Feature Stories | May 06 2009
(This story was originally published on 4 May 2009. It has now been republished to make it available to non-paying members at FNArena and readers elsewhere).
By Greg Peel
The last big market crash experienced in Australia was the Crash of 1987. We did not suffer meaningfully from the tech-wreck of 2000. While ’87 now seems tame compared to what was going on in 2008, it was nevertheless a short, sharp shock of great significance and it ultimately heralded in the last deep recession of 1992.
When the broad stock market fell heavily in 1987, the share prices of Australian mining stocks fell just as heavily. Metal prices, however, did not. Metal prices had been rising in the 1980s but had greatly underperformed what was the parabolic curve of the stock market into 1987. After an almost unnoticeable stumble, metal prices just kept rising through to 1989 as again the stock market reached new highs. The recession then followed keeping a lid on both. But in 1994 metal prices took off again. This time the stock market was left behind.
The surge in metal prices lasted only to the beginning of 1995. There began a long slow decline which was not to turn around again until after the mild recession of 2002. Stock markets, however, surged ahead in the great technology bubble. The internet did not need metals. This all ended in tears of course, and both the stock market and metals prices entered 2003 feeling rather depressed.
Then China entered the picture.
It is hard to appreciate now – in 2009 – that the Australian stock market has not always been all about the resource sector. The importance of the resource sector has ebbed and flowed over the decades, perhaps best represented by the ebb and flow of BHP’s relative market capitalisation and weighting within the index. That weighting has followed long cycles of global industrial production strength or weakness inside and outside economic cycles.
Since 2003, nevertheless, the performance of the Australian stock market has been inexorably tied to the performance of BHP and the resource sector. The period 2003-2008 saw the commodity “super-cycle” defined as Chinese economic growth dominated the world. It was a cycle that drove a soaring commodity-led global boom. That cycle is now either over, or has suffered a serious blow. We are now in the middle of the most serious financial crisis since the Great Depression. It has been credit-based, and has permeated almost all corners of the global economy. Some believe the GFC may yet prove worse than the Great Depression.
Others however, such as the finance ministers of the G7, believe the global economy will begin to recover by the end of 2009. The recent 25% rally in the stock market is predicating this. But no one expects the global economy to turn on a dime. Rather it will likely take years to work through the deflation of the credit bubble. The global economy will need to walk again before it can run.
Can we honestly expect, therefore, that commodities can simply pick up where they left off in the boom times of 2003-08?
The metals and mining analysts at Citi in Europe are advocating caution. They note:
“Many top-down strategists some time ago selected the mining sector as a ‘go to’ sector on the assumption that it would be the beneficiary of future IP [industrial production] stabilisation. In the process they helped the sector recover 46% of the ground that it lost (relative) in 2H08.”
This “go to” attitude belies the experience of previous recessions, which will usually start with banks taking the first hit as soon as a downturn becomes possible, and will end after banks have first led the stock market back to strength. And this current GFC began with US banks, while commodity prices did not collapse for nearly a year later. This GFC is all about the bursting of the credit bubble, meaning it is even more rooted in finance specifically than past recessions (such as the tech-wreck, oil shocks). Yet this time the resource sector has taken off ahead of the banking sector, and not everyone is convinced the recent bank sector rally is even justifiable.
It is thus no surprise that resource sector analysts (bottom-up side) were very much dooming and glooming late last year and were thus surprised when metals prices started to go for a run. As Citi suggests:
“Previously nervous mining analysts are now belatedly pushing the sector. Beware.”
JP Morgan’s Asia Pacific team are also concerned by this resource sector turnaround. We can put the 25% stock rally down to the supposed “green shoots” of a recovery – the signs of stabilisation theme now being pushed by the US Federal Reserve and backed up by an apparent slowing of the rate of economic contraction. But the JPM analysts note:
“[The resource sector’s] recent spell of outperformance began in October when any green shoots of economic recovery were still seeds in frozen earth. How do we explain strong performance by a cyclical sector when the world is still trying to find a foxhole to hide in?”
The analysts point to three influences to address their own question – China, the inflation trade and human nature.
