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China Economy Dragging Commodities Lower

Commodities / Commodities Trading Apr 21, 2012 - 06:19 AM GMT

By: Zeal_LLC

Commodities

Best Financial Markets Analysis ArticleCommodities have been sinking like stones since late February, an unusual divergence from the rallying stock markets.  This relentless weakness has wreaked havoc on commodities sentiment, leading traders to abandon commodities stocks.  As we all try to make sense of this surreal bloodbath, one catalyst keeps coming up.  Western perceptions of the Chinese economy have been a real drag on commodities.

China is indeed one of the major drivers of this past decade’s secular commodities bulls.  As the world’s most-populous country, it has over 1.3b people who collectively consume vast amounts of resources.  China sports the fastest-growing major economy on the planet, which has recently catapulted it to become the world’s second largest after the US.  China is also the second-largest importer on Earth.


Many of these imports are raw materials, which China’s myriads of factories fashion into finished goods that are exported globally.  As the world’s largest exporter, the sheer quantities of commodities necessary to feed this machine are staggering.  And the great income this export trade generates is inexorably raising the standard of living in China, and of course wealthier people consume more commodities per capita.

So there is no doubt China is at the heart of the global commodities boom, this giant’s incredibly rapid rise is unprecedented in world history.  Thus Western investors and speculators eagerly hang on every data point that might illuminate how China’s economy is faring.  And unfortunately for commodities and the stocks of their producers, recently these reads have been coming in below Western expectations.

The latest arrived heading into Friday April 13th, when China’s National Bureau of Statistics released the country’s Q1 GDP.  And though it came in at an awesome annual growth rate of 8.1%, which any other major country would die for, this disappointed traders.  Q4’s growth rate was 8.9%, so China was seen to be “slowing”.  And coming in below expectations of 8.3%, it was decelerating faster than feared.

So that day futures traders dumped commodities, driving their primary index down 1.2% to challenge a new correction low.  Unfortunately there are plenty of instances like this over the past year or so.  I could easily write a whole essay explaining them and their immediate market impact.  But the key takeaway for now is China slowdown fears are inarguably a major thorn in the side of commodities prices.

As I’ve contemplated this while lamenting the ongoing carnage in commodities stocks, I’ve wondered about the Chinese stock markets.  Here in the States, the fortunes of our flagship S&P 500 stock index (SPX) color the sentiment for the entire country.  I elaborated on this recently in an essay on the SPX’s impact on the upcoming US elections.  With greed and fear universal, why would China be any different?

Are the fortunes of the Chinese stock markets affecting traders’ outlook on that country’s economy both domestically and globally?  And if Chinese stocks have been weak, is that a major factor contributing to the odd divergence witnessed in commodities recently?  I decided to take a look, and the results are provocative.  Indeed US commodities prices have been following China’s stock markets lower lately.

Naturally the mighty SPX is the best measure of US stocks’ progress, and the old-school Continuous Commodity Index (CCI) remains the premier way to track commodities as a group.  Over in China, the local equivalent to the SPX is the Shanghai Stock Exchange Composite Index (SSEC).  It is based on its components’ total market capitalization relative to a starting day (in December 1990).  Like the NASDAQ Composite, the SSEC’s components include all stocks listed on that exchange.

In order to investigate any potential interrelationships between commodities prices and the Chinese stock markets, I built a couple charts comparing the two.  To keep their percentage moves perfectly comparable, I indexed each to a common base of 100.  For reference, the SPX is also included.  And its well-known major highs and lows are used as the base dates from which all three series are indexed.

This first chart normalizes the premier commodities, Chinese stock, and American stock indexes from the common base of the SPX’s major interim high at the end of last April.  As the SPX started consolidating and then correcting, the SSEC and CCI followed it lower in similar selloffs.  Commodities were actually considerably more resilient than both countries’ stocks in tumultuous August, with the CCI surging fast.

But our woes as commodities-stock investors and speculators began in September.  Late that month a brutal one-two punch bludgeoned the CCI to new lows, crushing sentiment.  First the Fed failed to launch QE3 as some traders expected, igniting one of the periodic QE3 scares.  Then overnight heading into the next morning, a preliminary private report claimed China’s manufacturing activity was slowing.

The result was a mind-boggling 4.2% plunge in the CCI, its biggest down day since October 2008 in the dark heart of the stock panic.  If such a selloff had happened at higher levels, it wouldn’t have been as devastating.  But erupting near lows it just shattered the CCI’s lower support.  So futures traders, spooked by China fears, dumped commodities with reckless abandon.  Sadly, this wasn’t even remotely justified.

