The logic goes that while China accounts for just over 20% of non-oil imports into the US, it is the marginal price setter in key sectors that determine prices for commodities as well as consumer goods.  The import prices of goods from China since 1997 is illustrated in the following chart:

It’s notable that import prices trended down across the period – until the RMB was allowed to start appreciating against the USD (that’s the light blue line in the chart). From 2005, the prices of industrial supplies have taken off as these are more sensitive to movements in underlying commodity prices. Note too, that while the RMB has been permitted to appreciate by 20% from 2005 to 2009, consumer prices were only up 7%.

But from mid-2009 onwards, consumer prices have kept pace with the exchange rate:

And perhaps the most obvious catalyst are the rising labor costs in China:

This of course must happen if the root cause of the trade imbalance between China and the US is to be addressed – that is Chinese living standards have to rise relative to the West. Rising wages are also necessary if Chinese consumption is going to rise as a percentage of GDP.

It’s just that the risk is that with all this loose money floating around, the compounding effects of rapidly rising Chinese unit labor costs could get out of hand pretty quickly. It mightn’t be a problem for today, be it is a reasonably likely scenario for tomorrow.

Notably, it is the US and the Eurozone that have enjoyed a renaissance in export orders. China’s exports continue to grow but at a more subdued pace. This is all somewhat irrelevant to the commodity producers cause our export demand is driven by construction not manufacturing – and as we have noted elsewhere, China is in tightening mode when it comes to construction. Hence, we are joined by Russia and Brazil at the bottom of the table.

This doesn’t mean to say that the capital base could not be depleted further still – the only relevant benchmark for today’s world is the 1930′s and if we follow that experience then the Grand Chasm still lies before us.  Still with the Obama announcement that tax cuts to the commercial sector would be extended – it is clear that the government is keen to encourage capital spending. The provisions of the proposal include “extending the 50% bonus depreciation deduction for qualifying investment purchases made before September 8, 2010 and increasing it to 100% for purchases made between September 8, 2010 and December 31, 2011.”

Now as Mark’s Market Analysis coherently argues (here), the prospect of these changes stimulating investment is pretty low. “Businesses make decisions about capital investment based on demand, profitability, and credit availability.” This change in tax accounting is simply about timing differences.

Still for the purposes of arguing a point – that government intervention distorts prices – let’s assume that capital spending takes a turn for the better. Then who benefits from the tax cut? Potentially, each business that makes a new investment – depending on how it’s deployed etc.  But definitely the vendor of the goods being acquired. As the old aphorism goes, “when everyone’s a gold miner, it’s time to sell shovels”. Whether its the semi-conductor industry or retailers of IT equipment, presumably they will be holding their breath at prospect of further tax cuts. In a relative sense, prices of their products may even outperform.

Running through the export and import data by country – USD denominated volumes continued to rise across the board into October (visit the WTO site – World of Warcraft should be worried).

No surprise that the same overall shape is evident in the Baltic Dry Index and Dow transports.

The BDI has lead the consistently lead $TRAN over the last 12 months.  With the transports making new highs recently (seemingly confirming the highs in the broader indices), what then to make of the recent pullback in the BDI?  World trade made some sort of near term peak?

Big picture – Australia’s trade deficit rose in seasonally adjusted terms from $1.85bn in September to $2.38bn in October.  While a relatively strong domestic economy has been continuing to suck in the imports, our export sector has been flagging.

So what is going on?  Well, it appears that the price compression that has been underway in the commodity sector continues unabated – particularly in those big ticket exports – iron ore and coal.  Consider the following chart of the Implicit price deflators:

Export (and import prices) continued their downward trend.  Now maybe this can partly be explained by the strength in the AUD, but there seems to be more to it than that.  Have a look at the export and import price indices:

And the explanation from the ABS as to the drop in export prices:

The Export Price Index decreased by 9.6% in the September quarter 2009. The decrease was driven mainly by falls in prices received for coal, coke and briquettes (-34.2%) and metalliferous ores and metal scrap (-12.1%), as well as the appreciation of the Australian dollar against all major trading currencies. These falls were partly offset by rises in prices received for non-ferrous metals (+16.1%) and petroleum, petroleum products and related materials (+5.4%). Through the year to September quarter 2009, the Export Price Index decreased by 20.7%, the largest annual decrease since the current series began in September quarter 1974.

Postscript – we have mentioned previously that the AUD was starting to look a little green around the gills.  As always, Kevin’s Market Blog has succinctly analysed the prevailing trend in his blog today (see here).  The global carry trade about to be unwound perhaps?

So to BHP, the world’s 11th largest company by market capitalisation (at least last Thursday).  This is a company at the peak of its powers.  The strategy is simple, if a bit of a mouthful, to own a – ‘portfolio of tier one, low-cost, long-life, expandable and export oriented assets, diversified by region and commodity”. Couple that with low financial risk (net gearing ~12%) and an EBIT margin of 40% and you are on a winner.

The one metric that keeps coming up is the 40% EBIT margin.  I have discussed it before as something that should prove hard to maintain.  BHP makes the claim that their strategy has delivered this margin and the resultant return on capital of 25%.  This is only partially true of course.  It takes two to tango.  So while BHP operate a resources business that has the scale, reliability and a relatively low cost base - the other dimension to achieving such gratifying margins is demand.

And this is where, in the short term, China’s overcapacity comes in.  In the longer term this slide, from a presentation by Don Argus, suggests the cost of carbon could be a problem.

Now don’t get me wrong – notwithstanding the inevitable managerial inertia that will set in – BHP is, and will continue to be, a great company.  And I’m happy to accept a 2025 vision that has long term demand being underwritten by the urbanisation and industrialisation of China and India.  It’s just that a lot can change in 15 years.

Again, the market wisdom that a company’s share price peaks with earnings momentum comes to mind.  As I’ve suggested before, I just can’t see current commodity prices being sustained over the near term.  At a P/E around 20 times BHP is trading expensive given these demand side risks.

Let’s come back to the European Chamber of Commerce report separately…