Why China’s Heading for a Hard Landing, Part 5: A. Gary Shilling
The hard landing that I foresee for China will probably prick the global commodity bubble, which is already showing signs of topping out.
Agricultural product prices have jumped, the result of robust demand, bad weather last year in Russia, recent floods in Australia, and dry and hot La Nina conditions in Argentina.
Industrial metals such as copper were on a tear. So were precious metals, such as silver.
But much of the leap in commodity prices was due to investors and other speculators. Exchange-traded funds had already tied up much of the physical supplies of gold and other precious metals. Futures contracts held by speculators were up 12 percent in 2010 through October, with sharp increases in bullish bets on crude oil, copper and silver. Volatility forced futures exchanges to raise margin requirements on a number of commodities.
The confidence that China would continue to buy huge quantities of almost all commodities has been the bedrock belief of speculators. For example, there were rumors that China was again building its emergency petroleum reserve in the first half of this year.
I’ve studied many bubbles over the years, and concentrated on predicting their demises. Commodities show every sign of being in one.
China added to the commodity frenzy last year by slashing exports of rare-earth metals used in high-tech batteries, TV sets, mobile phones and defense products. China supplies 95 percent of these elements, and consumes 60 percent, exporting the rest. Its exports of rare earths fell 9 percent in 2010, but still exceeded the government’s quota by a third.
Chinese authorities cut the export quota for the first half of this year by 35 percent from a year earlier. Japanese manufacturers of high-tech gear are seeking alternative supplies. Of course, China maintains that its ongoing trade and political spats with Japan have nothing to do with the tighter quotas. They were necessary, Chinese leaders say, to sustain rare-earth development and deal with environmental damage caused by mining.
Speculators are starting to take stock of the evidence of a hard landing in China, and industrial commodity prices, including copper, are swooning. As in the past, warnings about shortages in key industrial inputs are magically being contradicted as unaccounted-for stockpiles materialize.
Agricultural producers are influenced by global demand and by weather-driven supply. I’ll leave it to others to forecast the weather. But note that ideal growing weather often follows the kind of bad weather we’ve seen lately, and bumper crops and surpluses often replace worrying shortages in a crop-year or two.
Furthermore, China imports (and might have stockpiled) soybeans and other agricultural products that would suffer from a slowing economy. Weakness in industrial commodities can easily spread to the agricultural area. Notice the close correlation among all commodity groups in recent years. The huge quantities of hot, highly leveraged money now sloshing around the world tend to end up on the same side of the same trade at the same time.
As speculators suffer setbacks in one area, they quickly bail out of other, fundamentally unrelated areas to preserve their capital.
The bursting of the commodities bubble will be bad news for developing-country producers such as Brazil, which has thus far largely escaped recent global economic and financial woes but is a major exporter of iron ore and other commodities to China. Developed commodity exporters -- Canada, New Zealand and Australia -- as well as their currencies, may also suffer.
I’ve long believed that a hard landing in China would be preceded by a price collapse in copper and other industrial commodities. Copper prices peaked in February, and Barrick Gold Corp. (ABX)’s agreement on April 25 to acquire copper producer Equinox Minerals Ltd. to gain mineral resources outside its area of specialization is a classic sign of a peak.
Another classic sign of a speculative price peak was the sudden appearance of copper inventories where none were thought to exist. As prices start to break, hoarded commodities suddenly become available for sale by highly leveraged owners. Copper in China was so abundant that bonded warehouses were full. In January and February, extra copper was sold abroad as Chinese exports were eight times the year-earlier total.
Falling Copper Prices
London Metal Exchange bonded warehouses saw copper inventories leap 17 percent in the first quarter. Furthermore, to circumvent tight bank lending in China, borrowers are relying more on available letters of credit to finance copper arbitrage trading and otherwise have the use of the borrowed money with copper purchases as their collateral. If copper prices continue to fall, those borrowers will have to sell their copper on the market to prevent further losses, resulting in still-lower prices.
Meanwhile, sugar topped out in February, and cotton in March. I pointed this out in a speech to an investor conference in April, and several people in the audience questioned my facts. I compared those who hadn’t noticed this peak to Wile E. Coyote of the “Road Runner” cartoons, who runs off the cliff and finds himself suspended in air before dropping to the valley floor.
Further confirmation came May 2, when silver prices, which had skyrocketed earlier, started to collapse and virtually all other commodities followed: crude oil, cotton, copper, grains and even gold.
Moving in Lockstep
As I noted earlier, there is so much leverage money floating around the world that regardless of how it’s managed -- by fundamental, momentum or technical strategies -- it tends to end up on the same side of the same trades at the same time. So, when one of these positions reverses, the effects spread rapidly as speculators bail out of their positions to reduce risk and preserve their capital. Keep in mind that the prices of the wide variety of commodities continue to move in lockstep.
Many commodity bulls see this trend as a short-lived midcourse price correction and have maintained their long positions in copper, crude oil, corn and even silver. But markets anticipate, and it now appears the declines in commodities are foreshadowing a hard landing in China, with the effects spreading globally.
(A. Gary Shilling is president of A. Gary Shilling & Co. and author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” The opinions expressed are his own. This is the last of a five-part series.)
Read more Bloomberg View op-eds.
To contact the author of this column: A. Gary Shilling at email@example.com.
To contact the editor responsible for this column: Max Berley at firstname.lastname@example.org.