x Abu Dhabi, UAETuesday 25 July 2017

Future of commodities rides on China's boom

This is the year of the treble Cs: China, its consumer spending and consequent commodities demand.

This is the year of the treble Cs: China, its consumer spending and consequent commodities demand.
This is the year of the treble Cs: China, its consumer spending and consequent commodities demand.

This is the year of the treble Cs: China, its consumer spending and consequent commodities demand. Last year was one of deep recession, daring rescue and, thankfully, dramatic recovery, led by globally co-ordinated central bank stimulus measures.

The most notable success was China's US$500 billion (Dh1.83 trillion) two-year stimulus package, which was substantially front-loaded into last year. It delightfully delivered 9.5 per cent GDP growth, with similar progress likely this year. If the forecast materialises, reflating China will soon overtake deflating Japan as the world's second-largest economy. However, a significant portion of this centrally stimulated V-shaped recovery came from spending on infrastructure, which included capacity expansion for highly cyclical industrial commodities like aluminium, cement and steel. As this capacity comes on line in the next few years, will there be enough demand to absorb it, or will prices correct? The concern is that capacity utilisation levels in several segments of the commodity extraction and production industry are running well below peak levels and the front-loaded stimulus programme will wind down this year.

On the flip side, will we see a repeat of the past decade's pattern of price hikes and volatility? Supply growth in the past decade has been meagre relative to the sharp rise in demand from populous emerging nations like China, especially in less cyclical agricultural commodities and moderately cyclical oil. Looking past the near-term fluctuations governed by the recovery's uneven pace and inventory levels, the main scenario for the decade ahead is one of a supply-constrained market that will drive prices broadly higher with high volatility. More than ever, the amplitude of commodity price fluctuation will depend on the pace of China's consumption, its commodity inventory management and global supply disruptions.

Another factor is the dollar exchange rate, since it is the basis for most commodity pricing. If the dollar weakens in the near term, which is likely, commodities will find support as consumers stock up on goods and those who are not dollar-pegged feel less price pressure. If the dollar rallies in the second half of the year due to global risk aversion, it will be a headwind for commodity prices. But if such a rally is driven by unexpected US economic strength, the dollar would benefit. The dollar-yuan exchange rate will only modestly impact prices since a modest revaluation of the latter - in the range of 3 to 4 per cent - is already widely expected.

For once, the statistics neither mislead nor overstate. China's commodity consumption is on a roll. Well publicised facts include China's car industry selling a million units per month, now ahead of the once car crazy US. China recently surpassed the industrial giants of Germany and Japan in terms of combined oil consumption and now buys more of Saudi Arabia's oil exports than the US. With its push for infrastructure, China now snaps up more than half of the world's steel, cement and iron ore.

For the mother of metals, copper, its share of global consumption has risen from a fifth five years ago to more than a third today, and possibly four fifths by mid-decade. Most telling, it consumes two thirds of rare earths, essential ingredients in electronics manufacturing. Also, the commodity intensity of China's economy is high. For example, in the energy sector, China can afford to pay about quadruple what Germany or Japan can for a barrel of oil to achieve the same level of incremental GDP output.

A significant factor in the commodity price outlook for this year is whether Chinese private demand rises to offset public stimulus spending and moderate exports. The past decade of China's spectacular growth has been juiced up by a low-price, export-centric model propelled by two advantages. First, developed market consumers lapping in the wealth effect of rising home equity. Second, the price advantage of an undervalued currency, thanks to a sterilisation programme that resulted in a stunning $2.3tn of hard currency reserves.

Starting in late 2008, as the recession raged consumers capitulated, exports shrank and inventories declined. Exports have revived of late and are likely to achieve about 20 per cent growth in the year ahead. But export growth will moderate as the absolute levels rise. With the wealth effect operating in reverse and credit constrained, developed market consumers will remain weak for an extended period. More of the global consumption burden, if one can call it that, will have to come from emerging markets in the decade ahead. Already, two thirds of China's exports go to other emerging economies and this ratio will need to be maintained or enhanced for its continued well-being.

Most importantly, Chinese consumer demand needs to ramp up from an anaemic 35 per cent of GDP, which is about half the level of both the US and that of its emerging counterpart, India. To facilitate this, five drivers matter: urban to rural migration must continue; employment levels must rise; credit must expand; consumer confidence must be sustained; and per capita disposable incomes must rise, driven by productivity increases.

All appear to be in play. Disposable income, which has been rising substantially faster than GDP, will probably continue to outpace it given high productivity levels. Urbanisation, which results in a higher consumption lifestyle, is expected to rise at a rate of about 1 per cent a year from the still-low levels of below 50 per cent. Credit utilisation is still low; for example, less than 10 per cent of car sales are credit financed versus 70 per cent or more in India and the developed world.

Historically, Chinese consumers have a high propensity to save because they have no social safety net; as social programmes improve, their propensity to spend will increase. Public spending is likely to shift from manufacturing orientated, fixed asset infrastructure to social programmes like education, health care and environment. To secure commodity supply for its growing appetite, China Inc has employed a broad array of strategies that include buy, build, inventory, influence, pressure and control. In just the past five years, it has bought companies outright in South America and Canada, and smartly secured rights to various supply bases in Africa. It is building vast amounts of new capacity, especially in industrial metals and oil refining. Its inventorying of easily stored commodities greatly increased last year to take advantage of price weakness, and established a price floor.

To impact long-term pricing, it has set up a commodity futures exchange with influence that is rising. Finally, in some sectors it has gained outright control over the industry; in rare earths, it controls more than 90 per cent of supply. The letter "C" begins both commodities and China. But it also begins the word complexity. Investing in commodities is tricky - it is a convoluted mix of assessing demand, projecting supply, anticipating short-term supply disruptions, decoding what is already priced in by the market as expressed in the futures curve, factoring out excess inventories and adjusting for currency fluctuations.

The mutual-fund pioneer John Templeton's observation is more true in the commodities market than any other: "An investor who has all the answers doesn't even understand the questions." Yet the main scenario is for positive momentum in commodity prices. A less probable yet significant scenario is for elevated prices to lose steam early this year, and the least probable scenario is a spike this quarter.

We must balance the short-term risks of pumped up prices and excess capacity with the long-term inevitability of supply constraints as a billion consumers in China and elsewhere move up to the economic middle class and their appetite surges. If an inflationary scenario eventually occurs, which is unlikely this year but likely in subsequent years, it will be important to allocate to commodities in your investment portfolio to hedge the loss of purchasing power. In college we train for As. In real world investing, getting some Cs would be a good idea.

Rehan Syed is the head of portfolio management at ABN AMRO Private Bank in Dubai. The opinion expressed is personal and not necessarily that of his employer.