So Chinese equities were first to accelerate out of the GFC lows fired up as they were by the sizeable fiscal stimulus that was directed particularly at infrastructure expenditure. Equities ran hard and fast peaking in early August 2009.

Meanwhile commodity prices themselves didn’t bottom until March 2009. And while they responded to the Chinese stockpiling that was conspicuous through to late 2009, prices themselves were relatively restrained in their appreciation. Until expectations of QE2 began to surface that is. From the correction lows in mid-2010, commodities prices have been on a tear.

For mine, this latter leg in commodity prices has been a investor driven phenomenon – whether it’s a response to the supercycle story or the fear of the failure of paper money. I’ve slotted the Baltic Dry Index into the background – as an admittedly flawed indicator of Chinese demand for bulk commodities – as it seems to make the same point.

Putting aside the issue of what factors have driven commodity prices higher, the fact remains that Chinese equities have been in a relative downtrend ever since the middle of 2009. The obvious conclusion is that higher commodity prices are bad for a infrastructure-build driven GDP. Is this exposing a key flaw in the Chinese growth model – that the more (debt-funded) investment is plowed into infrastructure, the higher commodities prices are driven and the larger the problem when this model is brought to its inevitable end?

It’s a valid question – as when we look inside the relative sector performance of Chinese equities since the beginning of 2009 we see that it is the energy and materials sectors that have been ‘holding up’ the composite index – or put another way, it is the financials in particular that have been hanging heavy around the neck of the Chinese equities markets. Are the financials hinting at what is to come?

The US has been leading the way – from the JP Morgan Global PMI Report report (here)

The US PMI rose to an eighty-month high in January, while its counterpart in the Eurozone hit a nine-month peak. The UK PMI rose to its highest level since (UK) data were first collected in 1992. Meanwhile, the China and India PMIs crept higher from December’s three-month lows and an expansion was signaled in Japan, albeit only slight, for the first time since last August.

Only Australia and Greece were on the contracting side of the ledger. On the face of it, this ‘fundamental’ demand should throw a supportive bid behind commodities – and may help explain why the major miners have caught an updraft over the last couple of days. (Chart from Investment Postcards from Cape Town here)

Yet it’s reasonable to ask whether it is only fundamentals driving commodity prices.  While it might well be argued that base metals have at least paid some attention to the ebbs and flows in industrial production, the relative strength in gold suggests that there may be more to the story.

Similarly, supply constraints cannot explain the entirety of the recent rise in foodstuffs:

Bernanke (at the National Press Club here) claims that higher commodity prices are the result of emerging world demand and supply constraints. This is true – at least in part.  Certainly, weather patterns over recent times have not been conducive to agricultural production nor for the supply of some industrial commodities. And yes, emerging world demand has been strong since early 2009.

But this is too simplistic an explanation as it ignores the role of government and speculation in driving commodities prices.

Without exception, ‘fundamental’ demand has been strong due to government stimulus efforts. Most particulary, the rise in emerging world demand was intimately tied to the launch of China’s huge monetary stimulus in 2009. This trend has reached its end.  China is tightening money – and other emerging economies have been applying their own capital constraint measures. The fall in the Baltic Dry Index may be partly inspired by oversupply, but fading ‘fundamental’ demand is also at play. It is no coincidence that Chinese equities have also caught a cold.

The reversal of stimulus policies reflects a need to slow price rises.  For example, food prices are said to comprise 35% to 40% of disposable income in China, and are higher in other emerging economies. Higher food prices will inevitably squeeze demand, and more ominously, lead to unrest. It’s notable that at the same time Bernanke was making his speech, UNCTAD was hosting a conference on Global Commodities with the explicit aim of “calling for attention to climbing, volatile prices” (here).

The point is that there is a limit to the price that emerging markets can pay for commodities – and the evidence suggests we are close to that point.

So if China is tightening money, we might reasonably expect commodity prices to start easing – in anticipation of declining demand from emerging economies. Yet copper tops US$10,000/t, Brent breaks US$100/bbl and cotton makes new record highs. This raises a question as to who is buying – and increasingly over the last decade, the answer has been investors.