China is clearly the big influence on global financial markets which did not exist back when the Arabs were cutting off the oil supply in the seventies, or when the US went into a frenzy of leveraged buyout deals in the early nineties, or even when the US went tech-mad in the late nineties. So while strategists are loathe to use the expression “things are different this time”, the reality is the economic growth story of China in particular and the likes of India, Brazil, Russia, and “other Asia” in general is critical in determining just how long and deep the GFC might prove to be. Twelve months ago, the majority of economists believed that while the US might enter a recession, there would not be a “global” recession because China et al would just power merrily on. It was this sort of attitude that helped the oil price to almost US$150/bbl. China, they said, was “decoupled” from the US and the developed world.
This prediction has now proven to be flawed. The global economy is expected to show contraction, and Chinese GDP growth of only 6% is, for the world’s most populous nation, considered to be “recession” anyway. But those still optimistic suggest that while emerging market economies might have stumbled, they have by no means fallen. So while the developed economies carrying dealing with their massive deficits and desperate economic stimulus packages, the emerging markets, with a bit of stimulus of their own, can return to normal programming.
And that’s one reason why commodity prices and thus resource stocks have rallied ahead of banks and the rest the market.
Arguably the initial turning point in commodities came not so much from Chinese stimulus, but from the “inflation trade”. The inflation trade is based simply on the connection between US dollar-denominated commodity prices and the US money supply. The US Treasury has been printing trillions of dollars with which to both save and stimulate its economy, and the more dollars there are the more inflated commodity prices must become. This is just a mathematical price relationship – it has absolutely nothing to do with any perception of increased commodity demand. And nor is it simply US dollar-specific. Monetary stimulus is underway all over the developed world.
Yet JP Morgan’s third explanation is what the analysts offer as perhaps most influential in the turning point of commodity prices in October – a time when everyone thought the world was going to hell. Human nature dictates that investors tend to cut winners and hold losers. If you make a bit of a profit you bank it quickly for fear the market may turn around again, but if you’re staring at losses you tend to hang on to a simple hope that things will turn around soon.
When commodity prices were rising to their peaks this time a year ago, many investors were overweight resources, subscribing to views, for example, that oil was on its way to US$200/bbl. The other side of the market switched to underweight resources, as they were convinced the rally was way out of hand and that the China story was overplayed. Thus the underweight school cleaned up on the way down, while the overweight school spent every month thinking surely prices can’t go any lower, and not capitulating. When commodity prices fell as low as levels that many analysts thought they’d never see again in their lifetime, the underweight school decided it was time to square up. Hence they began to push up prices while the overweight school simply breathed a sigh of relief.
JP Morgan believes it was human nature that created the bottom in commodity prices, and the inflation trade and the China story which helped fuel the subsequent rally. This, say the analysts:
“…suggests that the sector has run ahead of itself. In our view, if economies move from free-fall to stability this would only validate the strength we have already seen. Unless stability turns into full-blown and sustained recovery, fundamentals will struggle to support what investor psychology started. This makes the risk/reward ratio for the [resource] sector unfavourable in our view.”
Which again implies the question: Can the world honestly just bounce back from a GFC and return to levels of pre-GFC boom in commodity demand?
One thing producers and manufacturers have learnt in recent times is how to manage their inventories much more efficiently. A lot of this has to do with computer and internet-based inventory control models. In the fourth quarter of 2008, notes JP Morgan, output in the general global economy was cut harder and faster than actual demand as companies quickly retreated until they could get a better idea of just how low demand might fall. No one wants to be stuck with unsold inventory. The fact that world credit markets dived into their most perilous phase in that quarter only exaggerated the effect.
What this means is that coming into the first quarter 2009, an inventory cycle has to kick in. Having run down inventories and stockpiles, producers and manufacturers have to start rebuilding them if they want to be able to conduct any business at all. If the rebuild is assisted by a return to real demand, then a sustained recovery should follow. But if demand is still on the down-swing, the risk is that companies have simply shot too far the other way in their inventory reductions and the apparent strength provided by inventory rebuilding is simply a furphy.
Such inventory rebuilding is why the resources sector is usually one of the first sectors to recover in an economic downturn. In the current cycle commodity prices began recovering even before any “green shoots” began to appear. But even if the green shoots are portending recovery, can global growth return to being robust, or even stable, in the next few years at time when, as JPM notes, “most developed economies will be carrying a significant burden of debt, both in the private and public sectors”. One blip in the inventory cycle does not immediately imply full recovery is underway.
