Caixin View: The Bounce That Didn't Come

China is the world’s largest consumer of raw materials, so its economic and industrial trends have a significant influence on global commodity markets. We had previously expected industrial commodities to be boosted this winter for two reasons. First, on the demand side, government efforts to speed up steel-hungry infrastructure investment to shore up economic growth should have offered some support for metals. Second, on the supply side, production controls on steel and aluminum plants over the winter, intended to reduce severe smog, seemed likely to lead to higher prices — repeating the phenomenon seen over the 2017-18 winter period. The controls were first imposed in November 2017 for four months and led to a surge in steel, aluminum and coal prices, along with industrial commodities as supply was curtailed.

Yet, so far, this hasn’t happened. Commodities used in construction have been particularly weak. The benchmark construction rebar contract on the Shanghai Futures Exchange, for January delivery, fell to a five-month low on Monday. The main ingredients for steel production — coke and iron ore — have slipped too. The most-traded aluminum contract on the Shanghai Futures Exchange, for January delivery, has dropped more than 8% since the end of August.

Here’s why we think these commodities are so weak:

● Winter heating production controls have been less onerous than expected. The government has relaxed its original target for cutting particulate matter and ditched the one-size-fits-all approach to pollution curbs it used last year, giving local governments more discretion to set their own production quotas. This has been widely seen as opening up opportunities for less strict enforcement.

● Infrastructure investment growth hasn’t increased as quickly as expected, though it bounced off a historic low in October, and the pace of investment in real estate development has continued to slow.

● The trade war and a slowing economy have hit industrial activity hard. China’s official Purchasing Managers’ Index (PMI) fell to 50.2 in October, the lowest since July 2016.

● Crude oil prices have dropped significantly since the start of October, bringing down other commodities

● Finally, the dollar has remained strong, putting more pressure on commodities priced in the greenback

At the same time, likely in expectation of a repeat of last winter’s tough winter production controls, steel production has ramped up in the last few months. Crude steel production hit record levels in October, rising for the third month in a row to 82.55 million metric tons.

The question now is, whether there will be a rebound in industrial commodity prices either later this year or, more likely, in the spring, after warmer weather makes it easier to build. We don’t think so. While infrastructure investment growth will likely continue to recover as a result of local governments accelerating bond issuance and fiscal spending, this will be offset by several other factors that will depress prices. Higher U.S. trade tariffs due to come into force in January will put even more pressure on manufacturing, and a ramped up trade war will probably hit economic growth more generally. Investment in real estate, another key consumer of steel, has been cooling due to price controls in big cities and tighter supervision over shantytown redevelopment programs that were previously a major driver of demand in smaller cities.

In hindsight we were too optimistic in our expectation of higher industrial commodity prices and we weren’t expecting the government to take a more relaxed stance on winter pollution controls. But the failure of prices to pick up is also a reflection of how much more bleak economic prospects have become compared with what they were in August.

Calendar

Nov. 27: National Bureau of Statistics (NBS) releases data for October industrial profits

Nov. 30: NBS releases manufacturing Purchasing Managers Index (PMI), nonmanufacturing PMI, and Composite PMI Output Index for November

Dec. 3: Caixin releases Caixin China General Manufacturing PMI for November