Investment demand for commodities is something that we have looked at before (here and here and here) so we won’t labour the point. Suffice to say, the current run-up in the prices of some commodities has all the hallmarks of classic price distortion away from fundamental demand (aka ‘bubble’ behaviour).  As seasoned traders will oft be heard to say – the prices have gone parabolic – meaning that speculative fervor has taken over. With the herd increasingly headed in the same direction, it will take progressively less and less to tip the balance in the other direction.

Conclusion – Just like the grotesque in Dorian Gray’s closet, high commodity prices are the non-to-hidden price we must pay for a forever young global economy. With QE2 itself passing into its twilight age, the risk/reward of being long commodities doesn’t look too flash – with diminishing upside and plenty of room on the downside. Emerging markets are already signalling weakness and the commodity currencies are showing all the signs of exhaustion. While we may not have called for the last rites just yet, the priest is in the parlour.

Disclosure – no position in base metals, long energy and agricultural equities, and nibbling at gold again.

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Postcript

• The Short Side of Long has a neat summary of current commodity markets in its “End of Month Commodity Report”
• Zero Hedge published a Standard Chartered report on “The threats of inflation” (here)
• and Nomura’s September 2010 report “The coming surge in food prices” (here) has a top 25 countries vulnerable to rising food prices

The point is that currencies matter. Consider for example the latest RBA commodity price index (original release here):

Commodity prices continued their surge higher in September – at least in US$ terms. In A$ terms, the index was actually lower month-on-month. The gap between the performance of the two has opened to a chasm that is rarely seen, or been sustained (at least for our dataset which does not go beyond 1982 and therefore does not include the commodity induced inflation of the 1970′s).

All this of course is a result of easy money – the impact of which can also been seen in the relative performance of the carry trade over the commodity trade (via AUDYEN and AUDUSD).

Prior to the Jackson Hole symposium, the carry trade was at an ebb and the commodity sensitive AUDUSD had begun to outperform. But once Bernanke reopened the sluice the rules changed. Even EURYEN has turned up – as the BOJ announced its own debasement strategy and China stepped up its support of the European periphary.

As the closest thing to a floating exchange rate, the AUD offers a rare pedigree in a world of big-arsed mutts. It makes the rationale for investing in it pretty simple. Good yield, rising commodity prices, reasonable government debt position. If you don’t like our housing market, you can always join a hedge fund or two and short our banks.

Still all good things must come to an end – not sure we are there yet, but our composite indicator for the materials sector is still not confirming the recent index strength. (It’s a composite of the Baltic Dry Index as a proxy for volume, the A$ denominated RBA Base metals index as a proxy for price and the Shanghai equities index for demand.  XMJ is the ticker for the ASX200 Materials index.)

The weight of money now seems to be gathering behind the notion that the Chinese are serious about slowing their economy – and that the crawling revaluation of the yuan is just another plank in this strategy.  The clearest prognostication of the markets reception of these moves to reign in Chinese growth is provided by the Baltic Dry Index:

It’d be fair to say freight rates have collapsed over the last couple of weeks.  When we read that capesize freight per tonne rates from Australia to China were down 25% last week (from Cotzias Shipping here), the simplest interpretation is that the demand for bulk commodities has taken a turn for the worse.

To place this in a little context, consider the following chart of world steel production:

The importance of China to global demand for iron ore and coking coal is self evident.  But to make the point all the more clearly, consider this excerpt from the World Steel Association’s May report (here)

World crude steel production in May 2010 was 9.8% higher in comparison with May 2007, before the impact of the global economic crisis was felt. However, while China, South Korea and Turkey showed increased crude steel production in May 2010 compared to the same month 2007, the US, Italy, Spain and Japan are not yet back to pre-crisis production levels. The EU is -18%, North America -14% and Latin America -9.8% down on the five months to May total in 2007.

Now the point of this thinking is that the reaction of risk markets to the news about the revaluation is understandable.  If we make the broad assumption that the downside risks around Europe have been essentially factored into the markets (for the moment), and that those relating to the US are in abeyance (for the moment), then those around China are to the fore – square and centre.  As the science of tipping points go, the yuan news was the proverbial straw on the camel.