As far as the inflation trade is concerned, if the recent rally in commodity prices includes an inflation “hedge” then JP Morgan believes there are better inflation hedges to be had. The gold price is no higher now than it was in March 2008. Bond prices have yet to reflect any inflation fear, given the reverse influence of “safety” in government bonds. If money supply-based inflation truly does become a problem then central banks will have no choice but to start raising their interest rates again, having spent the last year lowering them. They won’t be raising them because of booming economic growth, but to attract funds into government coffers to offset rampant printing. Otherwise hyperinflation is the next fear.
Central banks have lowered interest rates to help stabilise the credit crunch and get economies at least to a point of stability, if not back on their feet. If central banks were forced to raise rates ahead of any real recovery in economic growth then recession will be with us for a long time yet. Higher interest rates would be a death knell for companies and individuals only managing to hang on now. And in such an environment, there will be no increased demand for commodities. There will more likely be further falling demand.
The World Bank has pointed out the recent commodity boom was very long and very strong in comparison to recent booms. Commodity price increases were of a much greater magnitude than underlying GDP growth, and inflation was lower over the period than in previous booms. Previous cyclical downturns in commodity demand have lasted 4 to 19 years. Can this one last only one year?
A possible response to this question is, once again, China. Don’t forget it wasn’t that long ago we were talking about secular price shifts, the “super-cycle” and “stronger for longer”. Could the China effect mean that even a GFC of the magnitude of this one proves to force only a stumble in the global commodity cycle?
China has been a big buyer of commodities these past months and a very big reason why commodity prices have risen. The reason is two-fold: (1) the buying itself, and (2) the perception that China is buying because its massive stimulus package is working, and its domestic economy is set to grow strongly to offset its lost export market. Many have warned, however, that recent Chinese buying is no more than restocking of inventories and stockpiles which were run down over the previous several months. China naturally operates on destock-restock cycles, and commodity prices have not been this cheap for years.
JP Morgan believes Chinese commodity buying is “clearly more than a correction of overly low inventories”. Imports of iron ore, for example, have surged, and stockpiles had reached record levels in early April. JPM’s analysts had forecast an annual rate of steel production in 2009 to be 480mt, but in March the annual rate was running at 530mt.
China has also bought up so much copper locally that the Shanghai copper price has shot well ahead of the benchmark London price. Usually such price spreads don’t last long because of the arbitrage opportunity. But JP Morgan notes that the collapse of trade between the east and west has meant a shortage of ships available to transport the copper so the arbitrage gap remains.
But is this really evidence of a Chinese stimulus package at work? Or will China simply stop buying everything once the warehouses are full again, sending commodity prices back into a tail-spin?
JP Morgan does not believe the amount of commodity buying from China recently is necessarily excessive, given the sheer scale of public stimulus in the country and the level of bank lending associated with it. But it is also possible that China is “front-loading”. This implies that it is buying more than would otherwise be the case, probably to take advantage of comparatively low prices and to build “strategic” reserves rather than just the usual stockpiles. In the case of iron ore, JPM suggests record inventories may be all about being in a strong position in this year’s annual contract price negotiations.
In the meantime, it’s a very different story in the rest of the world. Japanese steel production, for example, fell 47% year-on-year in March. Even with a strong domestic infrastructure boost, is Chinese stimulus enough to return the world to strong commodity demand? JP Morgan analysts have forecast Chinese steel demand to net fall by 4% in 2009 as lost exports offset domestic projects.
“The risk is,” say the analysts, “that China’s inventory rebuild plays out and commodity demand and prices then look elsewhere for support and fail to find it”.
Citi’s analysts are even more unconvinced by the commodity price rally:
“Citi has for some time believed that the sector has bottomed for the cycle but we are urging extreme restraint in a sector which has already recovered 46% of the relative ground it lost in the bear market.”
Citi is referring here specifically to Europe’s resource sector stocks. But the message is nevertheless global:
“Economic indicators are stabilising, mostly in the “below zero” territory, and at least no longer plunging. That is not yet a recipe for miners to go on to reclaim all of the relative ground they lost since the world was in a wonderfully synchronised ‘super-cycle'”.
