Cross Asset Strategy
U.S. April CPI released on Wednesday was in line with expectations, and had some favorable details. The headline figure came in at 4.9% year-on-year, falling from 5% in the previous month. Rental inflation, the largest contributor to core inflation, showed signs of moderation. Core service inflation also cooled, driven by the travel and leisure sectors. Markets reacted positively to the print with higher equities and lower bond yields. Notably, the tech-heavy Nasdaq 100 index rose 1.1% led by a rally in mega-cap techs.
In our view, while underlying inflation is still somewhat sticky, it is stabilizing at a much cooler pace. In isolation this print is consistent with our base case that the rate hike at the May FOMC meeting was the last one. However, we’d note that this is just one of the important data prints between FOMC meetings, with another crucial release – the strong jobs report from last week – pointing to a different direction. Before the June meeting there is another month of jobs and CPI to look forward to, which should provide more clarity on the Fed’s policy path forward. As we discussed in a previous article, as the Fed policy shift looms, investors may need to think carefully about reinvestment risk, as rates of short-term T-bills will likely fall further from here. Thus we still prefer longer duration core bonds over cash equivalent instruments given their historically compelling yields and the opportunity for price gains and portfolio buffer over the coming years.
Strategy Question: Why China's recovery is not driving commodity prices this time around
As China’s economy continues to recover, a key question is how this recovery will impact the global economy – and specifically which countries, sectors, and companies will benefit the most. One of the key ways any country exerts influence over the global economic cycle is through trade, as in, how much does it buy and consume from other countries?
Two of China’s key trade conduits are overseas tourism (a services import), which we wrote about in a recent note, and commodity demand, which we are addressing today. China’s commodity consumption (much of which is imported) is perhaps the main way China impacts the global cycle. It’s easy to understand why. China is a major consumer, and an even more significant importer. As you can see in the chart below, China imports over 70% of the global share of traded iron ore, 72% of aluminum, and over 60% of both copper and soybeans. For this reason, any changes in China’s consumption could have a global impact. And indeed we’ve seen this in the past: when China stimulated post-GFC, eased policy in 2012 during the Eurozone debt crisis, or stimulated in 2015, each time it led to a boom in commodity prices and a boost to the global industrial cycle. Commodities are not just important in their own right, but many countries (indeed even the EM index to an extent), are highly correlated with commodity prices. Thus if China’s recovery boosts demand and prices, there are clear global implications. Interestingly, prices of crude oil disappointed many by largely trading range-bound between $70-$80/bbl over the early phase of reopening in China. In today’s note we’ll look at how China’s economy is recovering and whether this recovery will provide a boost to commodities.
CHINA COMMODITY IMPORTS
Why this recovery is different
In China, the 2023 growth recovery is looking very different from past cycles. While the property market has historically led the cycle, in 2023 it is still in de-leveraging mode. Instead, the recovery is due to the exit from COVID Zero policies, and this is driven largely by the normalization of the service sector following strict lockdowns. We have seen some initial recovery already. For instance, high-speed train tickets were instantly sold out for the May Labor Day holiday. But there are also plenty of signs that there is more to do. Service sector employment is far below pre-COVID levels across wholesale/retail, restaurants, hospitality, construction, business services, as well as new economy sectors like rental and delivery. International travel is around a third of pre-COVID levels, as bottlenecks around flight routes and permits, as well as the lengthy process to renew passports and visas also played a role. In contrast, sectors such as property, exports and infrastructure are facing more headwinds. The property sector is still de-leveraging. Although some pockets of the market (such as secondary sales and a few tier 1 and 2 cities) have shown signs of tentative stabilization in transaction volumes, the recovery is still far from broad-based. The export sector is more cyclically exposed and has room to slow further if our expectations for U.S. recession and global slowdown materializes. Last but not least, infrastructure investment has held up relatively well, while on the ground construction activity has meaningfully lagged. Given the push for more fiscal discipline, the odds for a big fiscal stimulus are low, in our view. Balancing the consumption recovery with the headwinds, we expect GDP growth of around 4% for 2023. And given some of the strength is clearly front-loaded into Q1, we expect a flatter growth profile in the rest of the year.
