Right, so this is pretty funny.
As you know, the monumental effort to squeeze leverage out of China’s financial system and thereby curb rampant speculation has played havoc with commodities of late.
Perhaps the most concise description of the problem came earlier this week from Citi. To wit:
One of the major drivers of the recent industrial metal sell-offs were increasing concerns over Chinese monetary conditions and macro slowdown.
When it comes to the commodities market, rising Chinese money market rates not only triggered large-scale unwind of the earlier reflation trades (mostly in the onshore futures market) which pushed iron ore lower, but also forced physical traders, especially the ones who stocked up with high leverage, to liquidate inventories, as well as accelerated the shift of downstream inventory cycle from restocking to destocking.
This is just the latest example of a phenomenon that’s been going on for years. Every time these backdoor credit channels get squeezed, something breaks. You saw it in the summer of 2015 with Chinese equities, you saw it in December with the Chinese bond market, you’re seeing it now with commodities, and you see it all the time in real estate.
Clearly, the contagion risk is quite high when it comes to commodities carnage and so there are very real concerns that the transmission channel between China’s tightening efforts and EM more broadly might well be the metals complex.
Well as Goldman notes, “market participants congregated in Hong Kong for London Metals Exchange Asia this week [and the bank] met with a number of key commodities producers, traders and investors to discuss the outlook for the Chinese economy and the metals markets.”
Here’s what everyone said…
The focus of most of our discussions centered on China’s policy stance.
Many market participants agreed that the recent metals sell-off was more of a risk-off effect and not demand driven, though they were increasingly concerned about the impact of higher rates on real demand and economic growth going forward.
There was a general consensus that commodity prices were likely to come under further downward pressure on the back of a persistent crackdown on off-bank balance sheets (e.g. WMPs) in China as well as anti-corruption in the financial system, which would likely drive a further decline in growth .
A number of market participants believe that this crackdown will persist for some months, after which easing would be forthcoming, but only after the Chinese activity data deteriorates somewhat. However some investors actually hold a more bearish view that the government will keep a tightening stance through year-end, driven by a strengthening reform bias.
There was noteworthy concern regarding the potential impact of the recent crackdown on banks and SOEs’ financing activities, which could have a negative impact on growth via the impact on the money multiplier. In the meantime, issuance of a number of onshore corporate bonds have already been cancelled, which was in some market participants views an early sign of future weakness in investment. Further, rising financing costs has underpinned negative sentiment over the economic outlook as business expansion may be constrained by this.
Worries about a persistent crack down on financing on the back of financial risk-control has clearly weighed on underlying sentiment. A few market participants had concerns about a potential deceleration of PPP projects for the rest of this year due to potential softness in fiscal support amid tightening, and developers’ funding capabilities could also be affected if financial conditions worsens.
There was a notable divergence in views about whether the government will support the economy again if it softens (due to current tightening) before the 19th congress meeting or keep tightening towards year-end. Most investors we met with held a strong belief that policy makers put a strong premium on stability ahead of the 19th congress meeting around October this year, therefore they should provide meaningful support if the economy softens. Having said this, they believe that policy remedies are likely to be behind the curve, therefore asset prices would have further to sell-off beforehand, and as such they expect a big trading range for metals prices in the coming months.
Copper was seen to have near-term headwinds, but the outlook may improve towards year-end. Most market participants were bearish on the copper price in the short-term due to their overall bearish macro sentiment and expectation of seasonal demand softening into June-July.
There seems to be much less enthusiasm in iron ore compared with the same time last year. Many market participants were bearish iron ore price as they saw the iron ore market as no longer in structural shortage, as was the case during 2016. Sufficient supply was seen to have dampened steel mills’ interest in stockpiling iron ore even if steel margins remain strong (mainly rebar).
On zinc, market participants are generally constructive on a near-term view given the current backwardation pricing structure resulting from low inventory levels, but point to risk ahead as forward fundamentals are likely to be weaker due to the expected ramp-up of zinc mine supply globally on high miners’ margin.
Nickel was the metal with the worst outlook for the remainder of 2017 in Bloomberg’s Asia LME week seminar survey. Many believe that China’s NPI supply this year will grow given that Indonesia has resumed exporting nickel ores, the nickel mining suspension in the Philippines is over, and recent squeezed margin of stainless steel is also putting downward pressure on nickel. Further, faster-than-expected establishment of integrated NPI-steel mills in Indonesia is viewed by some investors as a displacement of nickel demand from China to Indonesia. Some believe that NPI production cost in Indonesia is much lower than Chinese NPI production.
In other words: things are looking pretty bleak.