China Risks Make Commodities a Big Short

  • This will have far-reaching effects due to the fragility of the Chinese economy, which has become increasingly dependent on debt growth for economic growth
  • Many of the equities most sensitive to these effects are trading near their highest valuations in recent history, making them attractive short positions (XME, ACH, AAPL etc.)

The fact that commodity prices are highly dependent on trends in Chinese monetary policy is nothing new for global investors. I’ve written extensively about this link in the past, but the below graph has a nice refresher of how closely linked producer prices in China, (which mirror global PPIs), are to trends in China’s money supply:

Trends in Chinese monetary policy lead trends in producer prices, and they just took a sharp negative turn. This bodes poorly for commodity prices, just as valuations for commodity producers are near all time highs. Source

There’s also reason to believe this commodity down cycle may be more dramatic than previous cycles.

China’s commodity usage has been reliant on growing bubbles in China’s property sector for the past ten years. This happened due to the political incentive to maintain a key driver of economic growth, even after the fundamental drivers for that growth were no longer relevant.

Beginning in 2010, China’s working age population growth began to dramatically decrease following a 50 year stretch of breakneck growth. When an economic trend goes on for 50 years, it’s expected that private enterprises and the larger economy structure themselves around that trend continuing into the future.

In this case, Chinese property developers that planned for more demand were consistently rewarded with higher profits. New housing supply was consistently met with more demand at higher prices, and today, many of the richest people in China have their fortunes rooted in property development.

In 2011, cracks began to form around the narrative that property was a one-way bet in China, but before that could play itself out, Chinese monetary authorities flooded the economy with cheap money. This drove another boom in housing (and industrial commodities along with it).

This happened again in 2015 and again in late 2018.

The problem with this strategy is that it takes an increasing amount of monetary stimulus to revive the property sector each time. In this process, the larger economy becomes increasingly fragile, as firms and individuals become more indebted, just as the underlying drivers for property (population growth, higher incomes driven by increased globalization) continue to deteriorate.

We may now be at the tipping point where Chinese authorities have decided it is no longer worth the effort to revive the sector. This could be a sea change in strategy, as the CCP no longer ties the basis of its authority to its ability to generate economic growth, as that is no longer feasible.

The evidence of this is all around us.

China’s second largest property developer is in complete free-fall:

Source

This will have obvious systemic effects on the Chinese and global economy as one of the most indebted companies in the world now has its debt trading below 50 cents on the dollar:

Source

We’ve seen things like this before in China — maybe not to this magnitude, but we’ve seen companies struggle and get bailed out shortly after.

What’s unique in this situation is the response from Chinese authorities as one of its systemically important firms is near collapse.

The expected response would be for Chinese monetary authorities to begin ramping up the money printers, but trends in money supply and loan growth are surprisingly anemic. When dealing with systemic issues like this, the window to act is small, as the effects of defaults can quickly damage confidence, particularly when the underlying drivers for growth have already been deteriorating for some time.

Through both word and action, Chinese authorities are signaling they don’t plan on acting in the same extreme ways they have in the past. I think they’ll eventually reverse course and ramp up liquidity out of necessity, but in the meantime, it’s not hard to see what this might look like.

What happens to Evergrande doesn’t stay with Evergrande. The company is in a hugely complex set of IOUs with other companies and banks, the nature of which is difficult to understand with precision, but hard to overestimate.

We’re already seeing the market react to the systemic nature of Evergrande’s struggles — just look at the stocks of Vanke, Country Garden, ICBC, etc. over the past year.

A loss of confidence in property developers would quickly cause commodity consumption and prices to decrease, sending out a deflationary impulse throughout the world. This would have systemic effects throughout both the Chinese and global economy.

Meanwhile, many of the equities most sensitive to weakness in commodity prices and the Chinese consumer are trading at some of their highest valuations in history (NYSE: XME, ACH, AAPL). Taking short positions here and holding them until the Chinese authorities open up the floodgates of cheap money again is an asymmetric way to outperform the markets over the next 6–9 months.

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