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Exit Commodities?

Always an independent thinker, Rudi has not shied away from making big out-of-consensus predictions that proved accurate later on. When Rio Tinto shares surged above $120 he wrote investors should sell. In mid-2008 he warned investors not to hold on to equities in oil producers. In August 2008 he predicted the largest sell-off in commodities stocks was about to follow. In 2009 he suggested Australian banks were an excellent buy. Between 2011 and 2015 Rudi consistently maintained investors were better off avoiding exposure to commodities and to commodities stocks. Post GFC, he dedicated his research to finding All-Weather Performers. See also "All-Weather Performers" on this website, as well as the Special Reports section.

Rudi's View | Mar 30 2011

By Rudi Filapek-Vandyck, Editor FNArena

On Friday, April Fool's Day, two surveys into Chinese manufacturing will be released and both will show ongoing strong performance for Chinese exporters.

Alas, serious questions are being raised as to whether this will provide investors with the usual incentive for greater portfolio exposure.

For starters, Chinese authorities are hell-bent on reining in too-strong growth as their fear is for sustained higher inflation. Under these circumstances, another strong read for the monthly Purchasing Managers' Indices (PMIs) is more likely to trigger even more punitive action from the government.

Equally important is that more questions are being raised about the accuracy of such statistics. Official Chinese data are not adjusted for seasonal influences and thus March almost by definition throws up strong results, say economists.

This raises the risk that further government action on the back of these data might hit an economy that is not as strong as it appears.

A second anomaly is that Chinese data are compared with twelve months ago, while quarter-on-quarter comparisons are much better suited for short-term government policies and intervention.

These concerns are not new. It's just that they have become more important now that authorities are no longer stimulating jobs growth and economic expansion at all cost.

Earlier this week, China specialists at GaveKal-Dragonomics reported China's tighter monetary policy is starting to show up in slower growth in funding for real estate investment. This raises the risk for a full blown correction in the commercial housing market.

The analysts expect housing sales to continue falling in coming months, due to recent restrictions on purchases. This will add further pressure to property developers' cash flows and this, in turn, will curb new investment in housing. Dragonomics' concerns are echoed elsewhere.

It's not that China risks a double-dip recession like the US housing market is facing, but with the world uniformly and predominantly "long" China, the above developments have the potential to create a framework in which relatively small changes can lead to rather large short-term consequences; especially now that Chinese authorities have changed their tack by concentrating on reining in liquidity.

Regional asset managers at RBS in Asia recently expressed their concerns about the fact that 30% of fund managers in the region had positioned their portfolios Overweight materials compared to their benchmark indices.

In addition, noted the analysts, sector valuations in equity markets had now run up to two standard deviations above historical averages; often a signal that a maximum stretch is in place.

The RBS specialists suggest the materials sector is heading towards a "perfect storm" whereby slowing demand from China meets excessive market speculation plus the end of the Federal Reserve's QE2 program.

While not completely dismissing the impact from underlying demand in countries such as China, Brazil and India, RBS analysts suggest "liquidity" has played a key role in the rally for commodities since March 2009.

"Liquidity" in China plays a central role in a cautionary report issued by commodity analysts at DBS this week. One of the conclusions in this report reads as follows: "Fasten your seatbelts. It could be [a] fast ride down to July".

In line with economists elsewhere, DBS suggests upcoming data releases in China will show strong growth, but these data releases are also likely to mark the peak for this year.

As Chinese authorities are now stepping on the brakes, and genuinely reining in liquidity, growth will drop markedly in the next two quarters, predicts DBS.

It will then only turn back up strongly in Q4 because the Chinese authorities by then will have re-opened the liquidity tap. "If the past two years are anything to go by, growth will drop hard and fast", predicts DBS.

This is the point where investors whose portfolios are over-exposed to "China" and "commodities" might want to start paying attention.

While detailed information is not available, the likes of RBS nevertheless warn overall exposure to "China" by investors across the five continents is more likely than not at an all-time high right now – hardly the environment that can successfully withstand the confrontation with the above mentioned "perfect storm".

DBS argues that while financial markets have been plagued by sovereign debt issues in Europe, social unrest in North Africa and the Middle East, multiple earthquakes at multiple places and the threat of a nuclear disaster in Japan, the fact that private consumption in China has been slowing rapidly has remained under everyone's radar.

In addition, DBS cites six major influences that are all conspiring towards less liquidity in the world's most dominant growth economy:

– sharply reduced loan growth
– higher interest rates
– higher reserve requirements for Chinese banks (the RRR)
– a gradually appreciating currency
– a positive trade balance that has gone missing
– plus a vanished fiscal deficit

Previously, argues DBS, all these factors supported Chinese growth and demand for commodities. Now, these factors all point into the direction of less growth ahead.

The DBS report contains numerous excellent charts and graphs, that each speak more than a thousand words. Here are a few key examples:

Chart number one clearly shows how Chinese banks stepped up their loan growth in July last year, when equities and commodity prices hit lows for the year:

That same information, put in a different format, instantly reveals why DBS is more worried this time around: January and February have revealed themselves through negative growth and DBS suspects March will have offered more of the same.

Overall money growth in China is now as low as it has been since the opening months of calendar 2009:

While "real" retail sales have remained stagnant for nearly six months now:

The most "telling" chart, however, is one provided by RBS:

Conclude analysts at DBS: "A little slowing in China is surely just what the doctor ordered. Another ride down the roller coaster is probably more than she had in mind. Fasten your seatbelts. It could be a fast ride down to July."

Analysts at RBS reported to their Asian clientele earlier this week: "We recommend long-only investors to rotate their funds into other cyclical sectors, especially financials and technology (both are lightly weighted by consensus). We believe absolute return investors should sell all their materials exposure except soft commodities and consider going short."

Analysts at GaveKal reported the Fed has quietly allowed money supply in the US to ramp up in March (another event that has remained under the public radar).

This story was originally written and published on Tuesday, 29th March, 2011. It was sent out in the form of an email to paying subscribers at FNArena.

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