Former hedge fund researcher and commodities bear Andrew Hepburn looks at the potential implications of a widespread economic slowdown in the emerging markets on Canada.
A comforting narrative has emerged about our fair northern nation. It goes something like this: While the United States has been reckless in its lending, Canada is the smaller, prudent neighbour. So as the U.S. housing bubble burst and financial crisis ensued, Canada remained a well-regulated rock.
And speaking of rocks, the great northern land just happens to have the commodities required for the fast-growing economies of Brazil, Russia, India and China.
Time and again, Wall Street has pointed to these emerging market economies, the so-called BRICs, as the source of high commodity prices. Yet by now it’s very clear that China, along with Brazil and India, are slowing rapidly. Energy-rich Russia can’t be far behind if oil keeps falling.
China cut interest rates unexpectedly last week, signalling government concern that the sought-after soft landing of the economy is turning uncomfortably hard. As the Atlantic recently noted, many indicators of Chinese growth are flashing warning signs. Loan growth has collapsed, rail cargo and electricity output are sliding, and business sentiment has soured. India doesn’t look any better. Growing at close to double digits a few years ago, the country recently recorded a growth rate of 5.3%.
Prices are sliding: the benchmark Reuters/CRB commodity index, tracking a basket of commodities, is down more than 20% over the past year. Oil, copper and iron ore have all fallen substantially from their peaks.
Trouble for the BRICs means trouble for Canada, a major producer of natural resources. Whether it’s nickel in Sudbury or potash in Saskatchewan, our country has benefitted from the lengthy commodity boom that is now over a decade old. Alberta in particular requires lofty prices to make the oil sands economically viable. There’s also the tiny matter of the Toronto Stock Exchange, where energy companies alone represent 25% of the index.
Anecdotally, the supposedly insatiable demand for resources is gone. Analysts at Standard Chartered toured China to see what conditions were like on the ground for commodities. What they discovered and photographed were mountainous stockpiles of copper and aluminum. Reuters recently accompanied ANZ Bank analyst Nicholas Zhu on a similar expedition, this time finding large inventories of iron ore, a crucial ingredient in steel-making.
But slowing growth in emerging markets in and of itself is only one reason to worry. The second reason is how that weaker demand from the BRICs will affect investor behavior. Besides an effective increase in global demand, Wall Street’s insatiable appetite for commodities, in fact, has also been responsible for surging prices. Many of the bullish bets on resources by international hedge funds, pension funds and other speculators are predicated on the “story” of an ever-growing China et al. And the problem is, as the BRIC slowdown shows, that story is coming unglued. With its unraveling we are starting to see the bursting of a speculative commodity bubble. Financial players overran these tiny markets and prices soared, which can only mean falling prices when they leave the scene.
Another twist in the commodity bubble is the apparent role played by financing games within China itself. Multiple press reports (see here and here) suggest that significant imports of commodities from copper to soybeans are not for consumption purposes, but rather as a mechanism for obtaining bank credit. It’s also worth mentioning the stories of Chinese citizens and corporations themselves speculating on commodity prices , as one particular Bloomberg article about pig farmers stockpiling base metals aptly illustrated. In other words, what China buys exceeds what it needs, resulting in unused stockpiles and the prospect of lower future prices.
The Bank of Canada appears to be keeping a close eye on speculators. Last March, Governor Mark Carney gave a speech in which he argued that “while speculative pressures have reinforced, on occasion, the direction of fundamentally driven price moves, the Bank’s view is that a large, sustained increase in demand is the primary driver of this boom.” But internal Bank documents obtained under Access to Information legislation show an awareness of more speculative activity than Carney’s public remarks suggested. Drawing on published reports, a February 2011 memo prepared by the Bank’s financial markets group discussed evidence of speculators buying huge volumes of commodities ranging from copper to cocoa.
The document notes: “there are increasing signs of instability, illiquidity, volatility and price dislocation, all attributable to the speculative or financial participants, rather than the core commodity participants. Since the size of traded commodity markets remain much smaller than that of other financial markets, any marginal increase in commodities investment by market participants…has a disproportionate impact on prices.”
Admittedly, prices for most commodities are still historically high. But if the emerging economies keep slowing down and speculators flee en masse, Canada’s resource boom could quickly morph into a painful bust. It will surely count as a miracle if commodities and Canada escape unscathed from falling BRICs.