CHINAMacroReporter

Will Chinese Commodities Derail The Global Reflation Trade?

Leland Miller and Derek Scissors on why investor excitement over Chinese capacity cuts this winter is oversold, and the serious implications for the global reflation trade.

[Leland Miller and Derek Scissors on why investor excitement over Chinese capacity cuts this winter is oversold, and the serious implications for the global reflation trade.] For over a year, commodities bulls have feasted on China. In the aftermath of the recent Communist Party Congress, many investors are now drooling over the prospect the boom will continue, based on Beijing’s promises to supercharge its campaigns against overcapacity and pollution this winter. If such pledges are fulfilled, the thinking goes, substantial chunks of steel, aluminum, and other refining capacity will be taken offline, rebalancing markets and providing rocket fuel to already frothy prices. 2018 could prove to be an even more amped-up version of 2017.
by

Derek Scissors | AEI

|

American Enterprise Institute

November 22, 2017
Will Chinese Commodities Derail The Global Reflation Trade?

For over a year, commodities bulls have feasted on China. In the aftermath of the recent Communist Party Congress, many investors are now drooling over the prospect the boom will continue, based on Beijing’s promises to supercharge its campaigns against overcapacity and pollution this winter. If such pledges are fulfilled, the thinking goes, substantial chunks of steel, aluminum, and other refining capacity will be taken offline, rebalancing markets and providing rocket fuel to already frothy prices. 2018 could prove to be an even more amped-up version of 2017.

Not so fast. Investors are misreading what a winter of capacity or production cuts—an overlooked distinction—would truly mean for China’s commodities sector. Assuming the government follows through in its war on steel and aluminum capacity this winter—and since this campaign appears to bear Xi Jinping’s imprimatur, we expect as much—the effect could well be bullish for prices in the short run.

However, there is a danger in drawing more far-reaching conclusions, especially that commodities are primed for another banner year. In our view, previous efforts to cut net capacity have been illusory. If capacity is finally being cut this winter, there is still so much excess that production could survive unscathed for years. If, instead, it is production being cut for immediate environmental gains, it may simply re-emerge in the spring—all bets should be short-term. Any extended price rally relies on both the cuts being real this time and continued robust demand, despite the latter being increasingly unlikely.

To see this, investors should reconsider the fundamental question: What actually caused key commodities to rally in China over the past year? The official narrative implies a combination of sizzling demand and the government’s touted reductions in supply—a view widely accepted by markets. Take steel. The Ministry of Industry and Information Technology in late October declared the steel industry had already met its full 2017 target for cutting capacity 50 million tons, after reportedly meeting its similarly ambitious target for 2016. Critically, any distinction between gross cuts and net ones is glossed over.

Many traders accept this narrative because it accords closely enough with their own observations. For example, by 2017 Chinese iron ore imports had jumped to record levels and steel prices were rocketing skyward. Some high-profile capacity cuts were evident, such as those in Tangshan, China’s largest steel-producing city. Under these circumstances, the notion that Beijing had finally gotten serious in targeting excess capacity seems sensible.

Sensible, but not accurate. Our firm’s China Beige Book proprietary commodities survey, which includes hundreds of companies across steel, aluminum, copper, and coal, tracks capacity, production, and investment as reported by the firms themselves. Despite the fact that these firms have a very strong incentive to parrot the government story that they are cutting net capacity, for an astounding six straight quarters they have told us precisely the opposite. While some capacity has indeed been taken offline, as Beijing notes, net capacity rose from the second quarter of 2016 through the third quarter of 2017 in every one of these core industries.

The problem extends beyond capacity to production, specifically overproduction. In aluminum, for example, the percentage of firms reporting rising inventory has been at least 20 points higher than those reporting falling stocks in each of the six quarters. Supposed capacity cuts cannot mean much while inventory continues to pile up.

If not supply cuts, what explains the rally? For over a year, the counterpart to blistering demand has been speculative capital inflows. This is not unusual for China, as the “moneyball” at various times rolls into property, stocks, and bonds, as well. Here, it has kept commodities prices rising skyward for over a year. But, just as it has done with stocks and (recently) bonds, the moneyball also quickly rolls away when chosen markets lose their shine. If commodities demand weakens, investors relying on supply cuts will be exposed.

This could happen quickly. Many China bulls take comfort in the strong 2017 macroeconomic performance as indicating commodities demand will remain robust. In China Beige Book data, though, all four commodities sub-sectors showed substantial demand weakness in Q3, off what may have been a Q2 peak. While this so far represents just one quarter, not yet a trend, any extended slide will cause the moneyball to flee. Until genuine supply reduction becomes clear, there could be intense and sustained downward pressure on prices.

Chinese commodities, like the economy, remain in many ways a black box, so investors can be excused for holding to a government narrative. But there could be serious repercussions from taking government projections at face value. A sharp rather than slow commodities reversal, unexpected in the aftermath of the Party Congress, would reignite doubts about Chinese growth. It would also elevate questions over global growth. To the extent the commodities rally is important to global reflation, a sustained fall in Chinese prices would shake confidence elsewhere.

