In our last post on Chinese Math, we discussed the implications of China’s export and investment led growth model. To put this growth in perspective, consider that imports of energy and metals increased by an average of 45% annually from 2010 to 2011 while their share of China’s GDP rose to an all-time high. Mainland China now accounts for 9% of global energy imports while its share of global metal imports is 26%.
We expect China’s slow down (hard landing) to be much more severe than the consensus and given its disproportionate share of the world’s commodity consumption, the impact will be most uncomfortable for the world’s metal exporters. We continue to believe that the Australian economy is the most vulnerable to crack’s in China’s façade given its concentration of trading partners (China now represents 28% of Australian exports up from 6% a decade ago) and its concentration of exports (as ores and metals make up 72% of goods shipped to the mainland). But Australia is not alone in its vulnerability. The CRABS are the commodity rich countries that are riding China’s spending spree. They are Canada, Russia, Australia, Brazil and South Africa. We think the CRABS will ultimately be a much bigger problem than the PIGS.
As we discussed in a recent letter to investors, “We have long believed that the recent crisis marked the beginning of the end for the China-driven commodity-demand theme. The implications of this inflection point will have significant consequences, but perhaps the most important consideration for now is recognition that the secular move in commodities has broken down for the first time in over a decade. As Chinese demand growth evaporated we correctly anticipated that industrial metals and the companies that produce them would break first. The glut of supply slated to come online in many of these markets precisely as demand begins to taper off, is a classic indication of a commodity cycle peak. We have not yet seen an equivalent supply response in the gold markets and given gold’s historic function as a store of value, we felt gold prices would disconnect from the rest of the commodity complex. The recent price action indicates that this logic may have been flawed. We expected gold to behave like a currency in limited supply, but it appears to be following the commodity herd over the ledge of the Chinese credit bubble.”
We now believe that emerging markets, led by China, may have played a larger role than we originally assumed in driving gold prices higher. We encourage investors to closely exam two recent papers authored by GMO. The first of which we read with some skepticism in January 2012, followed by another in April 2013, which we’ve considered more carefully. Like many commodities, gold is exposed to pro-cyclical factors in the emerging markets, which can be both a positive and a negative driver. Over the past thirteen years, the impact of emerging market demand on gold prices was unambiguously positive. However, this has not always been the case, and is not likely to be the case going forward, given the structural risks China faces today. The facts have changed. Now that gold has broken down along with correlations across the commodity complex, we believe we are at the end of the commodity bull market and perhaps the end of the gold era.
This is a significant change in our thinking and something we do not take lightly. We will continue to monitor the price action in gold and the correlation to central bank balance sheet expansion, but for now, it appears that rising gold prices, like the rest of the commodity complex, have been increasingly driven by emerging market demand. It follows that as the punch bowl of liquidity is removed from China’s credit bubble, the bull market in commodities should come to an end. Recent price action in gold appears to support this thesis. As gold has become an increasingly common asset within portfolios, we’d also encourage investors to take a moment to read Bienville Capital’s Framework for Gold.
Looking ahead, we think it makes sense to consider gold’s impact on global markets more carefully, as the volatility in gold may be sending an important message to investors more broadly. Importantly, we believe that the recent price action in gold reflects global uncertainties and is generally bad for risk assets in the short term. Ned Davis looked at the performance of stocks after similar drops in the price of gold and found that gold corrections have tended to happen amidst equity market corrections. Historically, equities have continued to drop during the weeks following the drop in gold, but have tended to start rallying after about a month. We expect this strong selling pressure to set the stage for another rally in equity markets later in the year. As a result, we have raised cash across the portfolios we manage and are preparing our shopping list to reinvest our capital at lower prices, in assets we believe offer higher potential returns. Rule o’ Thumb: “When the cover of a major financial magazine features a cartoon of a bull leaping through the air on a Pogo Stick, it’s probably about time to cash in the chips.” Pogo Stick below compliments of John Hussman.