China Effect Convulses Commodity Markets
--Financial Times. Published: November 15 2003 4:00 | Last Updated: November 15
Buying crazes are endemic to investment markets. This year it is commodities,
which have been hailed as a newly attractive asset class driven by the growing
power of China.
The traditional arguments for buying commodities are that prices of raw
materials don't move in line with equity markets. Some advisers tout the virtues
of commodities as real assets during times of geopolitical and economic
Others latch onto signs of recovery in the US, the world's biggest economy,
citing the attraction of raw materials during the early phases of an economic
cycle when global growth, demand for goods and production pick up.
A few also cling to the argument that commodities are a hedge against inflation.
The theory is that the prices of raw materials rise when price indices rise. But
the correlation has broken down over the past 20 years.
However, in recent months all the theories have been overshadowed by what
analysts are calling the China effect. "Chinese demand for commodities is
revolutionising global commodity markets," says Merrill Lynch Investment
Managers. "China has already overtaken the USA as the largest consumer of iron
ore, steel and copper."
In the first half of this year, iron ore imports to China rose by 45 per cent
and copper imports by 40 per cent. This voracious appetite has pushed the copper
price to a six-year high and nickel to a 14-year high.
China - the world's sixth largest economy, according to Merrill Lynch - now
accounts for between a fifth and a third of the world's consumption of alumina,
iron ore, zinc, copper and stainless steel.
"We've rarely seen this combination of cyclical recovery in the US and
structural change in China," says Tom Elliott, JP Morgan Fleming's strategist.
"The largest user of commodities is very rarely the fastest growing user as
well; it is quite remarkable. It is difficult to see an end to the run".
Some of the materials imported are turned into finished goods for export. China
exports much of the iron ore it imports once it has processed it into steel, for
example. Similarly, China's alumina imports are turned into aluminium and
China's exports are exceeded only by those from three nations: the US, Germany
and Japan. If current growth rates are sustained they will exceed those of the
US in less than a decade.
But the case for continuing growth rests heavily on the Chinese authorities'
ambitious plans to develop the country's infrastructure and on hopes that the
country's 1.3bn people are becoming avid consumers, clamouring for sophisticated
"Already Volkswagen sells more vehicles in China than it does in Germany, while
China consumes the same amount of global commodities as the US," says
JPMorganFleming. "By value, demand in 2003 for non-oil commodity imports will be
up to approximately $7bn compared with less than $2m in 1996. Growth is
phenomenal and the impact on the world should not be underestimated."
Eric Lonergan, a strategist at Cazenove, points out that China's share of world
copper consumption has risen from less than 5 per cent in 1990 to 20 per cent in
2003. This demand is growing in a similar fashion to those of Japan in the 1960s
and early 1970s, an era that ended with a surge in commodity prices.
Lonergan believes this surge will continue, coinciding as it does with the end
of a 20-year bear market in commodity prices, during which producers have
clamped down on production and severe supply constraints have emerged.
Capital spending by mining companies has barely grown, in real terms, over the
past 20 years, explains Lonergan. China may be pouring money into expanding
production and capacity, but globally the rising costs of bringing on new
capacity in many metal markets, as a result of environmental pressure and the
long lead times between discovery and production, will keep the lid on supply.
The bull case assumes that China's pace of growth will be unchecked. Yet there
are signs of unease in China itself. There are mounting concerns about what some
see as runaway imports and an overheating economy.
Beijing has already made clear, say old China hands, that it wants to see a
moderation in the growth of China's property, iron and steel, cement, aluminium
and vehicle sectors by tightening bank reserve requirements to limit credit.
Even the bulls acknowledge that the greatest danger to a continued boom in
growth and prices would be if tougher measures to put the breaks on growth
coincide with too much investment in production capacity in China. If, as some
suggest, Chinese producers have built up large inventories of metal, prices
Some also admit to concerns about China's creaking banking sector. Banks are
already burdened with a legacy of non-performing loans. According to official
estimates they make up 23 per cent of bank loans. Unofficial estimates put the
figure at nearer 50 per cent of banking assets.
