It has been a month since our last update on a trade idea that turned out to be a great success after all that was said and done. The trade idea in question was of course a topical one of going long crude oil and tactically adjusting both the direction and size of exposure. Having penned our last note on oil, it is time we moved on to greener pastures.
We have several reasons for moving on. One being volatility, something we discussed about last week; volatility is the life blood of the markets and the crude oil market seems to have lost a lot of it - conforming to our view that prices would trade in a range for the interim until a huge enough catalyst. Although we could have chosen to further speculate on the trajectory of oil prices, we don't see a utility for that. For the record, we are still more bearish than bullish on crude prices but remain adamant on a breakout; even the recent Iranian nuclear "deal" with the P5+1 failed to inspire a sizable move in prices, making us think what will.
Moving on now, we turn to a few trade ideas that are similarly based on a common broad theme: China.
China Will Likely Surprise Negatively
The debate about China's slowdown isn't a question of it it has happened but how much. While Chinese officials themselves have downgraded 2015's growth forecast to 7%, the lowest in more than 2 decades, we are more skeptical about the degree of slowdown than what the Chinese themselves would like the world to believe.
In short, we feel the deceleration in China's economic growth is far more acute and has both structural and cyclical elements to it (even assuming China has already overcome the hardest part of it social-economic transition) contrasting popular belief that the raging dragon has merely taken a breather.
For instance, a quick look at both the official and HSBC PMIs (Purchasing Managers Index) will indicate that the Chinese economy is at best just above stagnation. A 7% GDP growth for 2015 would easily put PMI figures of above 55. Rather, the PMIs have consistently printed very lukewarm figures in the ballpark of 50-51; they were previously even negative, connoting a contraction in economic activity.
Besides the PMIs, there are a myriad of other economic indicators that are calling the Politburo's mandated 7% a big bluff, such as total electricity consumption, vehicle sales, business activity, and fixed capital investment. Most of these metrics are pointing in the polar opposite direction to that of what the 7% growth for 2015 implies.
The consensus is what scares us. China is due to announce 1Q15 GDP data this Wednesday and we feel expectations of a 7% YoY growth is overly optimistic. Remember that China grew at 7.3% last year according to official figures.
Although we will not start a raving debate on the integrity of these official figures, an 7% annualized expansion in the world's second largest economy in light of actual happenings in and outside the mainland really beggars even the faintest of believes.
Trade Surplus Lowest In 14 Months, Imports Slump
Adding insult to the injury was trade data for March released Monday showing Chinese trade missing on all fronts. The trade balance (net exports) crashed to the lowest since February 2014 and was one of the largest misses on record. Despite the stronger Yuan since January, imports failed to meet expectations, hinting of lethargy in consumption and industrial demand.
- March imports fell 12.3% YoY in Yuan terms, missing expectations of a 11.3% fall;
- March exports fell 14.6% YoY in Yuan terms, missing expectations of an 8.2% rise;
- March trade balance fell to 16.16bn Yuan, missing expectations of 250bn Yuan
- March imports fell 12.7% YoY in Dollar terms;
- March exports fell 15% YoY in Dollar terms;
- March trade balance fell to $3.08bn
What really caught our eye was the continual slump in imports. If macro economic data misses for a month or 2 it may fairly be dismissed as noise. However, when data consistently misses for 5 months, it is telling us something.
Being the world's second largest economy, China has a huge role to play in the equilibrium of supply and demand, and therefore price formation. When we contemplated this particular set of trade ideas, China's import figures meant very much to us.
In our eyes, the weakness in Chinese imports implies that the world's largest single source of basic industrial commodities is waning. The one thing that China imports a lot of is base metals and basic commodities which its once bustling construction industry was so hungry for.
Remember the documentaries of those so called "ghost cities" that used to air on popular TV networks? They were probably the epitome of China's greatest economic and financial malfeasance.
More importantly to us, they represent an industry in structural decline, and the demand for industrial commodities that trails in its wake.
As China Sneezes, Commodities Catch A Cold
We don't think this is a cliché, that industrial commodity prices are tied to Chinese economic activity. Commodities such as iron ore, copper, zinc, and aluminum caught our eye for being inexplicably interlinked to the Chinese economy. In our eyes, the opportunity lies not in this knowledge but the arbitrage that can be played especially if current prices have diverged from their underlying trends.
Industrial commodities are mostly negative on YTD. The strengthening greenback and ongoing macro concerns over China have impacted the precious metals and bulks commodities in their own particular fashion. The exceptions have been aluminum, copper, zinc, palladium, gold, and silver; all of which have seen modest gains. Our outlook for these commodities remains to the lower end - continue weakness in prices.
Steel demand is seeing only seasonal improvements as is typical of the period immediately after the Lunar New Year; Chinese government officials also cite this reason for volatility in trade data, although we think there is much more to it than seasonality factors.
However, when we look at the largest source of demand for steel (hence iron ore) - real estate - demand on that front remains soft. One does not have to look far and wide of evidence of a property market in broad decline, and a construction industry on the verge of stepping into a lost era with record number of bankruptcies and insolvency cases in 2014 coming into 2015.
On top of major structural headwinds, reforms to the general business environment such as mounting environmental pressures have risen with strengthened environmental law. This has forced curtailments in steel consumption as firms start to adopt more deficient practices. This obviously has a long ways to go.
The bottom line: It is near impossible for steel demand to reach levs seen in the previous years.
Along with Citi, we expect spot iron ore prices to fall to the mid $30s and stay in that ballpark. Apart from waning demand, supply of the ferrous metal continues waxing. Large scale supply growth is set to add to pressure from weak demand and deleveraging within China's corporate sector. Moreover, cost deflation and marginal production are shifting to stickier suppliers with contracts that are less flexible than ever as producer costs bear an ever increasing burden on miners. We expect producers to maintain their current forecasted level of output for reasons that are obvious.
Iron ore demand in China is declining with steel production down YoY and domestic demand even worse. Large scale supplies should continue to enter the spot market despite declining prices and disappearing margins. All these basically mean that for an equilibrium to be achieved, prices have no choice but to head lower over the long term.
As a side note, credit rating agency Standard & Poors has placed several iron ore producers on negative watch in light of falling spot prices. This perhaps illustrates the severity of the situation we have described.
Trade Idea: Short Copper, Palladium, Steel
We favor building a short exposure to a complex of industrial metals. Our prime candidates are copper, palladium, and steel. We also foresee continued weakness in the Aussie dollar as weakness in Chinese macro economic data persists.
Depending on the market's reaction to China's GDP figures later on, weakness in these industrial metals should be capitalized on but with a few caveats. A weak dollar, or volatility in the dollar may cause undesired price action. As such, having a hedge the dollar will be a prudent way to smooth out returns as the trade plays out.