First, let me state again what every investor in commodities everywhere should know by now: China is your biggest buyer. Take a look at the nearby chart, which shows you China’s consumption of a given commodity as a percentage of world consumption.
So to answer the question I posed up top means you have to think about China’s growth rate. China slows, bad for commodities. China grows, good for commodities. Makes sense, right? In case you missed it, China’s manufacturing activity fell for the third straight month in June. The official purchasing managers index stood at 50.9, down from 52 in May. Any number over 50 means expansion and below that means contraction. Unofficially, things are probably worse, because officials have a way of dressing up doggy numbers.
What’s happened to commodity prices in those three months? Let’s look at the Dow Jones-UBS Commodity Index, which contains 19 commodities — everything from aluminum to zinc. Most of these 19 commodities have been falling for the last few months.
Keep in mind that China is still growing, just at a slower rate. Now imagine what happens if China actually contracts?
It’s one of those things that will seem extremely obvious in retrospect. But if you are worried about a slowdown in China — as I am — then you should shy away from commodities near the top of its buy list. This is the exact opposite of what I’ve said to do in the last several years.
This means you should particularly avoid cement, iron ore, coal, pigs and steel. You ought to feel better about food, wheat and chickens, which are not as sensitive to China’s buying. Oil, somewhat surprisingly, is far down the list too, and is something of an exception. While the price of oil was down in the second quarter, China’s imports were near record highs. It doesn’t mean oil prices won’t go down if China slows or contracts, but oil seems less susceptible than other commodities at this point.
The other giant exception is precious metals. While China’s imports of copper, coal and iron ore are all down from a year ago, China still buys a lot of precious metals. There is no official data, but estimates put Chinese imports of gold at 200 tonnes through June. That compares to 250 tonnes for all of last year, which was a fourfold increase from 2009. China’s bought all of this gold despite being the world’s largest gold producer.
This kind of analysis extends further. Certain countries too have been riding the coattails of China’s buying binge. Brazil, for one, is a big supplier of China’s raw material needs. No surprise it has been among the worst-performing markets in the second quarter, down more than 5%. So goes China, so goes Brazil. The same might be said of Canada (also down 5%) and Australia. Russia, another big commodity market, was down 7% in the quarter.
This analysis is unsettling, I admit. But it is worth thinking about what happens if China slows further or even contracts. Every economy contracts at some point, if only for a time. China’s economy hasn’t shrunk since 1976. That’s 35 years, a long time between economic bowel movements.
On the other hand, people have been calling for China’s demise for a long time. Most recently, Jim Chanos, the famous short seller and forever known as “The Man Who Called Enron,” has found many trouble spots in China’s boom.
He points out that fixed asset investment in China is 50% of the economy. This figure easily exceeds figures from past bubbles in other markets. All that investment created “ghost cities with no people, high-speed rail lines to nowhere and empty apartments.” He also flags excessive debt engaged in real estate speculation. “The whole country of China has become a nation of real estate speculators on leverage,” he says. Real estate as a percentage of the economy has reached levels associated with pre-bubble Ireland. Inflation is also getting out of hand — hence the Chinese buying of precious metals to protect their wealth — and food and basics now eat up 50% of the average Chinese budget.
All of this too is worrisome. What’s more unsettling is that few people want to face the ugly possibility that perhaps it is time to lighten up on commodities. “We do not think this is the time to be lightening up on commodities,” Barclays’ analysts declared emphatically in a recent note: “quite the opposite.”
That is the consensus opinion. And it is the easy opinion, because so far it has been so right. According to Barry Bannister at Stifel Financial, “Commodity prices have reached the highest 10-year rolling return in 200 years.” And in the last 10 years, the best-performing stocks have been those involved in commodity extraction. The chart below shows the FactSet industry categories and highlights the top and bottom five.
To date, “buy the dips” has been the right play in commodities. Perhaps the consensus will be right again. In fact, I hope it is. It is an easier world to invest in when you can count on China — the world’s second-largest economy — bringing its best to the table.
But I put up the caution flag here.
for The Daily Reckoning