"Something Strange Is Going On": Axiom Stumbles On The Reason Behind The Explosive Industrial Metals Surge

While overnight equity, bond and FX markets traded in a narrow range as a result of scarce mid-summer liquidity, mounting Trump administration and geopolitical concerns and uncertainties ahead of Friday's Jackson Hole symposium, the same can not be said about the latest "berserker" action in the commodity space in general, and industrial metals in particular, where China's horde of momentum-chasing speculators were unleashed overnight, sending Zinc to its highest since October 2007 at $3,180.50 a tonne, the bellwether industrial metal, and "doctor", copper surged to to $6,593 a tonne, its highest since November 2014, while nickel, used in stainless steel production, gained over 2 percent as it reached a 2017 peak.

Additionally, iron ore futures traded in Dalian soared more than 4% fueled by concerns of shortages and before curbs on futures purchases which are touted to come into force in the next few months.

Some, such as CMC market strategist Michael Hewson, have expressed their amazement at what is taking place in the industrial metals sector, and pointing out that something strange is going on, Hewson said "I'm looking at the prospect for the global economy and looking at the price of metals and there seems to be a significant disconnect between the two." He was referring to the disconnect between the global commodity index and surging industrial metals shown in the chart below, as well as tepid forecasts of global GDP growth.

Needless to say, industrial and mining companies have been delighted by the move, and as Hewson adds, "it's certainly helping the mining sector, which has been beleaguered for quite some time."

Still, the question on everyone's mind is what is causing this move, and how long can it continue?

One possible explanation is that - like everything else in China - the metals surge is simply a function of Beijing's credit impulse, which was unleashed in early 2016 and has been fading in recent months, and has resulted in yet another bubble, this time in industrial metals. The chart below, showing China's credit impulse with a 12 month lead, suggests that the move in metals may be peaking.

Overnight, an analysis by Axiom's Gordon Johnson who has been quite bearish on the metals space for some time, appears to have found confirmation that the ongoing move is indeed a function of Chinese credit dynamics. In a note alleging that "China’s 2017 Stimulus/Debt Binge Rivals its Record 2009 Spend" and asking "Will it Ever End?", Johnson writes that "China is not deleveraging (contradicting the official narrative) & ‘17 May Have Seen the Largest Expansion in Stimulus-Targeted Debt Ever." Here are some more striking details on what may have been the biggest driver of economic activity in recent years:

 Despite rhetoric to the contrary, we believe the data show that in 1H17 China embarked on quite possibly its most aggressive debt-fueled stimulus program yet (targeted primarily at infrastructure projects). That is, with cheaper credit leading to a lift in property sales (Ex. 1) as well as spiking infrastructure project investment, infrastructure FAI now comprises over half of China’s total FAI growth (Ex. 2) – as recently as 2/29/16, infrastructure FAI accounted for just 25% of China’s total FAI growth. And, as would be expected, construction vehicle sales (Ex. 3) – excavators + cranes + loaders – have virtually exploded higher, reaching record levels for two of three categories in 1Q17. 

The Chinese numbers are so hot, in fact, that they have prompted the Axiom analyst to wave the white flag of surrender on his bearish bet, if only for the time being:

... with credit still growing at a very rapid pace (Ex. 4) & credit costs historically low (Ex. 5) – both in terms of short-term interbank lending rates & thus, by default, longer-term term corporate & government bond rates – fears from the “China Bears” (us included) that President Xi Jinping is actively managing economic numbers higher ahead of the 19th Party  Congress (in Oct./Nov.) appear apropos. As such, while we remain bearish, we acknowledge that near-term growth in China could surprise to the upside.

And yet, with the Chinese credit impulse having turned sharply lower, and with the latest batch of Chinese economic data missing across the board, one wonders if these are the last gasps of the latest Chinese mini-bubble. Here is Johnson's take:

Some Data Points Have Begun to Turn. Chinese activity & spending data released for the month of July all came in below expectations (retail sales, urban FAI, & industrial production all missed expectations, reversing much of the gains seen in 2Q17).


Further, July Chinese home price growth slowed to +0.48% M/M (vs. +0.67% M/M in June) & 9.1% Y/Y (vs. +9.39% Y/Y in June & the lowest since 9/30/16) – Ex. 15.


Admittedly, while industrial production has held up better than expected, it appears confined to the bulk metals sector, with production of consumer related goods & other bulk commodities (i.e., cement) lagging (Ex. 7-8), Further, with the property market appearing to have cooled in recent months (Ex. 12), exacerbated by a slowing in investment growth (Ex. 11), we see strong 1H17 end-market demand in the steel sector as on “borrowed time”. To wit, as detailed in Ex. 10-11, while the slowdown in capital expenditures has been seen mainly in the private sector manufacturing space, there has been a notable softening recently in both infrastructure spending and property investment.

In other words, China's latest asset bubble, that of industrial metals, may be running on borrowed time. But until then, the dramatic price moves are already having an impact on the rest of the world: overnight, Bloomberg reported that Tokyo Steel Manufacturing hiked its hot-rolled coil prices as Chinese domestic demand remains robust and nation cuts exports, The company pushed its HRC price for Sept. +2,000 yen to 64,000 yen/ton, the highest since 2014. In other words, a delayed inflationary wave may be set to hit the world just as China's internal credit impulse ends.

More concerning, however, is what will China do with all the excess commodity inventory. For an indication of what may happen next, on Sunday the CEO of Australia's Bluescope warned that it was seeing a "flood" of cheap steel entering into Australia. Specifically, CEO Paul O'Malley said in a media call that "Australia’s anti-dumping regime is inconsistent with other jurisdictions that have recently taken action, resulting in “a flood of very cheap product being offered in Australia.”  As a result of this dumping of mostly Chinese cheap steel, the company was forced to slash its 1H18 outlook by a whopping 40% sending the stock price crashing. “We have very smart and very capable competitors in this economy,” he said. “They take every advantage in short-term jumps in the Australian dollar to source product from offshore."

Which begs the question: just how aggressive will China's industrial metals dumping be in global markets, once the bubble is over and Chinese producers shift to destocking mode, and more importantly, what impact will such a destocking have on already simmering global trade wars, especially since the rest of the world will have no choice but to retaliate. The answer should present itself in a few months...