Recent behavior by various central banks suggests that interest rate hikes could also be held hostage to Beijing’s supply decisions. What happens in China no longer stays in China.

More

CHINAMacroReporter

February 11, 2021
'The Biden Team Wants to Transform the Economy. Really.'
‘Biden and his more activist advisers hope to modernize key industries and counter an economic threat from China, swiftly emerging as the world’s other superpower. “The package that they put together is the closest thing we’ve had to a broad industrial policy for generations, really,” says Scott Paul, the president of the Alliance for American Manufacturing.’
keep reading
February 10, 2021
‘What the ‘Hong Kong Narrative’ gets wrong'
‘For a significant cohort of the [“pro-democracy”] protesters, the more accurate label would be “anti-China activists.” The one thing that seems to unite them is not a love of democracy, but a hatred of China.'
keep reading
April 15, 2021
'TSMC faces pressure to choose a side in US-China tech war'
‘Taiwan Semiconductor Manufacturing Company (TSMC) has maintained its historic position of neutrality, reflected in the company’s strategy of “being everyone’s foundry”.’
keep reading
April 14, 2021
The Belt & Road in the Post-Pandemic World
In this issue of China Macro Commentary, I have focused just on the ‘Digital Silk Road’ and how it supports the business expansion of Chinese tech companies, and on BRI ‘connectivity’ projects: ports (China is involved in 93 around the world) and on the growing China-Europe freight trains traffic (This wasn't covered sufficiently in the Report, so I included a recent article from the Wall Street Journal), plus on the U.S.'s failure to meet the BRI challenge.
keep reading
April 13, 2021
'2021 Annual Threat Assessment of the U.S. Intelligence Community'
‘China increasingly is a near-peer competitor, challenging the United States in multiple arenas—especially economically, militarily, and technologically—and is pushing to change global norms.’
keep reading
April 13, 2021
In Battle With U.S. for Global Sway, China Showers Money on Europe’s Neglected Areas
‘The number of freight trains running between China and Europe topped 12,400 last year, 50% higher than in 2019 and seven times that of 2016, according to Chinese authorities.’
keep reading
April 11, 2021
'Why manufacturing matters to economic superpowers'
‘Whether such reshoring matters for national economies depends very much on the industry.’
keep reading
April 11, 2021
China in Jamie Dimon's Letter to Shareholders
‘China does not have a straight road to becoming the dominant economic power’.
keep reading
April 11, 2021
'Alibaba’s rivals on alert after China’s regulators hand out record fine'
“Everyone with a clear mind won't self-regulate, you just pretend that you do. Who will pay for the loss if you lost your competitive advantage because you self-regulated and others didn't?”
keep reading
April 10, 2021
Alibaba: 'Promote the healthy and sustainable development of the platform economy'
‘From the perspective of the long-term and healthy development of the platform economy, regulation by law and support for development are not contradictory, but are complementary and mutually reinforcing.'
keep reading
April 9, 2021
'The Best Explanation of Biden’s Economic Thinking I’ve Heard'
‘When President Biden’s thinking about the infrastructure investments necessary, a lot of it is in contraposition to what he is seeing China doing in terms of strategic investments.’
keep reading
April 8, 2021
Liu Ge: Competing with China a farfetched guise for US’ infrastructure plan
‘Historically speaking, it seems the only way for the US government to make costly public investments was to create an adversary that is presumed to threaten its security.’
keep reading
April 8, 2021
'Antony Blinken interview: The secretary of state offers a window into Biden's foreign policy decisions'
‘ “Our goal is not to contain China, hold China back, keep it down,” Blinken underlined.’
keep reading
April 8, 2021
'US adds Chinese supercomputing companies to export blacklist'
‘The Biden administration took its first trade action against China on Thursday, adding seven Chinese supercomputing developers to an export blacklist for assisting Chinese military efforts in a move that will likely further escalate frosty tensions between the world's two largest economies.’
keep reading
April 7, 2021
'Remarks by President Biden on the American Jobs Plan'
‘Look, do we think the rest of world is waiting around? Take a look. Do you think China is waiting around to invest in this digital infrastructure or in research and development?’
keep reading
April 7, 2021
China: 'Power Trader'
‘The theory of power trade better explains China’s economic and trade policies than does the theory of free trade or protectionism,’
keep reading
April 6, 2021
'Train Wreck: Ultimately companies have to choose.’
MUST READ: Bill Reinsch succinctly but brilliantly summarizes the situations in China and the U.S. and between the two.
keep reading
April 6, 2021
'Buy American!': Pushing U.S. Companies to Onshore Supply Chains
The debate about how to deal with China commercially ‘has moved in two directions: running faster—improving our innovation capabilities in critical technologies to better compete with China—and slowing China down by restricting its access to U.S. technology.’
keep reading
April 4, 2021
'Why Defending Taiwan is in the U.S. National Interest'
