With Chinese demand drying up, the wheels are coming off the commodities supercycle, says James McKeigue.
What’s happened?
Since the start of this century, the prices of most natural resources have rocketed. For example, Standard & Poor’s GSCI index of 24 raw materials has risen by 400% since 2001. This surge has been described, most notably by US investor Jim Rogers, as a “commodity supercycle”. A recent UN working paper by Bilge Erten and José Antonio Ocampo suggests that since 1865 there have been four such supercycles, lasting around 30 to 40 years (including both the upswing and the downswing periods).
Previous cycles have been attributed to rising demand driven by America’s rapid growth in the late 19th and early 20th centuries, and to the post-war reconstruction boom in Europe and Japan. The driver of the latest cycle has been the rise of China. But now, with the GSCI index down 11.5% since late February, and mining share prices diving, some believe the wheels may have come off the supercycle.
Was China’s growth really so vital to the boom?
Yes. Since 2000 China’s economy has grown at a compound rate of 10% a year, making it the fastest growing major economy in the world. As it raced past Italy, Britain, France, Germany and Japan, its demand for commodities shot up. And China’s development has been incredibly commodity-intensive. Its level of fixed investment – spending on physical goods such as factories, infrastructure and housing – is much higher than other major economies, with around 46% of GDP based on fixed investment in factories, infrastructure and housing, compared to around 15% in a typical Western economy.
This building splurge saw China gobble up unprecedented amounts of natural resources. Since 2000 its share of the global consumption of tin has hit 50% from 18%, for example. Its share of nickel is at 43% from 6% and it uses 45% of the world’s copper from less than 10%.
So what’s gone wrong?
China’s growth is slowing. It recently downgraded its GDP forecast for the year to 7.5%. That may sound high to us in Britain, but it would be the weakest growth since 2004. And it could be far lower. There are always doubts over official Chinese figures: analysts suspect they may be massaged at various stages to help local bosses meet targets.
Other statistics paint a far worse picture. Electricity output – a key indicator of economic health – rose just 0.7% over the last year. State investment in railways has fallen by 44%; highway construction has dropped 2.7%. The state-supported heavy industries also look in bad shape: eight of the country’s largest ten shipbuilders have yet to receive an order this year.
Meanwhile, housing sales have fallen by 25% in the first three months of 2012, following a lending crackdown by the Chinese government. The industry employs 10% of the Chinese workforce and a further 20% indirectly.
What if China bounces back?
Some analysts expect China to have a ‘soft’ landing, or to relax monetary policy and ‘reflate’ its economy. Yet even if this rosy scenario pans out, there’s no guarantee it will drive commodity prices back up. That’s because China’s aim is to move away from relying on heavy investment in infrastructure and towards consumption. That means its growth will be less commodity-intensive, regardless of what happens.
Another factor pushing down commodity prices is that supply is finally catching up with demand. High commodity prices have encouraged investment in extra production. “Mining companies are acting as if China will remain at full throttle,” says Andrew Peaple in The Wall Street Journal. Research group Wood Mackenzie reckons that, “on average, annual output growth for copper, aluminium and nickel will be higher from 2012-2015 than from 2007-2011… In 2006, only iron ore had a surplus of supply over demand among major metals; by mid-decade, only zinc and lead could be in deficit.”
What about ‘financial’ demand?
Another wildcard factor could further undermine prices. Some of the demand in the last ten years may not have been real – some resource inventory is being stored for financial purposes rather than for construction or consumption. In China, the government’s lending restrictions have resulted in businesses buying commodities to use as collateral for loans, which they then used to speculate in other areas, such as property.
With the property market crashing, many such loans are likely to go bad and a lot of commodity collateral returned to lenders. That, in turn, will flood the market with extra supplies and push prices down further. The rise in popularity of exchange-traded funds that track commodities has also created ‘fake’ demand that could reverse if prices fall. No one knows how much copper has been bought for speculative purposes but copper analyst Simon Hunt fears it could be two million tonnes, around 10% of annual global demand.
Are all commodity prices falling?
Industrial metals are the most threatened. The outlook for others is more finely balanced. In energy, oil, as always, is vulnerable to geopolitics, while natural gas is already at a near-record low. Jim Rogers argues that “agriculture will remain strong”, with the global population expanding and getting richer and the supply of usable farmland limited.
Even here, though, note that Barclays analysts reckon Chinese calorie consumption per head already exceeds Japan’s. Then there’s gold. Commodity bulls argue that more money-printing by governments will lead to demand for commodities as an inflation hedge. We’d suggest that gold is the best insurance against this.