Copper prices have further downside risks

Is China’s 1929 moment coming?

How did China get here? Well, once upon a time, China got rich by making low-cost things and selling them to rich countries. Now this was always going to run out once its workforce stopped growing and its wages started rising faster, like they already have, and it got undercut by countries witheven cheaper labor. But it ran out a little sooner than that because the global financial crisis crippled its customers. So now China is getting rich by making the things it needed to be a rich country. New houses, subway lines, and roads, all sleek, all modern, and all paid for with borrowed money. A lot of it came from unregulated lenders, so-called "shadow banks," and was funneled through local governments and state-owned companies that then plowed the money into the property market. 

But there's still something ... wrong. It's a bubble mentality that comes out of the fact that China has more savings than it knows what to do with. Now a big part of the problem is that China's banks are only allowed to pay people piddling interest rates, all so that exporters can borrow for less. That means, though, that people don't like to keep their money in banks, since they're really losing money on it once you account for inflation. Instead, they pour their money into property, snatching up empty apartments and leaving them like that, because they think those are a better store of value. Or they buy shadow bank products with names like "Golden Elephant No. 38" that promise 7.2 percent returns, but, it turns out, are only backed by an almost-abandoned housing project. In short, anytime people find anything that resembles a decent investment, it gets bid up until it's unmoored from any kind of economic reality. 

And now that's happening to stocks. It's still nowhere near its 2007 highs—in fact, it's barely halfway there—but the Shanghai index has nonetheless been on a tear the last six months, up 50 percent in that time. Why? Well, it's not earnings. Those are down. No, it's the debt. Investors have become so exuberant, perhaps irrationally so, that they aren't just throwing their own money into the stock market, but borrowed money, too. Margin accounts, which let people do this, more than doubled in 2014. And to give you an idea how important this has become to the market, stocks tanked7.7 percent in a single day after the government announced it wouldn't let the three biggest brokerages open any new margin accounts for the next three months. It sure looks like China is replacing its housing bubble that just popped with a new stock bubble. 

The nightmare scenario is that China's stock and housing bubbles both burst at the same time that rates and inflation are low. That's because there wouldn't be any new, shiny bubble for people to get excited about, not that they'd need one when inflation is barely in positive territory. They could just sit on their cash instead—and they might. Psychology is a tricky thing. It's not easy to make people feel confident again, even for a government that has the kind of singular control over its economy that China's does. Especially when that's already become harder than it used to be now that money, for the first time in a long time, is leaving the country. The snag is that China's currency "wants" to weaken, but they're not willing to give up their dollar peg—which forces them to shrink their money supply at the exact moment that their economy needs a bigger one. China, in other words, has plenty of problems even if its people don't become too scared to do anything with their money. But if they do, watch out. 

It could be 1929 with Chinese characteristics.

Copper prices have further downside risks

A. Gray Shilling

So why are copper producers ignoring all the obvious economic signals -- lower demand, excess supply and falling prices -- and ratcheting up production? The answer is that producers have powerful incentives to increase output. (Disclosure: Gary Shilling manages investment portfolios in which copper is shorted, so I have a financial interest in falling copper prices.)  

Let me explain. Think back to the early 2000s, when it was accepted wisdom that fast-growing China would soak up most of the world’s commodities. China, indeed, has been buying more than 40 percent of annual global output of copper, tin, lead, zinc and other nonferrous metals. It's been gobbling up 50 percent of seaborne iron ore and huge quantities of coal. And it has built large stockpiles of crude oil. 

As manufacturing shifted to China from Europe and North America, the Middle Kingdom became a much bigger buyer and user of commodities than its domestic economy required.  

The jump in prices led commodity producers to invest in big new operations in Australia, Brazil and elsewhere. Many of these projects came online just as global demand slowed in a classic boom-to-bust commodity cycle. 

