The following was published by Na Liu of Scotia Capital yesterday.
China Commodities Weekly for the Week of January 25 - January 29, 2010
■ Last week, China’s urea and DAP prices were up; coal and oil products prices
were flat; and base metals, iron ore, steel, grains, and potash prices were
Macro – When China Begins
More Tightening News
■ More monetary
tightening news has surfaced so far this week. First, China implemented a
planned increase in the required reserve for some banks on Tuesday (50 bp for
those banks whose loan growth has been deemed too high). Secondly, the 21st
Century Business Herald said that Chinese banks extended a whopping RMB1.45
trillion in new loans during the first 19 days of the year. Now, Chinese banks
are required to report loan addition on a daily basis to authorities. Thirdly,
according to the Securities Times, commercial banks that had made large amounts
of loans this month were being instructed not only to halt new lending but also
to recall some already issued loans as soon as possible. The newspaper further
said the recall means that the new loan total for January will fall well below
market expectations, despite a burst of lending in the first three weeks of the
■ We understand that the impact of the loan restriction has been felt by
small business, property developers, private home buyers, and some importers
who need to open a Letter of Credit.
Local Investment Vehicles
■ Separately, the China Securities Journal, an official newspaper, said
that local governments, through their investment vehicles, had borrowed RMB3.8
trillion last year, about 40% of all new loans in 2009. This is why central
bank governor Zhou Xiaochuan has warned about risks in the buildup of local
government debt. We understand that a lot of local infrastructure construction started
last year was initiated by investment vehicles established by local governments
with land rights as collateral (like the offbalance sheet special-purpose
vehicles established by Western banks before the financial crisis). If the
commercial banks cut the lending to local investment vehicles, local
construction might be delayed.
When China Starts to
■ Many investors have asked us what the impact of the recent tightening
efforts by the Chinese government on the raw materials sectors would be. To
answer the question, we looked back to the market’s behaviour when China started
its last tightening cycle. Back on September 21, 2003, China hiked the reserve
ratio for the first time in the last decade (see Exhibit 1 on the first page).
The market ignored the signal, and market reaction was very muted. Commodities
and stocks continued to rally to new highs, and new loan growth was very strong
in the beginning months of 2004. And then in March, the Chinese government
began to tell the banks to quantitatively curb loan growth, and on April 25,
2004, the central banks announced the second hike of the reserve ratio. This time,
the commodities markets and local Chinese stock markets did not take it lightly
and suffered a very severe pullback. But eventually, this severe pullback was proved
to be a buying opportunity for the multiple-year bull markets that ensued.
■ Based on the experience in 2003 and 2004, the question for investors
today is whether the recent tightening (and the market reaction towards it)
bears more resemblance to tightening in September 2003 or March-April 2004. The
experience of China’s last tightening cycles taught us a simple lesson: if the
market ignores the initial tightening, it will trigger another tightening that
could not be ignored any more; if the market takes the initial tightening
seriously, eventually it should prove to be a good buying opportunity.
■ And this is why we wrote last week: “our near-term investment strategy
is: if the pullback last week, triggered by policy fears, continues and becomes
more meaningful, and if the Chinese commodities imports moderated in the rest
of the winter, we would aggressively buy the dip and load up for a strong
spring rally; on the contrary, if the pullback proved to be just a blip and the
raw material sectors continue to rally to new highs during the rest of the winter,
and if the Chinese imports continue to swell, we will sell some winning
positions in early spring to bring raw materials positions to ‘market weight’
■ If the market continues to correct before the
Spring Festival, the market reaction to the ongoing tightening will likely bear
more resemblance to April 2004 rather than September 2003. This is why we
believe it will eventually become a good buying opportunity for a spring rally.
Investors have to bear in mind that China is fighting against a “good”
problem: its economy is rebounding too quickly and liquidity is too ample. This
is in sharp contrast to Western economies, where economic recovery is too
sluggish and the velocity of money remains slow. Arguably, China is still the
envy of the rest of the world.
