HardAssetsInvestor

Written by Daniel Harrison  |

August 13, 2009

China And Commodities: Chicken Or The Egg?

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Are commodities supporting Chinese equity markets, or vice versa? And what happens when the A-shares start to fall? 

• The commodity/China connection
• Has de-leveraging already begun?
• China's take on precious metals

It's hard to find two asset classes that have risen more this year than commodities and Chinese equities. The Shanghai Composite Index, which tracks China's leading exchange, has risen 65%, while the prices of raw materials used to build the infrastructure of the world's fastest-growing economy have followed suit. Iron ore and crude oil have more than doubled, to around $110 a ton and $70 a barrel, respectively, while steel prices are up over 30%. Copper, aluminum and zinc have all fared similarly.

Returns have been especially big for companies taking advantage both of commodity production and Chinese consumption. CNOOC, China's largest oil producer, is up 45%, while Wuhan Iron and Steel has leaped 109%. China Coal Energy has surged a whopping 111%.

But in the past week, prices in Chinese shares have eased by around 10%, and many commentators have begun predicting a correction in local markets. That raises a big macroeconomic question: If A-shares fall further, what will happen to commodity prices?

Strong China, Strong Commodities

While some argue that the recovering global economy offers enough demand to offset any temporary weakness in mainland China, many are still betting big on cheaper energy and metal prices.

Jackson Wong, vice president of Investment Management at Tanrich Securities in Hong Kong, told Hard Assets Investor that a further 15% correction in Chinese mainland equity prices could occur within the next quarter. That, he says, will spill over to commodity prices.

"I do think that a correction in Chinese markets will trigger a pullback in commodities," he said. "When A-shares are moving up, people are thinking that the Chinese economy is growing faster, as it consumes more oil, copper or other industrial raw materials. There is definitely a strong relationship."

Wong adds that in the third quarter, oil could bottom out at $55 a barrel, but after that, China will enter a third bull market phase that should push prices higher again. His is a popular theory right now in Hong Kong: Chinese equities may be currently overvalued, but they'll only ease back for a little while before resuming their upward charge.

Yoji Takeda, who manages $1 billion of Asian equities for RBC Investment Management in Hong Kong, told Hard Assets Investor that he expects a very temporary weakness in both A-share and commodity prices in general. Although a high correlation exists between the two markets, he explains, so far there has been little overspill in the selling of mainland equities and metal prices. Therefore, market gains don't matter as much as China's economic growth, which is due to come in at 7.7% this year.

"The A-share market is already down 10% in the last few days, but base metal prices haven't moved at all," said Takeda. "So long as the Chinese economy is strong, commodity prices will stay strong."

For the moment, however, China's white-hot economy and pent-up demand for commodities shows little sign of cooling. In July, crude steel production in China jumped 13%, rising to 50.7 million metric tons, and although iron ore output fell 7.7% on the month, imports rose to a new record of 58 million tons. On Wednesday, the International Energy Agency said it expects Chinese oil demand to rise 2.8% this year to 8.1 million barrels a day-only to rise again in 2010 to 8.4 million barrels.