Cazenove argues that making too much of China's banking problems misses the
point. "China is unique in development history by growing at a sustained rate of
close to 8 per cent and simultaneously accumulating net external assets," says
Previous growth miracles in the developing world, and in Asia other than Japan
in the 1980s and 1990s, have been financed by large external borrowing. "China,
by contrast, has no balance of payments, inflation or - in our view - banking
sector problems," adds Lonergan.
Lonergan is more concerned by the amount of money flowing into commodities. He
points out that annual production of gold, platinum, copper and aluminium is
worth just 1.15 per cent of US pension assets. Even a tiny shift in asset
allocation would have a huge impact on the supply/demand equation for metals.
"It makes the sector very volatile," he says.
Instability represents the greatest danger for private investors. There may be
merits in putting a few per cent of big portfolios into commodities as a
diversifier, but only if investors can withstand shocks.
This time the risks are two-fold because the reason for buying commodities is as
much an emerging market story as a commodities story.
The bulls would say undoubtedly. China can only go from strength to strength.
Is that the whole story? The fact that commodity fund managers are patting
themselves on the back for achieving 250 per cent returns, and commodity price
indices have risen nearly 40 per cent since they bottomed at the end of 2001
might suggest that private investors have already missed the boat.
But it could be different this time Wags always say those are the most expensive
words in the English language. But yes, it might be different this time. US
recovery and the inexorable rise of China as a global economy may well continue
to drive prices up.
But there will be setbacks. Commodities are volatile and cyclical. Prices rise
when demand picks up and capacity is tight, but typically that encourages
companies to increase production to match demand.
Bear in mind, too, that the base metals in such demand in China make up a small
proportion of commodity indices, which include soft commodities (such as grain)
as well as energy commodities. Many analysts believe oil prices - which dominate
most indices - will weaken next year.
Can I invest in base metals alone? Yes. You can buy directly into companies that
produce base metals. There are also funds that invest primarily in mines and
mining stocks, including JPMF Natural Resources and Merrill Lynch World Mining.
Other commodity fund managers, such as Barings and Foreign & Colonial, invest
heavily in energy. Sophisticated investors can gain access to specific
commodities by trading futures.
What would signal the peak of the market? Be wary if we get a spate of fund
launches. Fund managers almost invariably rush to launch new funds investing in
the current investment fashion just at the market's peak. The most recent
example was the telecoms, media and technology boom.
As far back as 1873 10 investment trust companies set up to invest in the US.
The prospectus of one - Scottish American Investment Trust, known as Saints -
has a familiar ring. It waxed lyrical on the merits of the growth of the US, the
size of its population and its "illimitable" resources.
The launch coincided with what is now called the Year of Panic in the US and a
six-year depression. The trust survived by the skin of its teeth. Others didn't.
Almost a century later, in 1972, investment trust launches reached another
record on the back of a strong equity market and tax changes. The market peaked
that year and took six years to get back to the same level.
But the China effect seems unstoppable, particularly given the constraints on
supply. Investment crazes are typically justified by what become catch phrases
and supply/demand arguments. One of the worst examples was ahead of the turn of
the century when investors were urged to buy champagne as a sure-fire investment
because there would be a shortage of it during the millennium.
We've had commodity and emerging market crazes before, too. For a decade or more
India has been hailed as the next big economic miracle on the premise that its
middle-classes - equivalent in numbers to the entire US population - were
turning into frenetic consumers. The miracle still hasn't quite happened.
In stock markets the wall-of-money argument was a favourite during the 1980s and
1990s. It was much used, for example, to justify the bull market in 1987. The
theory was that the Japanese had built up a big current account surplus and a
wave of money was coming from Japan to invest in overseas assets. Traditional
notions of value - whether a stock was cheap or expensive - were thrown out.
The FTSE 100 hit a peak of 2443 in July 1987. Three months later the market
suffered its worst crash for 60 years. Afterwards, critics said it is a mistake
to rely too much on this wall-of-money argument. When conditions turn, money has
a way of quickly finding alternative homes.
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