One of the best phrases that I came across over my years of trading was “better to travel than to arrive.” At first I wasn’t sure if it was a phrase coined by some Gordon Gekko wanna-be trader back in the 80s or an abstruse Confucius saying. Either way it baffled me as not only was it grammatically incorrect but was also contradictory to every prose I was taught in school. After watching the pnl trajectory of my first trade, it all made sense; these were the six most powerful words in our industry!
Last few days, the market has been reacting contradictory to any bad economic Chinese data. The official PMI came out disappointing with domestic orders falling again. GDP growth in Q2 can go down to 7.1% from 7.3% in Q1. Forward looking indicators such as the new orders/inventories ratio vs. its 5 year range do not show a rebound in activity either.
But Emerging markets and risky assets are rallying…what gives?
Everyone has been pre-empting some sort of Chinese stimuli to be released to defend their 7.5% annual GDP growth target. This evening, the Chinese government came out with an announcement to expand tax cuts for small businesses and adopt other fiscal measures to boost job growth by renovating shantytowns and investing in railway construction to support the economy, but the devil is in the detail. Government officials have repeatedly insisted that the GDP level is less important than job creation and that growth may be allowed to fall to a floor at around 7% provided that this year’s target of 10 million jobs is being met. They have said that markets could be disappointed if they are expecting the types of stimulus that investors have become accustomed to as tackling overcapacity is the priority for economic work this year.
This is in sync with the efforts made at their end so far to improve the banking system, get rid of excess credit and slack in the system such as closing excess aluminium and steel capacity. Controlling air pollution has been another top priority, which has serious implications for steel demand going forward. Capital misallocation is evident in the trust sector, China could allow some of these to default, which may destabilize the shadow banking sector. This would not bode well for “copper” and “iron ore” markets. According to Baml, ~ 750k tonnes of copper stocks are locked up in these warehouse financing transactions (used for collateral), equivalent to 3months of import demand.
The other bull case quoted by momentum investors is the “seasonal” pick up in steel demand in China (using history as a guide). Iron ore at ports are at highs and we could see a destock as further Chinese deals unwind, but steel inventories are low at mills that can offset this. Even if Chinese steel demand picks up seasonally, there is supply to meet this. Maybe prices remain at best range bound, but possible to see a slowdown as we move through Q2.
We could very well be at the start of a turning point of a global economic recovery especially as data from the US improves vs. earlier in the year due to bad weather, but it’s not a slam dunk just yet. There are opportunities no doubt, but being selective is key rather than just piling in to buy everything. Iron ore trading up 10% from mid March lows of $110/t has the most downside of all Commodities facing the worst demand/supply dynamics into 2015 onwards as prices can head down to below $100/t. One can argue the rational to be long Aluminum, Nickel or Platinum given the potential tightness seen in their markets. The icing on the cake is that these commodities can benefit from a Chinese “stimulus put” if one were to exist, but could fare well even without it.
Investors seem like addicts looking for their next fix. Perhaps a dose of reality is better suited for them, compelling them to go back to the drawing board and focusing on fundamentals than just playing the momentum.
