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Asia-Pacific Currencies and the Commodity Spike - Global Exchanges

FICC Podcasts March 16, 2021
FICC Podcasts March 16, 2021

 

In this episode we interview BMO commodities analyst Colin Hamilton. Topics discussed include the causes of this year’s spike in base metals prices and the market implications of China’s new 5-year economic plan.


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About Global Exchanges

BMO’s FX Strategists, Greg Anderson and Stephen Gallo, offer perspectives from strategy, sales and trading on the foreign exchange market, related financial markets, and the global economy.

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Greg Anderson:

Hi, welcome to episode three of Global Exchanges. A podcast about foreign exchange markets and related issues. I'm Greg Anderson. My co-host, Stephen Gallo, and I will be joined by guest, Colin Hamilton, in this episode. Together, we will discuss developments in global commodities markets with an emphasis on Chinese demand and Australian supply. The title for this episode is Asia Pacific Currencies and the Commodity Price Spike.

Stephen Gallo:

Hi, I'm Stephen Gallo, a London based FX Strategist. Welcome to Global Exchanges presented by BMO Capital Markets.

Greg Anderson:

Hi, I'm Greg Anderson, a New York based FX Strategist. I'm Stephen's co-host.

Stephen Gallo:

In each weekly podcast like today's, we discuss our perspectives on the global economy and the foreign exchange market. We also bring in guests from the FX industry and from related financial markets like commodities.

Greg Anderson:

We strive to make this show as interactive as possible, so don't hesitate to reach out by going to bmocm.com/globalexchanges. Thanks for joining us.

Speaker 3:

The views expressed here are those of the participants and not those of BMO Capital Markets, it's affiliates or subsidiaries.

Greg Anderson:

Here we are on Tuesday, March 16th, and we're here with our first guest, Colin Hamilton, a Commodities Analyst for BMO based in London. Stephen, I know you were itching to get Colin on the show. In a nutshell, why?

Stephen Gallo:

Well, Greg, I'd like to get some insight from Colin on where he thinks China is in the policy cycle? How policy makers are managing risks within the economy? And if there's scope for policymakers to encourage perhaps different economic growth drivers in the coming one to two years.

Greg Anderson:

That's great, and for me, I cover the Australian dollar, it is a commodity, well, mostly a base metals currency, so I want to hear his outlook for metals.

Stephen Gallo:

I think I'm going to kick things off by starting with the currency angle in particular, because this is such an important policy lever for policy makers in China. And by setting some context too. So we know that 2020 was an exceptional year for the Chinese economy, not only because it had a quick rebound from COVID-19, but also because of its relative economic out performance. And we also saw this reflected in two things. Number one, the balance of payments, and number two, the RMB, it gained about three and a half percent last year in trade weighted terms, and it ended the year about 7% higher against the US dollar.

Stephen Gallo:

But if you turn the page to 2021, it looks like the pace of RMB appreciation has slowed. Particularly when we look at dollar CNY, that currency pair is basically flat year to date. So I'm wondering, Colin, from your perspective, were there any clues from the latest MPC sessions and the 14th five year plan concerning China's management of the currency, and where China currently is in the policy cycle?

Colin Hamilton:

Yes, thank you, Stephen. Welcome everyone. So, it's interesting for me, as a commodities analyst, I feel like half the time I'm a China policy analyst because if I get China policy right I go a long way to getting these commodity markets right.

Colin Hamilton:

And what we've had is a Chinese economy that, as you mentioned, led the rest of the world in terms of the recovery, but is now at a point where some of the reflationary pressures we were seeing through the second half of last year, have started to become inflationary bottlenecks.

Colin Hamilton:

And with that, it now feels that, as the PVOC is already saying, the Chinese economy is growing at potential. And when we get to this point in the cycle, that's normally when they start to press back on the brake pedal a little bit.

Colin Hamilton:

Now, heavy fixed asset investment growth driving a lot of the cycle last year. And what we also saw was still strong export markets for China in certain areas. And we saw particularly around the manufactured goods side, and of course medicinal equipment side. Still importing a lot of commodities. So, obviously when we talk about commodity currencies, you've mentioned there, the RMB, that is obviously one half of the commodity currency trade at any point in time. Your marginal buyer thinks in RMB terms. And it has become much more expensive for them to import the raw materials that is needed for growth.

Colin Hamilton:

And then when it comes to the policy side, that in itself is starting to feed through into the inflation numbers. We're just starting to see the brake pedal pushed a little bit. And we are going to see a little bit of tightening coming through on the property market in particular, caps on leverage for developers.

Colin Hamilton:

But as we look forward, in terms of what's coming out from the MPC meeting, the growth targets in my view were pretty conservative, should be easy enough to hit.