….

While I’m talking steel – thought the following chart of global steel capacity utilisation pretty interesting (again from worldsteel.org):

Whether from an implosion of European economic activity (which is very short odds) or from an export constrained China shipping excess capacity abroad – the rational agent will be wary of deflation getting the upper hand.  Hence, when we see the death cross in the CRB, we should doff our cap to the grim reaper:

In this context, I’ve been puzzling as to what the Baltic Dry Index has been up to:

Seemingly oblivious to the ructions in risk markets, its series of higher lows and higher highs since the March 09 lows continues.  As Cotzias Shipping notes (see here) its been the capesize tubs that have been pushing the BDI higher.  These are the fatboys of the seas, ships of over 150,000 deadweight tonnes – they only comprise around 10% of the world’s fleet by numbers but carry over 60% of dry bulk traffic.  Their cargo is made up of iron ore, grains, coal, cement etc.  And as the following chart from Dryships Inc. quarterly shows (here), growth in volumes is expected to continue apace:

Cotzias Shipping documents that Capes historically receive higher rates than the smaller size segments.  With current capesize rates still below those of the minnows, further upside is expected. As a consequence, expect more upside for the BDI.

So maybe the question should be why isn’t the BDI higher?  Has it lagged the global recovery?  If you consider how much a commodity currency like the AUD has outperformed the BDI (at least until recently), it looks like a valid point (charts from Cotzias Shipping April report here):

And if we take a longer term horizon, it could again well be argued that the BDI has reason to be higher:

Conclusion

After slushing around in the demand and supply dynamics that drive the BDI, my guess is that the rising index is catching up to fundamentals – just as those fundamentals are coming back down.  Perhaps, this is one of those disconnects that we spoke about earlier this week between physical and financial markets (see here).  The BDI is after all the most physical of markets.  One where a century old, family run, Greek shipping agent can look to the Baltic Exchange motto to convey the pathos of the current crisis:

Unfortunately  the  Baltic  Exchange  motto  which  stands  for  clear  Shipping  ethics:  “Our  word  is  our  bond”…  could  be  rephrased into the Greek Economic Crisis and be… “Our word is their bonds”…!!!

Worse still they have now slipped below the 50 day and 200 day moving averages.  Wonder how long this state of affairs can be maintained before some steam comes out of the commodities markets?

Market indicators

1) The USD is rallying – and the CRB has rolled over

With at least the juiciest dishes on the commodities smorgasbord priced in USD, the recent strength in the greenback will hurt commodities. Demand may have become more price inelastic than in earlier years, but with the CRB breaking its recent support expect further weakness to come.

2) China stockmarkets and the Baltic Dry Index are also soft

If the BDI is a reasonable indicator of bulk commodity demand, then it’s hinting at weakness.  Similarly, if China has lead the global recovery, the relative underperformance of its stock markets suggest that something is amiss.

Put these together and you get a near term picture suggesting lower commodity prices are on the way.

Economic indicators

1) Leading indicators – as we noted here, it looks suspiciously like the OECD CLI is marking out a turn.  This indicator has a reasonable track record in forecasting industrial production.

As Albert Edwards pointed out (analysed in “Leading indicators as buy/sell indicators for equities markets” here) – the lesson from the Japanese experience of the 90′s was to sell the rally when the stimulus was removed.  With the US and China both applying their own versions of the withdrawal method (though we note that Japan is still pumping away as furiously as ever) now is that time .

2) Purchasing Manager Surveys – Quite apart from the decline in China’s PMI (discussed here) – consider what these charts are saying:

As with many market signals in recent times, the bounce back in the steel price has been unusual as it has not yet been accompanied by supply constraints. In the context of a slowing in new orders growth (as might be expected if the OECD CLI were reading the pulse correctly) this inconsistently looks even weirder.   (See here for Markit’s steel report.)