■ At the end of this section, we would like to repeat what we wrote in our
thematic piece for 2010, entitled “Focus 2010 – China Outlook, The Three
Economic Trends” dated January 11, 2010:
“We note that the raw materials sectors have
rallied hard since last March without any serious pullback (and our
recommendation has been “overweight” all the way along). If any deep pullback
in the raw materials sectors were to happen in the next few months, we believe
it would most likely happen sometime in January-February 2010 … If some
investors decided to take some profit in early 2010, we believe that this could
become a very good buying opportunity for a potentially powerful rally in the spring
of 2010, when Chinese construction activities come back.”
Sector Preference –
■ During a time of policy uncertainties, investors might benefit from the
perceived defensiveness of the agricultural and fertilizer sectors. Indeed,
these sectors had lagged significantly in the sharp rally in the raw materials
sectors last year. Therefore, the downside risks are relatively limited,
especially after the recent pullback. As a result, we have decided to upgrade
our view on urea and potash to “positive” from “neutral,” and the DAP sector remained
our preferred play in the fertilizer sector.
■ As we wrote last week, we see limited downside risk for urea in the near
term as coal and natural gas prices are likely to remain high. This week, urea
prices rose again in China after the downtick the week before.
■ The DAP market is now supported by multiple factors in China: the power
outage is curbing capacity utilization in Southwest China; the railway
bottleneck in the winter months is reducing DAP transportation to consuming
regions; and the higher raw materials cost, with recent sulphur sales to China
topping US$140/tonne C&F, is limiting the downside risk for the commodity.
Therefore, we believe the Chinese DAP market will remain tight into the spring.
The latest statistics showed that China imported 97,793 tonnes of DAP in
December, up from 0.48 tonnes in November, while the country’s DAP export
dropped 40% MOM to 155,323 tonnes.
■ This week, the potash port quotation suffered a drop of
RMB100-RMB150/tonne to about RMB2,650-RMB2,700/tonne, but still higher than
import parity of US$350/tonne. The average retail price in the country was at
around RMB2,830/tonne. We note that with the port quotation dropping,
transaction volume picked up this week, and port inventory remained at a very
low level. In our opinion, potash prices in China will be stable into the planting
season, even with new imports arriving in the country. Overall, we expect
China’s potash imports to top 4 million tonnes this year, up from 2 million
tonnes in 2009.
■ To maintain our recommendation balance, we have downgraded our view on
steel to “neutral” from “positive.” We note that, even though Chinese steel
demand is likely to take off in the spring, high iron ore and coking coal costs
will likely to squeeze the margins of steel mills, particularly Chinese steel
mills, which rely heavily on spot markets.
Recap Of Our Calls
■ Essentially, we
are making four calls in our China Commodities Weekly: economic trends
in China, our overall sector call, our individual commodity sector views, and
our calls for the contract negotiations for certain commodities. We recap our
calls as follows:
trends: There are three intertwined trends for the Chinese
economy – seasonal (the current and next few months), cyclical (the current and
next few years), and secular (the current and next few decades). We are
currently a seasonal bear, a cyclical bull, and a secular bull.
■ Overall sector
call: Our overall sector call is to answer one question: purely from a China perspective,
should investors in the Western world be overweight, market weight, or underweight
in the global raw materials and energy sectors as a whole? To this question,
our current answer is overweight.
commodity sectors: On individual commodity sectors, we are now
positive on the copper, iron ore, thermal coal, coking coal, uranium,
molybdenum, corn, DAP, urea, potash, and hardwood pulp sectors. We are neutral
on aluminum, zinc, nickel, steel, wheat, soybean, methanol, ethylene, and crude
oil. We are cautious on paper products. Please note that our positive, neutral,
or cautious views on individual commodity sectors are all on a relative basis
from a China perspective.
■ Views on annual
contract negotiations: We are looking for a 25% rise in the 2010
annual iron ore contract. We expect the 2010 benchmark Australian hard coking
coal price to settle at US$175/tonne, up from US$129/tonne in 2009.