CNY Devaluation: Is the Market Misreading It?

Understanding China exposure by commodity is not so simple

Below we show commodities with the greatest end-market exposure to China. Among the complex, we see the greatest exposure in the bulks and base metals, although lean hogs screens high as well. By comparison, oil – which was one of the worst performers last week – has little exposure. While this screen should work well as a starting point, we note that there are reasons why some commodities will hold up better than their China exposure would suggest. Beyond factors listed below, there can be knock on effects across EM or other economies that may lead to a greater impact than China exposure alone would indicate.
Some key factors beyond the simple China demand exposure include:

• Availability of substitutes and price elasticity
• End market use, health and margins
• China’s domestic production potential
• Location of imported supplies, which can be impacted by currency of the host countries.

Imports can be deceiving. Even more than simply analyzing China’s demand for a given commodity, one should also consider the reliance on imports. The conventional wisdom is that those commodities China needs to import will be most at risk from a weaker RMB. This would likely single out three primary commodities:

• Iron ore (2015e net imports 933Mt, 71% of seaborne trade; 57% of global market; meets 81% of its total requirements);
• Copper (2015e imports 8.8Mt of interm./refined product, 45% of global trade; meets 85% of total requirements);
• Nickel (2015e imports 848kt, 47% of global trade; meets 81% of its requirements).

The reality is that there are few short-term substitutes for those commodities in which China needs to import.
Therefore, demand for these commodities will probably be the least responsive to the new RMB policy. Rather, those commodities in which China has substantial domestic resources (aluminium, alumina, bauxite, zinc, lead, coal) face the greatest price and import risk. China’s local industry/trade could switch to domestic sources once the policy is imposed.

FX impact on growth and trade may be overstated.
We can appreciate that the market may view devaluation as a sign of greater underlying problems in China, but some perspective is required. A weaker CNY vs. the USD reverses a long term trend, but the recent move pales in comparison to the large appreciation China has allowed over the past decade. Moreover, China is still facing significant YoY appreciation vs. the currencies of most of its trading partners.
Moreover, China was implicitly facing a stronger currency given USD peg and rising USD. The tradeweighted USD has appreciated 20% over the past 12 months. Given that China pegs to the USD, we have seen similar appreciation in the trade-weighted CNY, which is up 10.8% YoY, even with the recent devaluation vs. the USD. In other words, China may be devaluing its currency, but its currency has appreciated meaningfully vs. many commodity exporting countries. Hence, most commodity imports are still much cheaper YoY even before we consider the large price declines that have occurred in most commodities this year.
We also have not seen an increase in imports due to currency appreciation. Thus a modest depreciation shouldn’t suppress imports materially, in our view.
China’s CNY devaluation also helps support China’s exports, which have been weak YTD. A weaker currency is helpful for exporters, but in the case of China, devaluation appears to be more about easing recent currency pressures than outright export stimulation to offset a poor competitive position (as we usually see). China may be shifting growth towards internal consumption; however, such a large appreciation vs. key trading partners like Europe, Japan and South Korea has been overly punitive to its exporters. If the government’s goal is to slow the pace of appreciation and focus on a trade-weighted basket, China could see exports lift without materially increasing import costs.

The DXY is more important for commodity trading, and may be less of a headwind.
Traders rely more on the DXY rather than a tradeweighted basket. Fundamentally, currency translation impacts will have an impact on commodity supply, demand and USD pricing. However, most commodity traders have applied this concept vs. simple USD indices rather than a trade-weighted basket for each commodity. Typically, most commodity traders rely on the euro-heavy DXY, which is less impacted by China’s recent moves. If anything, the euro is getting stronger recently. Therefore, even though China’s actions should be bullish for the trade-weighted USD, we could see less benefit for the DXY and commodity prices.
Historically, industrial metals, crude oil and precious metals have recorded the highest beta with the USD.
The DXY relationships are hardly surprising as industrial metals, crude oil and precious metals are the most economically sensitive commodities as well. In fact, we could argue that the higher betas versus the USD for the most economically sensitive commodities reinforces our view that demand and fundamentals tend to outweigh currency effects over the long run. Grains, livestock and natural gas all tend to show lower exposure, as these commodities are more exposed to domestic end markets with business cycles that do not mirror those of the global economy. Natural gas has shown periods of high USD beta, but this is more a product of the extreme volatility in natural gas than any strong association with USD currency effects. Gold has the most consistent and material inverse relationship with the USD, as gold has properties of a currency and store of value.
However, DXY correlations are not static and have varied materially by month and commodity this year. More recently, we’ve seen a number of commodities report positive correlations with the DXY given the large gyrations in currencies and commodity prices. On a rolling 20-day basis, the greatest negative betas have been in precious metals, energy and cotton. However, over the past 6 months, energy has by far been the most sensitive to changes in the DXY. But if we look month-to-month, even energy has had months where the DXY beta was positive, namely Nov 2014, Dec 2014 and June 2015. Similarly, oil has seen months recently where the DXY beta was as negative as -3 or -5.

Government intervention could be a positive for growth.
We also think it’s important to consider the possible positive signals of China’s currency devaluation. The government has already implemented a number of easing measures, and the latest currency intervention may simply be a preemptive measure to protect the competitive position of many of China’s exporters as the Fed is set to raise rates (implying a stronger USD). In other words, China has embarked on pro-growth measures. We also wonder whether this could be a precursor to more stimulus (either fiscal or monetary) and stronger domestic demand, especially on the industrial/manufacturing side of the economy. Given that positioning and sentiment around China and growth is already so low, any positive news on Chinese growth could be bullish for commodity prices.

Adam Longson, CFA, CPA – Stefan Revielle – Elizabeth Volynsky – Lee Jackson – Morgan Stanley Research