Commodities, hard and soft, have seen a strong increase over the past year, with the S&P World Commodity Index rising 64%. It’s enormous. Metals like copper and steel have soared red, with Chinese demand surging following its post-pandemic reconstruction exercise. But China has recently started to act to stem the rise. It removed incentives for steel exports after its plan to become carbon neutral by 2060 led to the shutdown of many steel units. More and more Chinese leaders are now talking about the risk to the economy of rising input costs and stressing the need to cut prices. What is more important, however, is that China already started tightening its credit lines a few months ago. And this is the biggest.
CHINA WEAKENS CREDIT PULSE
China’s credit boost links credit growth to GDP, and this measure has been declining since the start of the year. What this suggests is that China is tightening credit to contain rampant expansion. However, this is not yet showing in the global growth figures, but it likely will, with a bit of a lag.
Since I do not understand enough the Chinese economy to give an overview of its importance, I borrowed some knowledge on the subject. I share some of the relevant material from a few reads here. These first nuggets come from a PIMCO coin in March.
China’s central bank has announced that it has started cutting coronavirus-related stimulus early – a move that may be much more relevant to policy developments in developed economies than is currently perceived … People’s People of China (PBOC) – aware of the country’s high indebtedness – ratio to GDP and rapidly developing financial markets – places greater importance on financial stability risks than most central banks, and liquidity is often managed for mitigate the risk of asset price bubbles alongside the traditional goals of inflation and exchange rate stability.
The important point to note in the above excerpt is the use of monetary policy to control asset prices. And here, the recent divergence in commodity prices and credit growth in China seems to suggest that there may be a possibility of a trend correction, as the credit boost and iron ore prices and copper have tended to evolve in a synchronized manner historically.
But let’s get into some more expert points of view. Below are some excerpts from an article by the Financial Times on the subject.
Mike Riddell, a senior fund manager at Allianz Global Investors, warned that China’s credit cycle is “the main global growth momentum to watch” because it has so far “resulted in strong global reflation”. Any further tightening would dampen global growth. âChina was once the first major economy to tighten its policies,â said Julian Evans-Pritchard, senior Chinese economist at Capital Economics. The latest signs of decelerating credit growth come after central bank demand. lenders to curb their activity in February. Decision-makers have targeted the real estate sector through the so-called âthree red linesâ policy, which aims to limit the financial leverage of major developers measured by three balance sheet indicators. The approach aims to constrain their access to credit, which has contributed to a construction boom that has pushed steel production to its highest level ever recorded last year …
As global attention has focused on the United States, where President Joe Biden’s fiscal stimulus package has boosted global economic growth forecasts, some investors point to China’s shift in lending patterns as one indicator. underestimated the trajectory of the global recovery. âUS tax spending completely dominates the inflation debate,â said Bhanu Baweja, chief strategist at UBS investment bank. “I’m surprised how little people talk about the Chinese credit boost.”
It is indeed a concern. China is the world’s second-largest economy, and it is naÃ¯ve to think that a reduction in the flow of credit to the economy will be without repercussions. And while the US $ 2 trillion infrastructure boost is expected to be a big tailwind for commodities, much of that is being factored in. What is not is the tightening of Chinese demand. Simple calculations reveal that every 1% change in the US economy can be offset by a 1.5% change in the Chinese economy.
Source: World Bank
So, if US growth does not surprise on the upside, but China’s growth is on the downside, the impact on global growth and hence on demand for commodities is likely to be of some significance.
WHAT IF THE PRODUCTS FAIL?
The big question that arises from this is: is the commodity boom nearing its peak? If so, it could hurt other asset classes as well.
Commodities and equities have had a significant positive correlation since 2015, as shown by the S&P World Commodity Index and the S & P-500. So if the commodity race weakens, so could the stock race.
But here, the traditionally tracked commodity, crude, may not be the best indicator. Indeed, after 2019, the correlation between crude and stocks weakened to a level below significance. Is this an aberration and will it revert to the previous strong synchronic trend between 2015 and 2019? That only time will tell. But for equities, a trend reversal for most metals and soft commodities could well mean a trend reversal as well.
So, keep a close eye on China and what it is doing to control prices. This may well be an early indicator of where commodity prices and stock values ââmay be heading.