

U.S. Stocks Fall on Valuations; 3M, Eli Lilly, Best Buy Drop
China to Cut Loans as Stocks ‘Bubble’ Grows, Xie Says
China Rally Will Last, No ‘Bubble’ Seen, Harvest Says
Templeton’s Mobius Says Stocks Face 30% ‘Correction’
Baltic Dry Index Has Worst Week Since October as Demand Slows
Rio Tinto Accuser Says Article Was His Own Opinion

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