Asia Pacific: The False Dawn
Andy Xie (Hong Kong)
Commodity prices have not bottomed, in our view, and the big fall has yet to come. The decline in 2Q04 was mostly due to unwinding of speculative inventory, and prices have recovered somewhat in the past month as this process has come to an end. China’s industrial production has not yet slowed discernibly, hence Chinese consumption of commodities remains at a high level.
China’s electricity consumption grew by 16.5% in 2Q04 compared with 16.3% in 1Q04, implying that the Chinese economy has yet to really slow. However, auto and property sales are slowing quickly, suggesting rising inventory. As these two sectors have been leading the economy, signs of these bubbles bursting would point to sharp production slowdown in the coming months. The turning point should be reached when production companies exhaust their working capital in inventory accumulation. When China’s economy really slows, we expect commodity prices to drop sharply.
The Chinese Economy Is Only Beginning to Slow
The market consensus is that China is done with tightening and the next move is easing. Commodity prices, especially for hard metals, which were pummeled over the previous two months, have bounced back substantially: the copper price is up by 10% from its low one month ago, and the nickel price is up by 43% from its low in early May. These signs have given the market the confidence to bid up commodity prices and cyclical stocks. This is a mistake, in our view — the Chinese economy is just beginning to slow, and it is too early to tell how far and how fast it will decelerate.
China’s industrial and electricity production did not change much in 2Q04 versus 1Q04, with increases of 16.5% and 17.1%, respectively, from the same period last year. If anything, factory electricity generation with diesel generators rose in 2Q04 due to worsening rolling brownouts. We see a case for assuming a higher GDP growth rate than China has reported for 2Q04, as the reported number seems inconsistent with the data at the industry level.
However, sales of autos and property — the leading products in this cycle — are slowing. Auto sales have been declining in the past few months from their giddy growth rates previously. Though auto production has yet to slow, price wars are unfolding in the auto market and auto inventories are piling up. Similarly, the average time for selling properties has lengthened, possibly by one month on average. That has also added to inventory. As inventory levels continue to rise, production should decelerate quickly as producers exhaust their working capital.
Commodity Prices Will Fall Substantially
When the market was convinced in April that China was going to tighten, unwinding of speculative inventory began, which caused commodity prices to correct. However, Chinese production, which drives real demand, had not slowed. After the inventory unwinding, commodity prices began to recover on still strong demand.
There is a high correlation between China’s electricity growth rate and the CRB index. Indeed, one could argue for causality, given the share of commodity growth for which China accounts. Chinese electricity appears to be a leading indicator for the CRB index by three to six months.
Chinese electricity consumption has averaged about 8% annual growth in the past quarter-century. It has averaged 17% in the past 18 months, twice as fast as the historical trend. This is consistent with the 50% increase in the CRB index since 2000.
Chinese electricity consumption should revert to the mean as the investment bubble deflates. During the transition, we would expect electricity consumption to decelerate by 50%, pushing the CRB index down by one-third if the historical relationship holds. That would push the oil price down to US$25/bbl and may halve the copper price, on our estimates.
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