China’s growth was not stalling as feared, later on its actual official 2011 GDP growth came in at 9.2%!  But from that point on, nervous Western traders started using China as an excuse to sell.  Even though the difference between 7%, 8%, and 9% growth is pretty trivial relative to China’s massive aggregate commodities demand, any hint of China slowing sparked fear.  Ironically China’s growth rate should be slowing, as the larger its economy gets the harder it is to continue growing fast off higher bases!

In October and November both commodities and the Shanghai Comp continued to rally and retreat with the world-leading SPX.  Normally commodities follow the SPX higher in its major uplegs, as rallying stock markets lead to expectations for an improving US economy which implies higher commodities demand.  But oddly in December, the CCI started to decouple from the SPX.  It followed the SSEC lower.

More minor data points that should have been inconsequential drove this late-2011 plunge.  For example, early in December China reported its industrial output “only” growing 12.4% year-over-year in November compared to 13.2% in October.  Unfortunately with traders already worried about China, the CCI ground down to new correction lows on this news.  China psychology was heavily influencing US commodities sentiment.

But with commodities so unbelievably oversold by mid-December, most of the weak hands were already shaken out so mostly buyers remained.  Thus the CCI finally started rallying with the SPX as it usually does and ought to.  Chinese stocks bottomed a little later in early January, when they started to join the global rally too.  Once again these interrelationships worked as they should, with the SPX leading the way.

But unfortunately in early March, both the CCI and SSEC started their vexing divergences away from the SPX’s strong upleg.  One immediate catalyst was China’s Premier Wen Jiabao cutting its 2012 economic-growth target to an 8-year low of “just” 7.5%.  Personally I didn’t take this too seriously.  7.5% growth for the world’s second-largest economy remains amazing in an absolute sense, what an achievement!

And exactly a year earlier this same guy had predicted that China would only grow by 8.0% in 2011, which sparked a commodities selloff.  But the actual at the end of last year came in at 9.2%.  Like any shrewd manager, the Premier was just lowballing expectations and setting a nice easy target to beat so he could look like a great leader.  Nevertheless, the CCI still plunged 1.7% that day.

And as March wore on the selling gathered momentum and snowballed, in both the CCI and SSEC.  This was crazy given the strong rally in the SPX that month.  The divergence truly made no sense at all fundamentally, it was purely psychological.  And even these fears’ foundation was flimsy at best.  Since when is the stellar 8.1% annual growth rate China achieved in Q1 a slowdown?  Talk about silly.

The Shanghai Comp finally managed to bounce in late March, and has been rallying sharply since despite a sizable pullback in the US stock markets in much of April.  Unfortunately commodities didn’t turn north with the SSEC, probably a reflection of the dismal sentiment due to the recent divergence.  Selloffs often take on a life of their own until everyone susceptible to being scared into selling anytime soon has already sold.

Not only are commodities lagging wildly behind the SPX, but so are the Chinese stocks.  The US economy is struggling to hit 3% GDP growth, China’s is over 8%, yet the US stocks are thriving while China’s remain down in the dumps?  This is really illogical and certainly not sustainable.  The huge divergence between the SSEC and the SPX that has opened up since December can’t last.

And when China’s stock markets start surging to catch up with the big US upleg, I suspect Western traders’ perceptions of a slowing Chinese economy will vanish.  The fortunes of local stock markets all over the world heavily influence how domestic and foreign traders alike view their respective economies.  As the SSEC’s overdue rally closes the gap with the SPX, China’s commodities headwind should shift to a fierce tailwind given how oversold and ripe for a major rally the CCI is these days.

The gap between the post-correction performance in the SSEC and SPX above is really big, but that short-term chart doesn’t even begin to tell the whole story.  So I made a second one, this time indexed to the SPX’s major bear low in March 2009.  Unbelievably, China’s flagship stock index had actually retreated near panic levels earlier this year!  This has huge commodities implications.

While the American stock markets have enjoyed a powerful cyclical bull since the stock panic, the Chinese ones have actually been mired in a cyclical bear!  After an initial massive surge in early 2009 that saw the SSEC nearly double, it has been grinding inexorably lower ever since.  The net result was by January 2012 this flagship Chinese stock index was back trading at March 2009 levels.

