fT -When we bang on about there being a seismic shift going on in the world of commodity financing on account of the hypothetical eventuality of no more petrodollar or sweatdollar recycling, we too are talking about a negative feedback loop of worrying consequences for commodity/sweat-power producing emerging markets.
But Goldman Sachs’ latest commodity note articulates this risk much more clearly (our emphasis):
The negative feedback loop is significant. The deflationary impulse created by lower commodity prices reinforces a stronger US dollar, as witnessed by recent moves in FX markets that resulted in weaker commodity currencies. This decreases the cost of producing commodities in these countries through lower wage costs that are priced in the weaker local currencies. Further, this deflationary impulse reinforces a stronger US economy and higher rates. The higher rates in turn raise the cost of funding for emerging markets, which reinforces the need for emerging markets such as China to deleverage and deal with significant macro imbalances developed over the past decade. This ultimately reduces the demand for commodities, particularly those that are tied to investment such as copper and iron ore.
In 2015, the shift in the composition of Chinese economic growth away from investment in productive capacity that is commodity intensive and towards more consumer-driven economic growth has been significant. Recent Chinese macroeconomic data suggest that investment’s contribution to GDP growth declined from 50% of growth to 15% in the first quarter. This helped to push “CapEx” commodities like copper to new lows for 2015. Although spot oil prices still remain above the lows of 2015, long-dated oil prices (a measure of the normalized oil price), base metal prices, bulk prices and precious metal prices have all made new 2015 lows in the past week.
The question to ask is: what happens when the world’s top consumer stops depending on an export-based economy like China, which in turn depends on that consumer’s promissory notes to global commodity producers to itself gain access to resources that allow it to serve the top consumer, other consumers and also itself?
The answer is: a potential economic quagmire.
Unless, of course, global commodity producers can be persuaded to accept Chinese promissory notes directly instead — something that’s not impossible but, let’s face it, much less likely than them continuing to accept the promissory notes of countries with good track records of not defaulting on those promises and on putting capital to work productively for the benefit of everyone.
A commodity producer’s primary concern, after all, is exposure to the ticking time bomb that is the fact that their natural resources won’t last forever. As resources run dry or become too costly, they know primary consumers will find ways to diversify into alternatives, many of which will be geographically neutral. That in turn means they know their economies will over time lose leverage over the rest of the world’s goods and resources.
Whatever value they consequently receive in return for these commodities (while they last) must logically be put to work making their own economies sustainable or, alternatively, be invested in such a way that the fruits of those investments flow to these countries for as long as possible.
Can China, one of the world’s hungriest and dirtiest commodity consumers, defend the interests of commodity producers as well as developed markets can? Can it be trusted to reinvest that capital as productively and as sustainably? As yet, it’s not clear at all that it can.
This ties in with Goldman’s point that Chinese macroeconomic data suggests that investment’s contribution to GDP growth declined from 50 per cent of growth to 15 per cent in the first quarter.
Which suggests there seems to be a disconnect between the paper wealth profits China’s stock market has been registering this past year and the rate at which they’ve been deploying resources to achieve this alleged value creation. (The caveat perhaps is that the rally reflected the deployment of existing intellectual resources on capex investments focused on resource and energy savings).
But as Goldman sees it:
While we have been expecting lower prices for CapEx commodities (copper, iron ore) for some time now, the speed of the recent declines has been unexpected, taking prices rapidly towards our bearish 12 month forecasts. Furthermore, the metals where we had been expecting higher prices later in 2015 on diverging supply fundamentals (nickel and zinc) have also seen similar rapid prices declines over the last few days.
Weakness in the Chinese domestic equity markets has recently become a talking point. However, we continue to believe that the equity sell off was mostly a catalyst in commodity markets and that the more far reaching implications are more erosion in the confidence in Chinese policy makers.
For commodity markets, what really matters is underlying demand weakness that started before the policy generated equity rally, particularly in the commodity-intensive fixed investment and heavy industry sectors. As such, while recent metals price action poses significant downside risks to our metals forecasts, it is still consistent with our bearish macro views, as our “Deflation, Divergence and Deleveraging” macro themes continue to play out. Our suite of indicators continues to paint a downbeat picture for Chinese commodity demand. Our China Current Activity Indicator (a broad-based alternative measure to GDP) is tracking growth around 6%, FAI has fallen to 11.4%yoy (down from over 17% a year ago), apparent steel demand continues to decline, and our GS China copper demand indicator is also in negative territory.
In more graphic terms, here’s how Goldman sees GDP growth implied from commodity consumption in China these past few years:
Not very encouraging.
Goldman says that with credit still growing at double the rate of GDP, it appears that the trend slowing in metals demand may last for years, highlighting further downside risks to their metals price forecast.
Again the only caveat is that China has mastered the art of less-is-more growth by deploying existing capital in an energy/resource saving manner.