Leland Miller and Derek Scissors on why investor excitement over Chinese capacity cuts this winter is oversold, and the serious implications for the global reflation trade.
For over a year, commodities bulls have feasted on China. In the aftermath of the recent Communist Party Congress, many investors are now drooling over the prospect the boom will continue, based on Beijing’s promises to supercharge its campaigns against overcapacity and pollution this winter. If such pledges are fulfilled, the thinking goes, substantial chunks of steel, aluminum, and other refining capacity will be taken offline, rebalancing markets and providing rocket fuel to already frothy prices. 2018 could prove to be an even more amped-up version of 2017.
Not so fast. Investors are misreading what a winter of capacity or production cuts—an overlooked distinction—would truly mean for China’s commodities sector. Assuming the government follows through in its war on steel and aluminum capacity this winter—and since this campaign appears to bear Xi Jinping’s imprimatur, we expect as much—the effect could well be bullish for prices in the short run.
However, there is a danger in drawing more far-reaching conclusions, especially that commodities are primed for another banner year. In our view, previous efforts to cut net capacity have been illusory. If capacity is finally being cut this winter, there is still so much excess that production could survive unscathed for years. If, instead, it is production being cut for immediate environmental gains, it may simply re-emerge in the spring—all bets should be short-term. Any extended price rally relies on both the cuts being real this time and continued robust demand, despite the latter being increasingly unlikely.
To see this, investors should reconsider the fundamental question: What actually caused key commodities to rally in China over the past year? The official narrative implies a combination of sizzling demand and the government’s touted reductions in supply—a view widely accepted by markets. Take steel. The Ministry of Industry and Information Technology in late October declared the steel industry had already met its full 2017 target for cutting capacity 50 million tons, after reportedly meeting its similarly ambitious target for 2016. Critically, any distinction between gross cuts and net ones is glossed over.
Many traders accept this narrative because it accords closely enough with their own observations. For example, by 2017 Chinese iron ore imports had jumped to record levels and steel prices were rocketing skyward. Some high-profile capacity cuts were evident, such as those in Tangshan, China’s largest steel-producing city. Under these circumstances, the notion that Beijing had finally gotten serious in targeting excess capacity seems sensible.
Sensible, but not accurate. Our firm’s China Beige Book proprietary commodities survey, which includes hundreds of companies across steel, aluminum, copper, and coal, tracks capacity, production, and investment as reported by the firms themselves. Despite the fact that these firms have a very strong incentive to parrot the government story that they are cutting net capacity, for an astounding six straight quarters they have told us precisely the opposite. While some capacity has indeed been taken offline, as Beijing notes, net capacity rose from the second quarter of 2016 through the third quarter of 2017 in every one of these core industries.
The problem extends beyond capacity to production, specifically overproduction. In aluminum, for example, the percentage of firms reporting rising inventory has been at least 20 points higher than those reporting falling stocks in each of the six quarters. Supposed capacity cuts cannot mean much while inventory continues to pile up.
If not supply cuts, what explains the rally? For over a year, the counterpart to blistering demand has been speculative capital inflows. This is not unusual for China, as the “moneyball” at various times rolls into property, stocks, and bonds, as well. Here, it has kept commodities prices rising skyward for over a year. But, just as it has done with stocks and (recently) bonds, the moneyball also quickly rolls away when chosen markets lose their shine. If commodities demand weakens, investors relying on supply cuts will be exposed.
This could happen quickly. Many China bulls take comfort in the strong 2017 macroeconomic performance as indicating commodities demand will remain robust. In China Beige Book data, though, all four commodities sub-sectors showed substantial demand weakness in Q3, off what may have been a Q2 peak. While this so far represents just one quarter, not yet a trend, any extended slide will cause the moneyball to flee. Until genuine supply reduction becomes clear, there could be intense and sustained downward pressure on prices.
Chinese commodities, like the economy, remain in many ways a black box, so investors can be excused for holding to a government narrative. But there could be serious repercussions from taking government projections at face value. A sharp rather than slow commodities reversal, unexpected in the aftermath of the Party Congress, would reignite doubts about Chinese growth. It would also elevate questions over global growth. To the extent the commodities rally is important to global reflation, a sustained fall in Chinese prices would shake confidence elsewhere.
Recent behavior by various central banks suggests that interest rate hikes could also be held hostage to Beijing’s supply decisions. What happens in China no longer stays in China.