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Have commodity markets peaked?
This seems an odd question in light of oil’s recent surge. But oil has largely being driven by the latest Middle Eastern worries. Look further east still, all the way to China, and there are reasons to wonder whether the upward trend in commodity prices may start to weaken.
It’s hard to overstate how crucial China has been to the commodity boom during recent years, especially in industrial metals. A recent Credit Suisse report (via the Pragmatic Capital blog) highlights China’s dominance. In 2000, China accounted for 14% of global demand for iron ore. By 2010, that percentage had hit 62%. For copper, those percentages are 13% and 29% respectively. For coal, they’re 0.3% and 15%. For soybeans–crucial as an animal feed–the percentage went from 23% to 59%.
So the view of where commodities are heading depends heavily on China’s economic prospects. The Chinese government tweaked its GDP target to 7.5% this year from the 8% it has aimed for during recent years. Of course, reported GDP has tended to exceed target–it came in at 9.2% in 2011 and 10.3% in 2010–so, for most market commentators, the change to the official target is trivial.
What’s more, although the Chinese economy has been slowing lately and Chinese authorities have felt constrained about easing policy too much because of persistent inflationary pressures, there are signs domestic inflation has dropped sharply in February, according to Capital Economics. Which should make policy easing…ummm…easier over the near term.
Add in growing evidence of a sustainable rebound in the U.S. economy and it’s easy to see why, apart from natural gas, most commodities have advanced since the start of the year, with metals showing some exceptionally strong performances.
Why then expect that commodity prices might be peaking?
Once again, come back to China. And there are good reasons to believe China will start to undershoot, rather than overshoot, its growth targets. The argument, which is taken from Peking University finance professor Michael Pettis, one of the most incisive observers of the Chinese economy, runs as follows:
China has been dependent on investment to drive growth. This investment has been funded by keeping interest rates exceptionally low, in essence forcing a transfer of wealth from Chinese households to industry.
The investment boom has created a huge volume of uneconomic debt in the Chinese banking sector–firms can only report a positive margin thanks to artificially low interest rates.
This type of growth is reaching its natural limits. Chinese household consumption can’t be driven down any further as a percentage of GDP; it’s already at the lowest measured levels anywhere in a time of peace. Which means that banks will be swamped with a huge amount of bad debts accrued by state-operated enterprises. There won’t be a banking crisis because China’s central government will take on the obligations. But this will cause China’s already underreported national debt to expand hugely.
With the government unable to pass these bad debts onto households, it will be left with less economic room for manoeuvre. The result will be “much slower growth and rapidly rising government debt,” Mr. Pettis wrote recently. Mr. Pettis figures that average Chinese growth in this decade will barely break 3%.
And that much of a Chinese slowdown over the medium term will be crippling for assets that have become so dependent on the Middle Kingdom’s economic fortunes. Like commodities.
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Incisive? The argument you repeat here has been made repeatedly by the Peking Professor over at least the past half-dozen years. He might turn out to be right, one of these days… but I wouldn’t hold your breath. How does China rank in terms of per capita GDP? Way down the list. China has plenty of track left for this train to roll on…
The Source is WSJ.com Europe’s home for rapid-fire analysis of the day’s big business and finance stories. It is edited by Lauren Mills, based in London.
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