But even as China's commodity-intensive exports to North America and Europe atrophy and China's own infrastructure spending slows, excess capacity keeps building. The reason: It’s not economical to suspend some of these projects due to high sunk costs and shutdown expenses. Some producers, moreover, may not be free to slash output as prices swoon, especially if they’re government-controlled and need foreign exchange to service sovereign debts.  

To see how market versus non-market forces are interacting, compare two widely used metals, aluminum and copper. Aluminum prices are down 32 percent from their April 2011 top, much less than copper's 41 percent freefall. Six of the top 10 aluminum companies are in Russia and China, where government decisions, not economic forces, often prevail. 

The government and state-owned enterprises in China push aluminum output to provide employment and to achieve other national goals, such as self-sufficiency in aluminum. In Russia and India, the goal is to generate revenue from aluminum exports that can be exchanged for currencies needed to pay down debt; in Brazil, the driver is substituting domestically produced aluminum for imports. 

Aluminum production in these emerging economies has been booming. Even though half of China’s output is produced at a loss, the Chinese government buys excess metal from smelters to avoid bankruptcies, bad bank debts and unemployment. 

 Much of the surge in aluminum output, however, is offset by cutbacks in the U.S., Canada and Australia. Alcoa, for example, is closing high-cost plants around the world. Since 2009, the aluminum industry in developed countries has shuttered more than 50 smelters. These moves have kept global prices from plummeting.  

By contrast, copper is produced mainly in the developing countries of Chile, Peru, Congo, Zambia and Russia. China is a net exporter of aluminum but an importer of copper. China had been building copper stockpiles but apparently that has slowed, along with China's slackened growth. The premium paid for copper on the Shanghai market over the London Metal Exchange was $85 a ton at the end of January, down from $160 a year earlier. 

Copper output in developed countries has been restrained by falling prices, except in the U.S. and Australia, where output has risen because the marginal cost of production is even lower than market prices. Copper inventories are rising as output grows in Chile, China, Russia and other countries. In Chile, the world’s largest copper producer, stocks rose by 170,000 tons in the second half of 2014, the highest in a decade except for a brief spurt in 2013. 

Copper is used in almost every manufactured product, from plumbing fixtures to autos to machinery. Some 56 percent goes into electrical equipment and construction, which are weakening as China's economy shifts from an emphasis on manufactured exports, infrastructure and construction to consumer spending and services. 

Since copper is traded in dollars, the strong greenback makes it more expensive for non-U.S. buyers, putting more downward pressure on prices. At the same time, since about 93 percent of copper is produced outside the U.S., labor and other production costs are dropping in dollar terms, encouraging yet more output. 

The upshot is that about 20 percent of mined copper worldwide is unprofitable at current prices.  A global copper surplus is likely this year, the first since 2009, with supply exceeding demand by 500,000 tons, or 2 percent of annual refined production, according to Goldman Sachs. The International Copper Study Group, made up of copper-producing and consuming countries, says demand will rise just 1.1 percent this year while output jumps 4.3 percent.  

In an atmosphere of falling commodity prices, copper will probably continue to be weak; it's a favorite short in portfolios I manage. The lower the price of copper, the more developing economies must produce and export to get the same number of dollars to service their foreign debts. And the more they export, the more the downward pressure on copper prices. That forces them to produce and export even more, in a self-reinforcing downward spiral. 

Bull market for stocks is 6 years old: Is the run-up over?

The housing market had collapsed. Lehman Brothers had gone under and General Motors was on the verge of bankruptcy reorganization. The U.S. was in a deep recession, and stocks had plunged 57 per cent from their high in October 2007. 

Fast forward six years, and investors are enjoying one of the longest bull markets since the 1940s. 

James Abate, chief investment officer of Centre Funds, says he sees a much stronger probability of the U.S. economy falling into recession than most investors and analysts. He says the stock market's gains are at odds with the performance of the economy. Growth remains steady, but could hardly be described as robust. That means companies will have a hard time boosting sales, ultimately undermining their earnings. 

"We will not be celebrating the seventh anniversary of the current bull market," Abate says.

DYI