Commodities Risk Crash on China Recession Threat, Smead Says

China is at risk of falling into a recession by 2015 that would reduce commodity prices as much as 70 percent, according to the chief executive officer at Smead Capital Management Inc.

Commodities from copper to crude oil may drop 50 percent to 70 percent from current prices in three years to five years, Bill Smead, CEO of the Seattle-based mutual fund, said in an interview in Singapore. China, the world’s biggest consumer of energy, metals and grains, has a 30 percent chance of slipping into a recession as property prices fall, hurting local banks that made loans to developers and home buyers, he said.

Smead, whose fund manages $170 million and has stakes in Starbucks Corp., McDonald’s Corp. and Bank of New York Mellon Corp., doesn’t own natural-resource companies because commodity prices are “massively overvalued,” he said. The fund reported net capital appreciation of 5.2 percent last year, compared with a 0.4 percent gain of the Russell 1000 Value Total Returns Index and a 2.1 percent rise in the S&P 500 Total Returns Index.

“Commodities are currently 50 to 70 percent above their cost of production,” Smead said. “History shows prices tend to bottom near the production cost. That’s at about $50 to $55 a barrel for crude oil.”

Companies and banks that financed China’s construction boom, which started in 2008, show signs of accumulating more debt than they can pay off, he said. China’s government debt, which may have risen to 20 trillion yuan ($3.14 trillion) by the end of 2010, or about 50 percent of its gross domestic product, is becoming a major constraint on its economic growth, research firm Beijing Fost Economic Consulting Company Ltd. said in December.

‘Woefully Undercapitalized’

China’s exports fell 0.5 percent from a year earlier in January, the customs bureau said today on its website. Imports dropped 15.3 percent, declining more than the 3.6 percent forecast by economists. Car passenger-vehicle sales in the country, the world’s biggest auto market, dropped 24 percent from a year earlier to 1.16 million units last month, the China Association of Automobile Manufacturers said in a statement yesterday.

“Local banks are woefully undercapitalized,” Smead said. “They financed all these developers when it was all build, build, build, build, build. Now, all these buildings are coming up and nobody wants them.”

Local governments in China, prohibited from directly taking bank loans or selling bonds, have set up more than 6,000 financing companies to sidestep those rules and raise funds for building stadiums, roads and bridges, the National Audit Office said in a June report.

Cleaning Out

Governments at provincial, city and county levels amassed 10.7 trillion yuan of debt by the end of 2010, the auditor said. Home prices fell for a fifth month in January, according to SouFun Holdings Ltd., the nation’s biggest real-estate website owner that began compiling the figures in July 2010.

“We’re not negative about the long-term prospects for the Chinese economy,” Smead said. “But what needs to happen for the success story in China to continue is that they have to clean the system. And that’s what a recession will do.”

He recommends buying so-called custody banks like Bank of New York Mellon Corp. and U.S. equities with low exposure to the Chinese market.

“It’s quite controversial of us to be positive on financial companies while Ben Bernanke has said interest rates will remain low,” said Cole Smead, director of marketing at the fund. “But when interest rates rise, money brokers will make money on people getting out of bonds.”

The Standard & Poor’s GSCI gauge of 24 commodities fell 0.1 percent to 679.41 at 2:09 p.m. Singapore time. The index has gained 5.4 percent this year compared with 2011’s annual increase of 2.1 percent.

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