The disconnect between price and supply is even stronger in the copper market.  You could reasonably argue that the market is anticipating shortages to come as the new orders are stronger in this metal with only the US looking like turning weaker.  Note however the new order to inventory ratio (not shown – go to Markit’s report here for further charts) is falling, suggesting speculative balances are on the rise.

Finally, aluminium too has seen its price run ahead of supply.  Same picture as copper for the new orders too and (would you believe it?) the new orders to inventory has also turned down suggesting at the very least a cap on prices to come. (Full Markit report here.)

Conclusion:

Short term – the odds are for a pullback in prices.  Whether this develops into something deeper depends to a large degree on how China’s demand is impacted by tightening in liquidity and more generally, how the US-China trade tensions are resolved. Even given a negative shock to China’s demand, the longer term picture remains favourable. This is not only because industrialisation will inevitably continue in China and India but the ultimate effect of money printing by the developed world will be debasement of paper relative to hard assets.

Buy the dip – and load up if there’s a deeper correction.

While the CRB did so early last week.

It is notable that the CRB made a low at the same time as the S&P500, while the BDI did so a week later. Not sure what that means. Could be the BDI is losing it’s touch. Or that the transportation sector is not as confident about the state of things.

Also, looking to the performance of the Shanghai Index:

If not as energetic a bounce, at least the Chinese market has found some legs in the face of the seemingly tighter credit conditions.

So what does it all mean?

Blogs like The Smart Money Tracker have been arguing that we are due for stage three of this cyclical rally. While White Magic & its Exposure makes a good case that whatever logic would suggest, the technicals are supportive of a strong push higher .

With prices rebounding strongly off their recent lows have to consider the alternative that equities can go on to make new highs. So while the fundamentals, don’t support it – if anything liquidity has peaked, broad money is still contracting, and the industrial production based leading indicators suggest that the global recovery may be topping – these may be yet to exert their pull.

Technically, we are about to enter the real resistance zone where any nervous longs may be anxious to sell.  The manner in which the S&P500 pushes through this resistance will say a lot about the market’s ability to go on an make new highs.

For the moment then it’s a market neutral position – though still with underweights in materials and financials while overweight in health care and staples.  Got a watching brief on the property and utilities sectors – think there may be opportunities amongst some of the recapitalised stocks but that is for another day.  It may hurt over the near term as risk appetite could go on a tear – but don’t like the risk/return of moving up the risk curve from here.

And if you really want to get inside the third leg – here is Rolf Harris and his timeless contribution to Elliot Wave Theory – Jake the Peg:

It’s a chart of XMJ (ASX200 Materials Sector) mapped against index that has equal weights apportioned to the Baltic Dry Index and the RBA US$ non-rural commodity price index.  Looks kind of interesting you might say (if you were inclined to talk out loud to yourself while pondering the chart).

But then take a look at this:

It’s the same XMJ against the Baltic Dry Index only.  Taken at face value, seems that price has been following volume.

Now as I understand it the BDI reflects a whole lotta variables than shouldn’t effect Australia’s listed exporters (how many container ships is China building this week?). Still as a grass-roots indicator of changes in marginal demand for commodities, whether it be for speculative stockpiles or actually making something, the BDI has a pretty good track record over the last 5 years at least.

Leadership in the Australian market’s rally since March 2009 has come from financials and the materials sectors.  It was notable then that the recent high in the All Ordinaries was not matched by the financials.

XXJ was rejected off the longer term downtrend from the September 2007 peak while it has definitively broken the Mar-09 uptrend.  With the weekly MACD crossing over, expect further weakness in the sector.

Turning to the materials sector.  While that line from March remains unbroken, the trend is up. Yet there are signs of weakness that will be a worry to those with their Tonka trunks full of dirt.

Is that weekly MACD turning over?  Considering the weakness in the AUD and CAD – seems like something is afoot.  Both have broken their uptrends and have formed double tops…

And then there is the Baltic Dry Index – that peaked in November and has been dithering through January looking for direction – while the CRB has similarly pulled back from its January highs.

On balance, the current selloff has more legs.  Having pulled back in a hurry, we may pause for a smoko, but for mine the risks are to the downside with a test of the 200 day MA (XJO ~4350) the most likely scenario.