‘As long as Washington assesses that American security is best served by defending forward—an approach that has served the United States well over the past 70 years—Taiwan’s de facto independence will remain a key US interest and driver of American policy in Asia.’
keep reading
April 4, 2021
'Why China Is Going All "Wolf Warrior," All the Time'
‘All this is to say that, living in Beijing as I do, I think the current approach is predictable and consistent with everything else we are seeing in China in the New Era.’
keep reading
April 3, 2021
'With Swarms of Ships, Beijing Tightens Its Grip on South China Sea'
‘Not long ago, China asserted its claims on the South China Sea by building and fortifying artificial islands in waters also claimed by Vietnam, the Philippines and Malaysia.’
keep reading
April 2, 2021
'Genesis Celebrates Launch In China With Dazzling, World Record-breaking Drone Show Over Shanghai's Iconic Skyline'
'The spectacular visuals were coordinated to present the world of Genesis, delivering an audacious storytelling concept while also breaking the Guinness World Records for "The Most Unmanned Aerial Vehicles (UAVs) airborne simultaneously".’
keep reading
April 2, 2021
Mo' Infrastructure, Mo' Problems Copy
‘China’s reliance on building roads, railways and airports to support growth has caused a spike in debt, with some of that money funneled into unnecessary infrastructure and uneconomic boondoggle developments.’
keep reading
April 2, 2021
How Does the U.S. Compare to China?
Two reports from Bloomberg – ‘Biden Starts Infrastructure Bet With U.S. Far Behind China’ and ‘Biden’s Biggest-Ever Investment Plan for U.S. Still Trails China’ – highlight a few of the differences.
keep reading
April 2, 2021
USTR | '2021 National Trade Estimate Report on FOREIGN TRADE BARRIERS'
‘Made in China 2025 seeks to build up Chinese companies in the ten targeted, strategic sectors at the expense of, and to the detriment of, foreign industries and their technologies through a multi-step process over ten years.’
keep reading
April 2, 2021
‘2021 Report Card for America’s Infrastructure’
‘The 2021 Report Card for America’s Infrastructure reveals we’ve made some incremental progress toward restoring our nation’s infrastructure.’ ‘For the first time in 20 years, our infrastructure is out of the D range. America's Infrastructure Scores a C-.’
keep reading
April 2, 2021
'US to make it easier for diplomats to meet Taiwanese officials'
'Plan to loosen restrictions on contacts with Taipei threatens to provoke China.'
keep reading
April 2, 2021
Biden Starts Infrastructure Bet With U.S. Far Behind China
Even though he didn’t rely solely on the China challenge to justify his new American Jobs Plan; devoted to infrastructure and more, President Biden certainly he had China in his sights. Because as Jonathan Hillman, a senior fellow at the Center for Strategic and International Studies, wrote“The United States is entering what could be a decades-long competition in which economic and technological power will matter just as much, if not more, than military might.” “Starting this race with decaying infrastructure is like lining up for a marathon with a broken ankle.”
keep reading
April 2, 2021
President Biden Lays Out His ‘American Jobs’ Plan
‘It has become a cliché in U.S. policy circles that the best China policy is to invest in core U.S. capabilities: education, infrastructure, and research and development,’ writes Evan Medeiros of Georgetown University in ‘How to Craft a Durable China Strategy,’ in Foreign Affairs.
keep reading
April 2, 2021
'China’s Dangerous Double Game in North Korea'
‘Beijing’s North Korea policy is primarily motivated by a desire to counter U.S. power in the Asia-Pacific region and increase Chinese influence on the Korean Peninsula.
keep reading
April 2, 2021
'Japan’s Suga to Be the First Foreign Leader to Meet With Biden'
‘Japan walks a narrow line as it seeks to maintain close ties with its only military ally, the U.S., while avoiding damage to economic ties with its biggest trade partner, China.
keep reading
April 1, 2021
'Convicted in Hong Kong'
‘Everyone in the former British colony understands the message being sent from Hong Kong’s new masters in Beijing:’
keep reading
April 1, 2021
'U.S. dollar at risk as China races ahead on digital yuan'
‘So why should America care about any of this?’
keep reading
April 1, 2021
PRC Foreign Ministry Response to the USTR's 'National Trade Estimate Report'
‘The accusations and slanders made by the US against China's industrial policies are groundless.’
keep reading
March 31, 2021
'Consumer boycotts warn of trouble ahead for Western firms in China'
‘Western executives in China cannot shake an unsettling fear that this time is different.’‘Their lucrative Chinese operations are at rising risk of tumbling into the political chasm that has opened between the West and China.’
keep reading
March 31, 2021
'How the Pandemic is Changing the Belt & Road Initiative'
‘The building of roads, railways, ports, and power plants is giving way to a BRI centered on technology—primarily telecommunications, connectivity, health care, and financial services.’
keep reading

Heading

Lorem ipsum dolor sit amet, consectetur adipiscing elit. Suspendisse varius enim in eros elementum tristique. Duis cursus, mi quis viverra ornare, eros dolor interdum nulla, ut commodo diam libero vitae erat. Aenean faucibus nibh et justo cursus id rutrum lorem imperdiet. Nunc ut sem vitae risus tristique posuere.