Colin Hamilton:

I do think we're at a point where the Chinese government is starting to get a little nervous about the non-performing loans that may be coming up in the second quarter of the year. And I think just a little bit more stability in currency, and indeed in economic growth at the current time.

Stephen Gallo:

So, if I understand you correctly, Colin, to sort of summarize things, what policy makers are doing is effectively heading for a better quality of growth, as opposed to outright quantity. They're being pretty conservative with their growth estimates. And policymakers are a little bit nervous about risks within the economy. I know you mentioned NBL specifically. So do you think that means they're pushing for a more balanced economic model or economic recovery with more emphasis on household consumption?

Colin Hamilton:

Yes. I think they really have to get the balance back in the economy. When push comes to shove, as it did last year, they always reach for the fixed asset investment lever, and they pulled it very hard. The consumers lagged. And retail sales are now starting to come back, but I think they would like to see the consumer add a little bit more. The more the consumer can do, and what we've seen from the Ministry of Commerce is a push in areas like autos, appliances, catering, as in installing new energy efficient cooking equipment, these are the sort of areas they're looking for the Chinese consumers to spend on.

Colin Hamilton:

Now, if that is successful, and I think it will be, that allows them to pare back the fixed asset investment, just a little bit, and keep the economy on a more stable path as we look forward.

Colin Hamilton:

Now, the nature of the recovery we had in China was a very metals intensive one. I mean, we are sitting a year past the Chinese economy just starting to emerge from lockdown. And we have copper prices roughly double what they were this time last year. We have iron ore close to record highs. That owes a lot to the fact that we had a very metals intensive recovery in your marginal consumer, being China.

Colin Hamilton:

As we start to see consumption pick up and policy pare back on the fixed asset investment side, that obviously takes a little bit off the edge. I think we've had a lot of competition for units in commodity markets over the past six months. But China's strong, and as China's recovering, now if China presses on that brake pedal, well, I'd be looking for a little bit less aggression in commodity prices.

Colin Hamilton:

In fact, I have most of them trending lower over the next six months. It will still be a strong year, and overall global demand growth for commodities. But in terms of the competition for units, which I think is key for commodity prices, I think you will see that pare back a little bit.

Colin Hamilton:

And what we'll go from is a situation where we've been trying to incentivize marginal supply into commodity markets for the past three to six months. We'll start to move to a point where we're maybe trying to push some off and dissuade some supply from the market as we look into the second half of this year.

Greg Anderson:

So Colin, one of the things that I look at often in my analysis of the Australian dollar is the Bloomberg Base Metals Index. The index was very stable in the 170 to 180 range in the second half of 2019. When we were pre-pandemic and the world was close to what I would call full output.

Greg Anderson:

The index dipped about 20% to 140 or so at the outset of the Coronavirus crisis, as you would expect. But then it began to rally, the base metals rally was particularly fierce over the first couple of months of 2021. Now we're looking at a base metals price index in the 230s. So, roughly 35% higher than pre-pandemic. We've got global GDP at well below pre-pandemic levels. And we're nowhere near full output, but base metals are 35% higher.

Greg Anderson:

Maybe I'm asking you to repeat yourself, but this is something that is really important for metals currencies. So could you run back through how that has happened again?

Colin Hamilton:

Thanks Greg. It owes to the fact that China is the biggest industrial economy. And for metals, in 2020, China was more than 50% of copper, aluminum, nickel, zinc demands for the first time in history. So really it owes a lot that to that China side.

Colin Hamilton:

And we had Chinese growth numbers that were actually quite spectacular in the second half of the year. That created a lot of pressure on the raw materials supply chain. And still with the supply side impacted a lot, particularly in areas like Latin America, by COVID-related restrictions, the supply chain just couldn't react in time. And with that it's created some bottlenecks in the chain.

Colin Hamilton:

And it is these bottlenecks that have led to the inflation in prices, helped by the fact that the ex-China manufacturing chain had de-stocked pretty hard through the second quarter of last year. As they started to recover and restock, that did create that competition for units.

Colin Hamilton:

So that for me is the key thing that's been driving prices to where they are. And out performing many other areas of the global economy. It has been a very metals intensive recovery, and a very China-led recovery in the metals side.

Stephen Gallo:

So, Colin, on that point, just to pause there and just talk a little bit about the inflation dynamic. I wonder if the overall picture just points to a preference on the part of policy makers for continued stability in the currency, just for the time being. Not a lot of volatility either way.