This is staggering and defies belief.  Obviously China is the world’s hottest economy, with incredible sustained growth.  As it expands and thrives, shouldn’t its stock markets rise to reflect the vast new profit streams and wealth being created?  With its economy growing between 8% to 9% annually since then, its stock markets falling 38% are definitely not reflecting these super-bullish underlying fundamentals.

For a simple illustration, let’s assume China’ GDP averaged 8.5% annual growth over the past 3 years (the actual is higher).  So between early 2009 and early 2012, China’s economy grew by nearly 28%.  No matter how overbought the SSEC may have been in mid-2009, there is no fundamental justification for it trading at similar levels today to when the Chinese economy was much smaller.  Economic growth drives revenues and profits, and profits drive stock prices.

So odds are the Shanghai Comp should be much closer to the SPX’s indexed cyclical-bull performance than it has been.  I don’t know where the exact number ought to be, of course, but let’s conservatively assume that half the divergence between the SSEC and SPX needs to vanish fundamentally.  In order for this to happen, the Chinese stock markets would have to rocket about 50% higher!  This is an enormous move.

And when the Chinese stock markets finally start reflecting the incredible economic success story in China, investors and speculators around the world will become a lot more comfortable with its growth prospects.  A rallying SSEC emerging from its cyclical bear will quickly turn China sentiment from bearish to bullish.  And as traders grow optimistic on this country, capital will almost certainly migrate back into commodities again.

Unfortunately with today’s SPX upleg getting long in the tooth, the fundamental normalization of Chinese stock prices isn’t going to all happen before this SPX upleg gives up its ghost.  So even though the oversold commodities are due for a sharp rebound rally right now, they aren’t going to enjoy the full benefit of sentiment on China changing before spring seasonals peak.  So most of these bullish China tailwinds for commodities will probably have to wait for future uplegs.

Nevertheless, the years of China growth fears hammering commodities are probably effectively over.  Cyclical bear markets, and stocks trading near panic levels, simply make zero fundamental sense in a thriving rapidly-growing economy.  As traders around the world start to realize this and bid up Chinese stocks, the bearish sentiment surrounding China’s economic outlook will inevitably turn bullish.

At Zeal we’ll be ready for this major shift.  While our commodities-stock positions have been crushed like everyone else’s in this upleg’s anomalous divergence, we eagerly await future buying opportunities.  By the time the selloff matures that will come after today’s SPX upleg tops, the Chinese stock recovery ought to be in full swing.  This will first limit and then eliminate the festering China fears that have weighed on commodities.  And after so much pessimism and fear, commodities are overdue for a massive upleg.

We can help you ride it.  We publish acclaimed weekly and monthly subscription newsletters loved by speculators and investors all over the world.  In them I draw on our vast experience, knowledge, wisdom, and ongoing research to explain what the markets are doing, why, where they are likely heading, and how to trade them with specific stock trades as opportunities arise.  Subscribe today!  We also publish comprehensive fundamental reports on our favorite stocks in promising sectors, with the latest on junior gold stocks.  With gold stocks ridiculously oversold, the buying opportunities today are amazing.

The bottom line is irrational China fears have indeed been a drag on commodities in recent months.  Traders’ worries about China’s stellar GDP growth rates decelerating have been exacerbated by China’s cyclical bear market in stocks.  But with the flagship Chinese stock index finally bottoming and rallying, the stiff commodities headwind should soon abate.  China sentiment will morph from bearish to bullish.

Chinese stocks, which heavily color global traders’ perceptions about the health of China’s economy, are overdue for a major bull market to reflect that country’s strong economic growth.  And as rising stocks ratchet up China enthusiasm, capital will naturally flow back into commodities as a consequence.  A positive China dynamic for a change should considerably amplify the next big commodities upleg.

Adam Hamilton, CPA

So how can you profit from this information? We publish an acclaimed monthly newsletter, Zeal Intelligence , that details exactly what we are doing in terms of actual stock and options trading based on all the lessons we have learned in our market research. Please consider joining us each month for tactical trading details and more in our premium Zeal Intelligence service at … www.zealllc.com/subscribe.htm

Questions for Adam? I would be more than happy to address them through my private consulting business. Please visit www.zealllc.com/adam.htm for more information.

Thoughts, comments, or flames? Fire away at zelotes@zealllc.com . Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!

Copyright 2000 - 2012 Zeal Research ( www.ZealLLC.com )

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6 Critical Money Making Rules