Commodity bubble turns manure pile

Truly, global markets do not understand commodity cycles. Some of this is folks talking their books. Some of it is pure ignorance. What we can say for sure is that as the commodities bubble pops, the leftover space is being filled with balderdash.

All areas of the commodity market are being covered in rhetorical manure, starting with China, according to Bloomberg:

  • Chinese growth has decoupled from credit.
  • Even in the property sector because more credit is going to more efficient SMEs.
  • Services share of growth is rising, needing less credit to generate growth.

“The impact of credit growth on China’s growth cycle has faded in recent years as construction, the most credit intensive sector, is no longer the key source of demand drive,” said Li Cui, chief economist at China Construction Bank International.

“The decline in credit intensity means Chinese commodity demand will change in its mix. Those related to construction, such as steel, will grow modestly but those related to manufacturing upgrading and green economy, such as copper, are still strong,” she added.

China’s developers now rely more in pre-sales than debt.

“The impact of credit growth on China’s growth cycle has faded in recent years as construction, the most credit intensive sector, is no longer the key source of demand drive,” said Li Cui, chief economist at China Construction Bank International.

“The decline in credit intensity means Chinese commodity demand will change in its mix. Those related to construction, such as steel, will grow modestly but those related to manufacturing upgrading and green economy, such as copper, are still strong,” she added.

This is all true as far as it goes. But the sum is greater than the parts. Chinese commodity consumption is still completely and utterly dominated by construction. The latest figures from Bloomie have upgraded the steel intensity of Chinese construction to nearly three-quarters of total demand:

It is less so for copper but it is a difference of degree not kind.

The current round of Chinese deleveraging is directly hitting the pipeline for this demand. As I have noted many times, construction sector regulation has dropped floor areas starts by 7% versus 2019 over the first five months of 2021. It’s still up slightly over 2020 owing to COVID-related drop early in the year but the crossover point to falls year-to-date is nearly here:

As well, local government debt has only fulfilled 26% of its borrowing quota for 2021, down very heavily from 2020.

If we conservatively calibrate these falls into construction activity at 3% of steel output over the next year then we get a drop in demand for iron ore of 40mt. Copper will be less but still material.

And that may be only the beginning. The one thing that is true about Chinese growth is that authorities are pulling various levers to increase output in less commodity-intensive segments. They are having some success, and this affords them the scope to drive old economy reforms further for longer. So we may see sequential years of falling construction. In the past, this has always led to panic and more credit, and it probably will again once old economy growth slows too far. But we are not there yet by some distance.

Another Bloomie piece today tills more manure:

China’s campaign to beat down commodity prices can’t celebrate yet.

“Intervention can help alleviate the pressure but it’s hard to change the trend,” said Hao Hong, head of research and chief strategist at Bocom International. “Commodity inflation is driven by global demand growth, rather than by China. China is only a price taker.”

For clues on what comes next, it’s useful to look at individual markets. Here’s a run through of some of China’s major commodities markets, and where they stand two months into an anti-inflation drive.

Similar arguments come from a new Goldman note go all-in on dung:

Physical markets don’t respond to talk. The bullish commodity thesis is neither about inflation risks nor Fed forward guidance. It is about scarcity and strong physical demand. The only thing that can fight real physical inflation is rate hikes, not talk of rate hikes. As we have emphasized in the past, commodities and the physical markets that make up the CPI are ‘spot’ assets that are mostly void of expectations and are determined by today’s supply and demand where the talk of potential rate hikes two years from now is entirely immaterial, particularly when such talk drives down the far more material 10-year yield. In addition, the Fed made it clear that they would continue to purchase bonds at an unprecedented rate and talked about tapering towards the end of this year. This means they would just be buying bonds at a slightly slower rate.

The bottom line is we once again see this talk, like the China talk several weeks ago, as a buying opportunity. However, as transient shocks from weather and Chinese-mandated repositioning have generated negative technical breakthroughs in the ex-Energy commodity space, we see the recovery from this latest dip taking longer than the other recent bouts of selling pressure.

Financial markets do respond to talk. In contrast, financial markets are ‘anticipatory’ assets and almost entirely driven by expectations and hence talk. As a result, the Fed’s comments, like China’s comments several weeks ago, are designed to minimize financial market volatility, not fight inflation. Ironically, fighting inflation requires substantially increasing market volatility through high and large enough rate hikes to slow strong physical demand. Yes, China has now positioned itself to potentially use its strategic reserves of metal – and copper in particular – to calm prices, but this will only feed the insatiable US and EU appetite for commodities that has just now been marginally increased by the Fed through lower yields. Further, if China reaches into its reserves today to meet Western demand, what will it have leftover in the years ahead should a major supply disruption develop, or indeed the likely shortages from the fast-approaching supply crunch timed from 2024? The only previous known copper stock release by the SRB in Q4 2005 had no sustained market impact, with prices rising 60% over the following 12 months. Reducing stock buffers, whether commercial or government, is ultimately a medium-term bullish development. And finally, the overall copper cathode market is heading into a 450kt deficit in the second half of this year, meaning persistent tightening pressures will likely still generate visible stock draws

Meh. The notion that neither inflation nor Fed has an influence on commodity prices doesn’t pass the laugh test. Here’s the relationship between copper and DXY:

The relationship is obvious. Goldman has recently argued that the huge decoupling we’ve seen this year is proof that DXY is irrelevant. My riposte is that it is because we have seen a bubble develop thanks to the post-COVID inventory supercycle misinterpreted by Goldman et al. As the Fed and China both tighten, this bubble is going to pop as speculative hoarding unwinds and scarcity turns abundance.

The notion that developed economy demand is the marginal price setter for commodities can only be described as stupid. China is all that matters:

70% of iron ore consumption. Half of base metals. And most of it goes into Chinese construction not exports. I mean, come on.

In short, the two major drivers for high commodity prices are Fed looseness triggering a falling DXY, plus Chinese fundamental demand based upon construction stimulus, and both are now in hard reverse.

Do the math. Don’t eat shit.

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