Stephen Gallo:

On the one hand you have, and we talked about this, you have policymakers tempering the credit cycle a little bit, trying to take some of the heat out of the investment-led growth story. Which I guess argues for a slightly weaker RMB, or less appreciation. But on the other hand, because of the back-up in inflation pressures, strengthened commodity prices generally at the global level, they also don't want the RNB weakening sharply either.

Stephen Gallo:

Would you agree, disagree with that? How would you comment on that?

Colin Hamilton:

Yeah, I think I would agree with you, Stephen. I mean, it is always an interesting point for them. But I think the low growth target points to the fact they're still relatively unsure about the global economic situation at the current time. I think there's persistent concerns there.

Colin Hamilton:

And to me, stability is key now. It gives them a little bit of leeway to rebalance the economy, means they're not having to deal too much with massive capital inflows or outflows, which is something they've struggled with I think in the past. And if they stabilize things then, as I say, they can come up with more coherent policies as we look a little bit further out.

Colin Hamilton:

And of course, part of the recent MPC meeting was the launch of this 14th five year plan, setting out the economic agenda for the coming five years and beyond.

Greg Anderson:

Colin, you talk about stability, but there's one area where we've seen a little bit of instability over the last several months. And that's in the trade relationship between Australia and China. China, starting last fall, again, imposing a bit of a buyer's strike on various Australian commodities.

Greg Anderson:

My question to you is, is this an economy altering thing for Australia? Are they not going to be able to sell these raw commodities anymore? Or are those commodities fungible and they can sell them somewhere else? Along with that, if China doesn't buy from Australia, where do they go to buy these commodities?

Colin Hamilton:

That's a great question, Greg. And certainly one I've been answering a lot over the past six months or so. First of all, I think it's important to note that two of the key trade flows have been maintained. Iron ore, China gets 60% of its iron ore from Australia. So the thing that really fuels the steel industry, well, it cannot do without that Australian supply. So not surprisingly that hasn't been included in the trade friction.

Colin Hamilton:

Nor has LNG, where again, Australia's the biggest supplier to the Chinese market. Obviously LNG very strategic in the de-carbonization process for China as a whole.

Colin Hamilton:

In my world, the ones that have really been affected are copper. And in terms of that one, well, certainly that copper is pretty fungible. It can be sold elsewhere. We've seen a lot of traders swapping cargoes of copper concentrate, so that material can flow into China. So there's been a slight rebalancing of trade flows in the copper side.

Colin Hamilton:

One which has proved a little bit more challenging is actually metallurgical coal. Australia, a huge supplier of metallurgical coal to the global market, 60% of seaborne trade emanates from Australia. And of that, well, China was taking about 25%. That trade has completely stopped. That is one where we have seen dislocations. In fact, we saw a situation not three months ago where the Chinese domestic price was actually double the Australian export price. A situation we've never seen before. So major dislocation.

Colin Hamilton:

Now, we're starting to see trade flows normalize. Australia's started to ship more cargoes to India and a little bit more to Japan. And we are seeing more US and Canadian coal cargoes heading into China. Obviously that helps the US agreement in terms of taking more energy material.

Colin Hamilton:

The other area China is looking to is Mongolia, a big coal supplier, and we're starting to see more cargoes come through from there.

Colin Hamilton:

And the other thing though, the interesting thing that I think is very under appreciated. As part of this process as well, China has invested pretty hard in technology to allow it to use more of its own domestic coal again. So it's got a declining resource, but by investing in technology, and it is low carbon technology and it's reducing emissions, well, that's also allowed them to lower the call a little bit on international markets. Which actually plays well into their dual circulation strategy which is another key component of their coming economic agenda.

Stephen Gallo:

Colin, one of the things I wanted to ask you was about a topic that showed up a lot at the MPC meetings and in the five year plan, this green agenda. Now, it's not unique to China, we've seen this in many other jurisdictions, the focus on environmentally sound growth. But I wonder if the focus on this from China's perspective is also to do with energy security in terms of managing or curtailing the vulnerabilities that China has faced here over the years, particularly on fossil fuels. If the green agenda and the green targets have something to do with mitigating that energy and insecurity, what are your thoughts on that?

Colin Hamilton:

Yeah, thanks Stephen. I think this is a big change in Chinese policy. As you say, the push for de-carbonization is a global trend. China, first of all, wants to be seen as a global leader. But the security of supply on the energy side is an important thing to them.

Colin Hamilton:

Now, what I think you're likely to see, they've mentioned this phrase, rural revitalization, an awful lot in the MPC meeting. It's basically taking urban land revenues and taking those revenues and reinvesting them in rural infrastructure. I think a lot of that will be on the renewable energy side. The more electricity that can be generated that way, and used for things like heating and cooking and the like, well, the less they will have to import fossil fuels. So, it reduces that reliance on the rest of the world, it gets China in a better energy security position. So I think that is actually an important development.

