China Fears The Key Worry For Commodities‏

The violent sell-off seen over the past few days in risk markets has not left commodities untouched. Notwithstanding a small rebound Friday morning, energy and metals have been shed on a large scale with Brent crude trading at USD102/bbl after flirting with a two-month high earlier last week. Si LME copper has moved firmly below USD7,000/MT. A sell-off in bond and equity markets and broad-based USD strength on accelerated Fed tapering of quantitative easing (QE) fears are widely cited catalysts. But before becoming too preoccupied with the Fed scaling back on easing, we stress that fears over a continued deceleration in Chinese growth have become a very central issue as well – not least for commodities.

The channel for China fears last week was partly a drop in the HSBC flash manufacturing PMI further below the 50.0 level in June to 48.3 (from 49.2), see Flash China for details, and partly a surge in Chinese money market rates due to a lack of liquidity. While the People’s Bank of China (PBoC) eventually managed to calm markets somewhat with liquidity injections, the recent experience points to something more fundamental in terms of Chinese monetary policy. The PBoC has intervened less in the FX market lately, thus providing less CNY liquidity, an, at the same time, regulatory tightening during the spring is also working to tighten monetary conditions. The main focus for the new leadership in China is on structural economic reform and managing financial risks. Authorities continue to signal a willingness to sacrifice short-term growth to achieve this. As a result, we are stressing substantial downside risks to our forecast for a moderate recovery in H2.

For commodities, it is no news that the Chinese recovery this time round has failed to bring back the demand growth for energy and raw materials seen in past recoveries. The Chinese imports of commodities have been surprisingly muted, despite some indications that the State Reserve Bureau has been utilising depressed price levels to make some strategic additions to inventories. One of the reasons for this has been increased domestic supplies of some materials such as copper. Coupled with weaker-than-expected activity, this has been weighing on demand in the People’s Republic. Top this with an ongoing structural decline in Chinese growth, and one that is importantly set to become notably less commodities-intensive going forward results in a rather dire cocktail for commodities.

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