On the surface, there are confusing signals by major commodities in 2014 as some have gone sharply up while others have done the opposite. The source for the disagreement is clearly rising geopolitical tensions that mask major commodity users’ economic deterioration.
Sooner or later, anyone close to the inner workings of the stock market learns a lot of sayings from the trenches. “Don’t fight the tape” and “the trend is your friend” pretty much say the same thing. “Don’t fight the Fed” is a bit more strategic, but a more obscure saw that bridges the wide gap between economics and the tape is “Dr. Copper is the only metal with a Ph.D. in economics.”
I have never met an economist that is a good short-term trader or a short-term trader that is interested in economics. I am sure they exist somewhere, but they are a rare breed. Still, economics and trading come together in the copper trading pits due to copper’s highly specific industrial uses that show copper demand to have a direct correlation with economic growth.
So far this month, trading in May copper futures resembles what a trader would call a “bear flag.” Copper became weak, breaking through major support at 3.15 and sold off hard in just three days to trade below 3.00 on the heels of weak Chinese economic data and the Crimean annexation. Since then, copper has been consolidating, chopping below 3.00 in a congestion resembling a flag. If you use colored candle or bar charts , the flag gets to have a red pole and colored banner.
It is interesting to overlap copper and oil on the same chart and note that in 2013, they have begun to notably diverge — strong oil price and weak copper — while in 2014, that divergence has accelerated . While China is the number one consumer of both copper and oil, here geopolitics play a major role for the outperformance of oil, and (Chinese) economics play a major role for the underperformance of copper.
Chinese industrial production has seen decelerating growth for three years. Industrial production in China increased 8.60% in February 2014 over the same month in the previous year. Still, industrial production in China has averaged 13.16% from 1990 until 2014. The swings in industrial production are not so large anymore due to the growth of the financial sector and the resulting smoothing-out effect from credit interpretation, but there is a decisive weakening trend .
Earlier in March we got the shocking news that Chinese exports for February fell 18% from a year earlier, following a 10.6% rise in January. Imports rose 10.1%, yielding a trade deficit of $23 billion instead of the projected trade surplus of $14.5 billion. That means you still have a stronger local economy outside of the manufacturing sector, but a definite sign of weakness emanating from abroad.
Still, combined exports in January and February fell 1.6% from the same period a year earlier vs. a 7.9% full-year rise in 2013. On a combined two-month basis used to smooth out a one-month gyration, we again see that imports rose 10% year-over-year in the first two months, compared with a 7.3% rise in 2013.
Any way you slice it, the decline in exports feels different than just a hiccup. It is proportionate in size to the decline Chinese exports saw in 2009 following the Lehman collapse and the resulting repercussions for global trade. The trouble is copper and other industrial commodities are not nearly as bombed out as they were at the time of the Lehman collapse, so there is room for quite a bit more weakness if indeed the Chinese economy is downshifting, and global trade is experiencing cyclical weakness.
Naturally, I would spend more time considering the pros and cons of copper producers like Southern Copper (NYSE:SCCO) and Freeport McMoran (NYSE:FCX) as well as mining conglomerates like Caterpillar (NYSE:CAT) . It does not matter that much they have sold forward as copper production and how many orders for mining equipment they have booked. Typically, valuations of such investments tend to get depressed on top of any possible hit to profits should the copper price continue to deteriorate due to weakness in global growth.
What does one do with Chinese stocks in this environment? Luckily (or not), the Chinese stock market has been divorced from economic growth for quite some time, where the benchmark indexes tend to have wide swings that many find difficult to understand.
For example, the size of Chinese GDP has more than doubled since the market hit its high in 2007, while major stock benchmarks have been cut by more than half in the same time frame. This is because economic growth in China is not run for profits but for the sake of “stability” and jobs.
The PBOC-engineered forced lending spree in 2009 in order to boost the economy is certainly beginning to haunt China in 2014. The Chinese economy is no longer growing on a savings-and-investment cycle, but a credit-growth cycle that is spinning out of control and producing less marginal GDP growth for every new yuan of credit. In many cases, this credit can only be obtained from the shadow banking system as banks simply would not extend such loans, which has resulted in an explosion in shadow banking activities . Such shadow lending — but this time at the corporate level in China — is beginning to resemble CDO financing for subprime real-estate buyers in the 2000s in the U.S. as their only choice of financing.
The legendary George Soros recently had some invaluable insights on debt-driven growth in China: “The Chinese leadership was right to give precedence to economic growth over structural reforms, because structural reforms, when combined with fiscal austerity, push economies into a deflationary tailspin. But there is an unresolved self-contradiction in China’s current policies: restarting the furnaces also reignites exponential debt growth, which cannot be sustained for much longer than a couple of years.”
It seems to me that market signals from copper, Chinese exports, and Chinese industrial production indicate that a reckoning is likely much closer than a couple of years. I think we will see it in 2014.
Written by Ivan Martchev for Market Watch, March 26, 2014.
Ivan Martchev is an investment specialist with institutional money manager Navellier and Associates. The opinions expressed are his own. Navellier and Associates holds a position in Caterpillar, Freeport-McMoran, and Southern Copper for some of its clients. This is neither a recommendation to buy nor sell the securities mentioned in this article. Investors should consult their financial adviser prior to making any decision to buy or sell the above mentioned securities.
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