Conclusion: We believe the recent strength in copper may be a leading indicator for China easing its tightening policies. This is bullish for Chinese Equities and may serve to keep a floor under copper prices going forward.
Position: Long Chinese equities (CAF); Short Copper (JJC)
As the facts change, we do. While we’d like to help our subscribers make money on 100% of our positions, the reality is we’re wrong on about 15% of them (14.4% on longs and 16.1% on shorts to be exact). Most importantly, however, rather than stay dogmatic about our losers, we accept the fact that markets don’t always trade in the direction our research suggests.
In the spirit of this process, we went back to the drawing board on our short on Dr. Copper. After having put out a note early last week affirming our conviction in this position in light of the disastrous setup for growth and housing in the U.S., we revaluated the risks and have come to conclude that they are starting to outweigh the reward. Those risks include: Chinese demand accelerating, accelerating dollar debasement, and supply constraints.
We know growth is slowing globally. U.S. 2Q10 GDP came in at 1.6% (10bps below our estimate) and looks to continue rolling over sequentially driven largely by a weakening consumer (we are revising down our 3Q and 4Q GDP estimates to be released soon). As it relates to China, roughly one-fifth of all Chinese exports are to the U.S. so there will be negative knock-on effects in the Chinese economy as a result of slowing growth domestically. Understandably so, the likelihood that China reverses its tightening policies or accelerates the creation of policies designed to support domestic consumption increases with every incremental negative economic data point out of the U.S. and W. Europe – of which there will be plenty of going forward. For instance, this morning the China Times reported that China’s State Administration of Taxation is considering “large” tax cuts to small and medium-sized businesses to support their growth and development. If enacted, this is incrementally bullish for Chinese employment and consumption.
As it relates to the potential for dollar debasement, the Fed will have plenty of opportunities to quantitatively ease going forward given the negative economic backdrop domestically. If Bernanke and Co. give in to market pressure (which it appears he will based on his commentary out of Jackson Hole), we expect the dollar to resume its decline after closing up on a weekly basis for the previous two weeks. Further dollar debasement from here is positive for copper prices (r-squared = 0.69 on a two-month basis).
With regard to supply, copper inventories stocks on the London Metals Exchange continue to trend down and are at a nine-month low. We initially thought that those inventories would start to grow as growth slows globally, but the potential for accelerating demand out of China could serve to keep inventories in check at low levels. While the global growth story may be in question, the domestic consumption growth story in China continues to accelerate.
In addition, some experts are predicting that there may be a deficit in copper next year as demand outstrips supply for the first time in four years. The impact of a volatile few years of pricing is that there has been limited investment in mines and therefore there will be limited new supply coming on in the next few years. According to Pan Pacific Copper, “With few new large-scale mines on the horizon and stagnation at existing facilities, in our view, price direction will be upwards given the approach of multiyear deficits.” So as demand naturally continues to grind higher, supply may actually take a few years to catch up.
In the end, Dr. Copper has a Ph.D. in being a leading indicator, particularly as it relates to China and global growth. We think the potential for policy easing and accelerated demand out of China is growing and that is a major factor we will continue to monitor as it relates to our long position in Chinese equities and short exposure to copper. As we’ve seen throughout the year, any easing of policy or rumors of easing is bullish for Chinese equities and will likely serve to keep a floor under copper in spite of the negative backdrop for real estate in the U.S.