A Bottom, or Dead-Cat Bounce for Commodities?

What was going on up in the northern hemisphere on Friday? More coordinated central bank manoeuvres…or just deeply worried economic central planners?

After markets closed in Australia, news emerged that China lowered interest rates and Mario Draghi from the ECB upped his rhetoric – again – about the need for more drastic action on the monetary policy front.

First, the China story from Bloomberg:

China cut benchmark interest rates for the first time since July 2012 as leaders step up support for the world’s second-largest economy, sending global shares, oil and metals prices higher.

The one-year lending rate was reduced by 0.4 percentage point to 5.6 percent, while the one-year deposit rate was lowered by 0.25 percentage point to 2.75 percent.’

And the European story from Reuters:

European Central Bank President Mario Draghi threw the door wide open on Friday for more drastic measures to prevent the euro zone from sliding into deflation, promising to use whatever means necessary as China also acted to boost its sagging economic growth.’

With many fearing the euro zone could be heading for a Japanese-style lost decade of deflation and recession, Draghi’s remarks were reminiscent of when he pulled the bloc back from possible disintegration in 2012 by promising to do "whatever it takes" to back the common currency.’

Given its importance for Australia, today I’m going to focus on China’s actions. As far as Europe goes…well, I though Draghi ‘threw the door open for more drastic measures’ months ago. Is he still talking about it? As they say, Mario, put up or shut up.

But back to China. The interest rate cut…the first in two years, is an interesting move. Obviously, it shows that China has concerns about the rapid slowdown in economic activity over the past few months. ‘Targeted’ stimulus and liquidity injections have not really done too much…the economy has continued to deteriorate despite the ongoing stimulus measures.

So, will an interest rate cut, or more if needed down the track, do the job? Well, you need to think about that question on a few levels.

First, in the very short term, it will create some positivity towards assets sensitive to China, like iron ore, commodities, and the Aussie dollar. The bearish trade on this front has been so popular lately that the move by the People’s Bank should provide a short-term, knee-jerk rally. You’re seeing that in the Aussie market today. Investors love the smell of central banking in the morning.

Keep your eye on iron ore though. Most other commodities are heavily ‘financialised’, meaning financial market traders (rather than real world users) influence the price in the short term.

But iron ore is a less developed market and is dominated by end users rather than derivative traders. That is, real life supply and demand determines the price, not speculators working for investment banks.

If iron ore responds weakly, you’ll know not to get too carried away by the move. If it rallies and then continues to head higher, lasting longer than, say, a few weeks, it might signify that something larger is in the works.

In other words, it could suggest that China has thrown in the towel on their reform and rebalancing policies and just wants to generate growth the good old way. That is, via ‘fixed infrastructure’ spending (houses, railways, bridges, tunnels, etc.).

I would put this scenario as a low probability though. The PBoC issued a statement accompanying the rate cut saying that, ‘it does not signal that the direction of policy has changed. There is no need for strong stimulus.’

It’s telling the market not to expect too much in the way of monetary stimulus. And for good reason…keep in mind that cutting interest rates in China is a little different to cut rates in the debt soaked West.

That’s because in the West, seemingly everyone is in debt…and in aggregate, they are. The West — be it the US, UK or Australia — are net debtors, so overall, their economies benefit from a lower cost of debt.

But in China, it’s different. There, the household sector is the primary saver…and the corporate and government sectors are the debtors. In effect, they borrow from the household sector.

So lowering interest rates in China hurts (again, in aggregate) the household sector and benefits the corporate and government sectors.

But as you probably know, the Chinese authorities are trying to rebalance economic growth away from debt fuelled infrastructure growth and more towards domestic consumption.

That is, they want corporates and local governments to ease their debt based spending and the household sector to increase theirs.

Lowering interest rates drastically, which will hit the household sector via reduced interest income, isn’t going to achieve that. On the other hand, keeping monetary policy too tight will hurt corporate borrowers and impact employment, which will hurt household consumption too.

In other words, China continues to walk a tightrope…across a very deep gorge.

The scope of interest rate changes gives you an idea of the thinking going on in China right now. The lending rate fell by 0.4% and the saving rate fell just 0.25%. Normally, they fall (or rise) in unison.

This means banks’ net interest margins will take a hit. So the burden of this adjustment, albeit small, is the banking sector, not the household sector. This tells you that the rebalancing aim is still alive.

Time will tell though. Keep your eye on the commodity price bounce and especially the iron ore price for clues. If what you’re seeing now is just a short-covering rally, then it should fade out pretty soon.

My view all year has been that China won’t pull another stimulus rally out of its hat, because doing so would just makes things worse in the long run. This view could well be wrong, but I think you’re better off seeing it as another tentative step along the rebalancing tightrope.

For that reason, Australia remains in a post-China credit boom adjustment phase too. Ironically, our adjustment will probably be tougher than China’s. That’s because we don’t have anything to replace the mining boom, which has still got a few years of deflation left in it.

Housing? That race is almost run.

I’ll have more on that story later in the week when the Bureau of Resource Economics (BREE) releases its half-yearly update on mining investment.

Greg Canavan+
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Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

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