What does this growth outlook suggest regarding commodity demand
From a fundamental perspective the outlook suggests that near-demand recovery will likely be gradual, and probably quite differentiated depending on the respective commodity’s exposure. Take oil as an example. Consensus expects1 that China will account for a big chunk of the incremental increase in oil demand in 2023 – to the tune of one million barrels per day, out of a total increase of 2.6 million barrels per day projected for this year when travel fully normalizes to pre-COVID levels. So far, oil demand recovery in China appears to be broadly on track with this assumption But given the various bottlenecks in international travel, a full recovery this year is far from certain. For industrial metals such as copper and iron ore the cyclical headwind from a slump in the property market may well prove to be a much bigger challenge. New residential constructions are down 18% y-o-y in Q1, after two years of steep contractions (-11% in 2021 and -40% in 2022, see Chart below). Given the new leverage rules and slowing sales, property developers are unable, as well as unwilling, to buy land, which will mean less construction will take place down the line. Sales activity has reflected this weaker trend. Despite a short burst following the removal of Covid restrictions, sales activity has fallen well below the 2019 trend – creating what is likely a “new normal” of weaker activity as the property sector continues to deleverage and rebalance after years of excesses.
NEW RESIDENTIAL CONSTRUCTIONS REMAINED WEAK IN Q1, AFTER TWO YEARS OF STEEP CONTRACTIONS
China: newly started construction: residential building Mil.Sq.Meters, seasonally adjusted
Our outlook assumes a moderate contraction in housing construction activities in 2023 and 2024. These feed into only modest growth in fixed asset investment growth, at least in the early part of this recovery.
For the sake of metals, especially iron ore, and to an extent copper, housing is the sector that matters. Infrastructure investment tends to have no correlation to commodity imports and is far less commodity-intensive than housing. With a still subdued outlook for property construction, base metals could be less supported.
HOUSING MATTERS MORE THAN INFRASTRUCTURE FOR METALS
30 large and medium-sized cities: commercial residential building: floor space sold
CORRELATION BETWEEN PROPERTY CONSTRUCTION AND COMMODITY IMPORTS
CORRELATION BETWEEN INFRASTRUCTURE INVESTMENT AND COMMODITY IMPORTS
Despite the cyclical recovery and headwinds in the economy, the Chinese government remains quite focused on making sure the economy stays on track for the de-carbonization goals. Local governments are assessed and monitored on energy consumption targets. The overall regulatory structure around emissions, pollution control and energy efficiency has gradually tightened up over the last few years. So the curbs and controls around highly polluting and energy-intensive industrial activities such as metals and mining industries may well get even tougher in the coming years. From an overall perspective, these supply-side changes are putting upward pressure on costs, and the overall impact on prices has been very limited due to the housing sector slump and frequent price intervention from regulators. The overall green transition will likely entail significant further investment in electrification and related infrastructure, but as it is taking place over many years, the cyclical impact will likely dominate, at least for now.
However, gold is seeing a bounce and could have further to go
Gold enjoys multiple tailwinds in the current environment. Real yields and the strength of the U.S. dollar are traditionally the key fundamental drivers of the yellow metal, and both are appearing supportive. It’s increasingly clear that yields are on a downtrend, as the Federal Reserve hinted that the latest rate hike may be the last of this cycle; and the dollar is on track to unwind the historically excessive overvaluation that built up last year. We are also seeing gold’s safe haven characteristic coming back – as it responded strongly to the U.S. regional bank distress since March. As we further advance into the late cycle, fragile risk sentiment will likely continue to encourage diversification into gold.
From a demand perspective, central bank buying is in focus. Reported global central bank gold reserves rose by 34% year-on-year in Q1, making it the strongest start to a year on record. The World Gold Council believes that central banks will remain net buyers in the short term2, which could be a solid support to gold prices. China has been a key buyer adding 58 tonnes in Q1.
CHINESE CENTRAL BANK HAS BEEN A KEY BUYER OF GOLD
China official reserve assets: gold, mil. fine troy ounce
On the other hand, demand from hedge funds, Commodity Trading Advisors and retail investors remained sluggish. Managed money positioning is still about 50% lower than it was in 2019/2020, indicating plenty of room to add to the trade.
The ongoing debt ceiling debate in the U.S. also highlights the importance of diversification, especially for USD-based investors. In the lead up to the 2011 episode when Congress increased the ceiling just days before the “X-date” and the credit rating of U.S. debt was subsequently downgraded, we saw some significant outflows from USD into other safe haven currencies/assets. Notably, gold bounced ~10% amid the immediate debt-ceiling related volatility. We favor gold as both a tactical hedge and a strategic allocation, and see opportunities across spot/derivative strategies to accumulate.
2 World Gold Council, IMF, Respective central banks as of Mar 2023.
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