17 February 2010
The market rally of the last couple of days has been most forcefully felt in commodities as investor’s risk appetite has come back in spades, but the risk that Chinese demand is overblown means going long metals could prove a highly risky trade.
A number of economists, such as Albert Edwards at SocGen, have highlighted the risk of a potential trade war if China does not devalue the renminbi. Supposing it does bow to international pressure and at the same time Germany shores up Greece’s debt, then ‘markets will swing back to a risk-on frame of mind’, says GaveKal’s Asian economist Joyce Poon.
‘However, for a number of reasons that are linked to China and let’s face it, China is now a major part of the metals story, we believe that being long metals today is too dangerous,’ she says.
China’s inventory situation, like much about its economy, is notoriously difficult to second guess, but there is mounting evidence that massive surpluses are building.
Looking at the global picture, the latest stats from the World Bureau of Metal Statistics show that production outpaced consumption from January to November last year pushing inventory levels in most metals to near decade highs.
‘It seems likely that a lot of these stockpiles have been taking place in China,’ says Poon. She points out that by extrapolating from Chinese sectoral financial data and dividing the nominal value of inventories by the cost of goods sold, a guestimate can be made. Even then, the issue of Chinese goods simply leaving the factory for the warehouse being classed as sold does cloud the picture, but she says the direction, if not the absolute levels of inventory, can be worked out.
Companies had been successfully cutting inventory levels through 2007, probably due to more efficient inventory management and an economy in a structural upward trend,’ she says. ‘But in the past two years the inventory to sales ratio has soared to plus 40-50%.’
She believes this is due to a combination of a slow reaction by companies to last year’s sharp drop off in demand and excess liquidity fuelling speculative buying of metals
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To put this in context; since the 1960s, commodity prices have reliably tracked the growth in production of the major economies until the last four years when metals rallied way beyond this. Following the recent rally, the gap between commodity prices and economic activity is approaching the record high recorded in April 2008.
‘In our view, the risk-reward on metals in unfavourably skewed to risk,’ he adds. ‘There are better ways to play a Chinese, and global economy, that stays on the rails.’
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