What China’s rebalancing means for commodities

Following a disappointing September US employment report (released October 2), oil prices began to rally, and have subsequently climbed over 10%

Commodity prices have rallied over the last two weeks
October has seen both oil and metals prices rally sharply, on the back of weaker US macro data, announced supply cuts (in metals) and stretched positioning. But we do not believe that this signals any significant change in fundamentals. Rather, we continue to look to the long-run commodity supply trends, and the ‘hard-data’ of EM demand – which paints a more bearish picture, but one that is also starting to signal a rebalancing of demand away from capex and towards opex commodities.

But the longer-term trends are in supply…
We have long argued that strong EM commodity demand bid prices up during the last decade. Ultimately this incentivized capacity buildout and technological innovation – pushing us into today’s oversupply, where prices have been searching for a new lower equilibrium. Coupled with inter-related macro trends (the “3D’s of macro”: deflation in input costs, divergence of US growth and the US$, and deleveraging of EM debt) this has kept commodity prices locked in a downward trajectory since mid-2014.

…and China demand rebalancing – where we see that a shift from “Capex” towards “Opex” consumption has started
Most financial markets have taken a uniformly bearish view on the situation in China. However, digging into the guts of the commodity demand data we find rising demand for “opex” commodities (energy and consumption-based metals such as aluminum) and declining demand for “capex” commodities (steel, cement, iron ore). This should actually increase confidence in Chinese policymakers’ ability to rotate growth away from investment and towards consumption.

History tells us this rebalancing is to be expected at China’s level of income and is a permanent, structural change
For years, China-watchers have been emphasizing the need for China to start this rotation. Through the lens of commodity demand, it now appears to have started. Furthermore, our historical analysis of the typical growth path that economies take tells us that this change is both expected around China’s current income level, and is permanent. This means that peak metals demand growth is very likely in the past for China – raising a bearish question for long-term capex metals demand: which country will be the “next China”, rapidly scaling up capex to building out productive capacity, and driving future metals demand growth.

Michael Hinds – Commodities Research – Goldman, Sachs & Co.