China’s supply-side discipline
Recrudescence: The state or fact of breaking out afresh; a revival or rediscovery of something regarded as good or valuable
For those of us who have worked in funds management for more years that we care to admit, we have lived through times of significant transition in the investment landscape. Wistfully, I do recollect occasions when I had had enough leeway to analyse trends; time to form judgements about whether we indeed were in the midst of a change in the investment environment or not. Armed with knowledge that I had time at my disposal, even when I made mistakes, I changed course without inflicting much damage on the portfolio. Sadly, with the advent of central bank activism, high frequency trading, ETFs and Twitter, attention spans have shortened while individual stock volatility has increased, even if the VIX index doesn’t show it.
In the last couple of monthlies, I referred to a gut feeling that something seemed to have changed in the investment landscape. Since the onset of the global financial crisis, debt and deflation have been the dominant narrative for markets. It’s no secret that the Federal Reserve learned from the depression of the 1930s and has done its best to avoid persistent deflation from setting in to an extreme. The single biggest achievement in the past eight years for central banks has been preventing a 1930s-style depression. Yet, as followers of the Austrian school of economics know, business cycles are caused by distortion in interest rates and severe mal-investment from excess credit creation. No country more than China typifies this extreme misallocation of capital.
Following the deluge of credit in China, the effects of mal-investment are starting to show. Between 2015 and mid-2016, China became the vortex of a potential crisis that could have led to a major economic setback across the world. Rising interest rates in the US and capital outflows from China created conditions ripe enough for a financial accident. Fortunately for China, Ms Yellen (who was in China in February 2016) did not raise rates in March 2016. In hindsight, it seems that was the pivotal start of a series of events that might give us a clue to as how macroeconomic conditions seem to have changed.
Commodities: the return of supply-side discipline
Just around the same time, major oil-producing countries came to a tentative arrangement to cut back on production. Unlikely as it seems, oil prices hit lows of around US$26/bbl in February 2016. At that time, I remember reading that the world feared a collapse of economic activity in China, a potential devaluation of its currency and even further deflation. Yet, in that crisis, a hint of supply-side discipline was starting to emerge in the most significant commodity for markets and economies. In Q2 16, another almost improbable event occurred: the closure of some coal mines in China.
For years, the Chinese government paid lip service to supply-side consolidation. Yet, when it came to implementation, the potential job losses from such closures always held them back. It’s possible that the realisation has finally dawned upon them: keeping jobs alive in industries plagued by over-capacity was putting their banking system in peril. Several commodity producers are massively leveraged and uncompetitive on production costs. China might seem to be capitalist but there is a strong socialist streak, especially when it comes to social order and job preservation.
Since the financial crisis of 2008, there is some justification in laying blame on unbridled capitalism and free markets. Recent political swings are proof of the severe impact upon several sections of society. However, in my opinion, one attribute of free markets is undeniable. In capitalistic countries with a healthy respect for returns on capital, free market prices convey a very strong signal to adapt economic behaviour. It is no wonder that high-cost capacities were mothballed sooner by listed companies in Western markets. Purely as a result of a shutdown in capacities across the world, there seems to be a bit more semblance of balance between supply and demand in zinc, nickel, copper and iron ore.
The trillion dollar question surely remains: does China remain disciplined and pursue this consolidation to its logical end? Steel (and possibly cement) are industries in China to keep tabs on. From the last available statistics, there is almost 250-300 million tonnes of excess steel capacity in China, based on an optimistic 6.5% annual GDP growth target. There are reports that some old and inefficient plants will indeed be shut. On the back of those reports and a rising energy and iron ore pricing environment, we have seen steel prices rally recently.
Waiting for the Trump tirade
But maybe there is another dimension: external pressures that could force China to take this more seriously. The new US administration has so far been very quiet on China; other ‘foes and allies’ have so far received most of the attention. Yet the elephant in the room is hard to ignore. Surely, at some time in the near future, we will hear a Trump tirade against ‘too much stuff being exported from China’. If I were in the Chinese think-tanks, wondering how to mitigate this impending threat, would it not make sense to accelerate closures of inefficient manufacturing capacities and kill two birds with one stone?
If this does turn out to be the case, i.e. China does cut back on capacities, the supply-side discipline could be the fundamental justification for the revival in commodity prices that we have witnessed over the past year. It’s difficult to envisage a return to the gung-ho decade when BRICS and cheap credit drove commodity prices to levels not seen before. However, it may be enough to keep this breakout on a steadier but upward sloping curve. No wonder that some of the smarter economists are suggesting that we might well be at the end of a 30-year bull market in bonds. Rising energy and commodity prices, close to full employment in the US, rising wages and potential protectionism are sufficient ingredients to make us think about a possible end to persistent deflation.