Colin Hamilton:

I also think you've got a population which don't like the pollution they're seeing. And obviously in a command economy structure, you want to keep the population happy. And with that you are starting to see a bigger clampdown now on the heavy emitter sectors.

Colin Hamilton:

So what you're seeing, the targets of the MPC were pretty strict. A 18% reduction in carbon emissions per unit of GDP. And to meet that, well, that's being shipped down to both the provincial, and indeed industry level. You're seeing heavy pressure now on the steel industry to cut blast furnace output. In Inner Mongolia, we're seeing cuts to ferro-alloy and aluminum production.

Colin Hamilton:

The net effect of this, China will still buy commodity raw materials. They'll still be investing in the raw materials side. They'll still be processing a lot of those domestically. I think you will see a little bit less Chinese refined metal production. And therefore a little bit less Chinese refined metal export. So if you want, deflation shipped to the rest of the world through metal exports over the coming five years.

Greg Anderson:

Colin, you mentioned Chinese exports and processing, and I want to transition to a topic that is more rare than the correct pronunciation of aluminium. See, I said it. The topic that I want to transition to is rare earths. So roughly 10 years ago, China imposed a brief sellers strike on rare earths exports to Japan. Now we have a situation where markets are worrying about the potential of a seller strike of rare earths exports to the US and perhaps other places like Taiwan or Australia. The US is trying to quickly rebuild its rare earths mining and processing industries. Realistically, from your perspective, how fast can this be done? And how powerful is this tool that China has of threatening to withdraw rare earths exports?

Colin Hamilton:

Yeah, thanks Greg, it's an interesting one. Rare earths, they're one of these topics that comes up every four or five years or so. It's a little microcosm. China really does control this market. We're talking 90% of global production in China. And the rest of the world is highly reliant.

Colin Hamilton:

Now, it's interesting you mentioned that period, back in 2010 it was, where there was a spat with Japan. At that point, we actually saw rare earths engineered out of a lot of things. But now though, rare earths are a core part of the green energy transition. They're used in wind turbines, they're used in electric vehicles, particularly Neodymium and Dysprosium, they form very good magnets.

Colin Hamilton:

So what happens now, China's certainly put it out there that they may think about reducing exports for security of supply purposes. Now, the rest of the world would struggle then, and that would put a big halt to some of the green stimulus processes maybe underway. So, China has a bit of power in this regard.

Colin Hamilton:

As you say, we're starting to see a response to this from other areas, both in the US and indeed in Australia, where there is a lot of rare earth capability there. The economics though, well, the price levels they've been at over recent times, don't justify the investment.

Colin Hamilton:

So it really has to be regulation or government-led in terms of the response coming through. It will take a couple of years. And I think it's mainly down to the downstream processing. And I mean, it's not the nicest business. So as a result, there is some environmental permits needed. But I do think this time round, you will see a little bit more action and strategic action taken by government to offset this risk.

Colin Hamilton:

The other area that I suppose is similar, but not quite as extreme, is in cathode technology for battery manufacture. Where China dominates, they've got about 75% global share of demand. Of course, what we now have is gigafactories starting to pop up. And every individual country wants their own gigafactory for a little bit of security of supply. So I think this is going to be an ongoing trend.

Colin Hamilton:

What it actually means for my markets, many of the metals markets I cover have been running on one engine for the past 20 years. That's the China engine, it's been a very strong engine. But actually demand, or first use demand in the rest of the world, is actually slightly lower than it was 20 years ago, in the cases of key things like copper and steel.

Colin Hamilton:

Now you can make the case that you're going to have much more balanced growth going forward. And that is actually helpful for longer term investment I would say in commodity markets as a whole.

Stephen Gallo:

Thanks a lot, Colin. I think we'll end things there. Greg and I both want to thank you very much for joining us on the podcast and sharing your insights. We'll be sure to have you on again.

Stephen Gallo:

To the rest of our listeners, we want to thank you again for listening and hope you'll join us for our next podcast in a week's time. Thanks.

Greg Anderson:

Thanks for listening to Global Exchanges, listen to past episodes and find transcripts at bmocn.com/globalexchanges.

Stephen Gallo:

We'd love to hear what you thought of today's episode. You can send us an email or reach out to us on Bloomberg. You can listen to this show and subscribe on Apple Podcasts, Spotify, or your favorite podcast provider.

Greg Anderson:

This show and resources are supported by our team here at BMO, including the FICC Macro Strategy Group and BMO's Marketing Team. This show is produced and edited by Puddle Creative.

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Greg Anderson Global Head of FX Strategy
Stephen Gallo European Head of FX Strategy



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