Market Chaos
Stockresource Resource Hotspot 338
Sovereign debt concerns in the Eurozone have been steadily mounting during 2011 and, when combined with the slow pace of economic recovery in the U.S., have severely eroded investor confidence.
The wave of negative news in recent months (financial, political and natural disasters) has culminated in a collapse in global equity markets during the past week as fears of a global recession escalate – with the S&P downgrade of the USA’s AAA status being the catalyst, but not the cause.
Coming close on the heels of the GFC the current correction phase started with a base of fragile investor sentiment and as a consequence the equity market reaction has been dramatic.
However, the GFC did result in many companies and investors repairing their balance sheets and reducing leverage – and this is likely to form a better foundation for creating low risk investment opportunities this time.
However, we caution that the potential for large public sector spending initiatives to stimulate economic activity in the major western economies is somewhat reduced at this time compared to the GFC period.
Equity, bond and gold markets have all captured the headlines in recent days, and oil prices have also been quick to fall.
Ironically, lower oil prices will act as a significant broad based stimulus that will be important as markets enter the recovery phase.
Equally importantly, the lower energy prices will also translate directly into lower inflation – providing governments with a critical weapon when setting policy.
However, the situation for the broader commodity complex is more opaque – and to a significant degree highly dependent on the actions of China.
Clearly any slowing in economic activity in the U.S. and the Eurozone will lead to softer demand for base metals and bulk commodities, creating near term pricing pressure – albeit global industrial production is tracking above pre-GFC levels even after the Japan tsunami / earthquake disruption.
At the same time many commodities have been experiencing significant supply challenges and disruptions in 2011 (creating tight market balances in many markets) and China has been depleting inventories during the first half of the year (due to credit tightness, high commodity prices and seasonal behaviour).
This creates a potential buying opportunity for Chinese participants now that prices are falling.
Exacerbating this feature is the growing importance of China as a consumer of resources – currently accounting for around 40% of global base metal and steel demand, and almost 60% of iron ore consumption.
These figures are well above level experienced leading into the GFC.
Having establishing the increasing importance of Chinese demand for commodity markets and their potential to rebuild inventories during the balance of the year, we examine its historic actions.
This indicates that in fact Chinese purchasers tend to be a stabilising influence in commodity markets due to their marginal-buying attributes (i.e. re-stocking inventories during periods of price weakness), as well as the policies of the government.
Indeed during the GFC China undertook a massive stimulus program that saw substantial infrastructure investment, construction activity etc. – essentially propping global commodity demand virtually on its own.
However, this time around China doesn’t have the same level of firepower.
In particular, inflation continues to run at above target levels (circa 6.5% pa driven by high food prices) limiting the scope for monetary easing to support domestic growth.
On a more positive note the Chinese economy is steadily becoming less dependent on vulnerable exports to support its economic growth – with exports currently running at around 28% of GDP, compared to a level of around 38% ahead of the GFC.
Overall, we anticipate strong support for commodities from China on any further price weakness, as well as increased credit availability once inflation figures start to ease – albeit the easing of inflation may still be a few months away.
Turning to the equity markets, the U.S. equity risk premium (pricing of equities relative to bonds) has already blown out to levels comparable to period following the collapse of Lehman in September 2008.
Accordingly, despite the risks associated with the escalating European sovereign debt crisis, investors with a longer-term outlook should view the current equity market selloff as a buying opportunity – particularly for stocks that have significant defensive attributes (including strong balance sheets, diversified earnings etc).
