CHINA & COMMODITIES: STIMULUS NEEDED TO BOLSTER CHINA S SLOWING ECONOMY

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1 CHINA & COMMODITIES: STIMULUS NEEDED TO BOLSTER CHINA S SLOWING ECONOMY April 4, 214 Northern Trust Asset Management 5 South La Salle Street Chicago, Illinois 663 northerntrust.com Edward Trafford Basic Materials and Industrials Analyst et44@ntrs.com China s weakening economy will likely prompt the government to enact monetary and fiscal stimulus. We see an increasing likelihood that China will enact a new stimulus plan, given weak economic data, social unrest and violence, deteriorating growth in the manufacturing and retail sectors, a slowing housing market and an economy, as characterized by the leader, Premier Li Kequiang, that is facing difficulties and risks. While propping up the economy via investment in infrastructure may appear to run counter to the Nation s Five-Year Plan, we believe an economic slowdown resulting in a hard-landing puts the longer-term plan in jeopardy. We expect announcements on infrastructure, social housing and welfare (hospitals and schools) in the coming months despite an economy that is already heavily reliant on investment spend (Exhibit 1, data as of 3/31/14). Underlying economic data has weakened, suggesting that GDP could fall below 7.% by yearend, therefore Premier Li Keqiang s announcement on March 6 outlining a 7.5% GDP growth target for 214 increases our confidence that stimulus will be enacted. Our recommended weighting to the broader commodity sector remains neutral, but our preference for the hard commodities (ferrous and non-ferrous metals) has increased as we enter the second quarter of 214. As in prior stimulus cycles, we believe these accommodative government policies will drive prices for hard commodities higher. Given that the stimulus will have little impact on soft (agricultural) commodity demand, we think this subsector could underperform in the near-term. Hard commodities including aluminum and steel should be supported by declining production as high-cost producers curtail production. Our conviction in hard commodities is heightened by an expected reversal following the meaningful outperformance of agriculture, relative to hard commodities in 214 s first quarter (Exhibit 2, data as of 3/31/14) when copper was down 1.92% while corn was up 18.96%. We see the greatest risk to our stimulus thesis coming from a stronger economy should exports pick up meaningfully. The likeliness of this occurring increases as the Renminbi depreciates. EXHIBIT 1 EXHIBIT 2 CHINA S INVESTMENT DRIVEN ECONOMY COMMODITY MOVES NOT HOMOGENOUS China Investment as % of GDP Corn vs Copper Futures % of GDP Corn ($/bushel) Corn (LHS) Copper (RHS) Copper ($/lb) Source: Bloomberg, International Monetary Fund Source: Bloomberg, CBT, CMX Commodity Exchange

2 Over the mid- to longer-term, we remain negative on hard commodities, such as copper and iron ore, as we expect inventory surpluses will unwind, become liquid and push prices toward the marginal cost of production. Steel remains our preferred commodity, given global capacity reduction, rational behavior by both domestic and non-u.s. entities, an increasingly oligopolistic structure (three players make up approximately 7% of the U.S. flat sheet market), increasing demand and declining input costs. WHY HAS CHINA S ECONOMY SLOWED SO SHARPLY? Less accommodative monetary policy as the government attempts to curb shadow banking and non-standard credit practices; Measures aimed at slowing the housing market; Plant closures to tackle pollution exacerbating an already weak manufacturing sector; and Soft retail spending, which is intrinsically linked to the slowdown in housing and magnified by the crackdown on excessive government spending. China s slowdown is not indicative of a broader global slowdown. Exhibit 3, the Citibank Economic Surprise Index, shows that China s economy has decelerated rapidly with the index now at levels last seen in 29. Similar to the period (Exhibit 4), we look for an increase in fixed asset investment (FAI) growth to tackle this slowdown. We believe FAI for 214 will come in above the government s target of 17.5%, which would have represented a 21-basis-point (bp) slowdown from 213, as the government starts infrastructure projects to stimulate the economy. EXHIBIT 3 EXHIBIT 4 CHINA ECONOMIC SURPRISE INDEX COLLAPSES FAI GROWTH TO REVERSE COURSE? Citigroup Economic Surprise Index China FAI YoY Growth Citigroup Economic Surprise Index Level 1 5 (5) (1) (15) (2) US China Europe FAI YoY % Change Source: Bloomberg, Citigroup Source: Bloomberg, National Bureau of Statistics of China 2

3 WE SEE HIGH LIKELIHOOD OF STIMULUS We see 7.% full-year GDP growth as the floor for 214, with the government stimulating the economy in order to meet this threshold and maintain social stability. Looking across the data, we believe the government will do what it always has done: put its foot back on the accelerator to support the weakening economy. Our freshest datapoint, HSBC Flash PMI did little to assuage our concerns over the economy. We expect this stimulus to be somewhat akin to that seen in the second half of 213, when individual projects were leaked by government press bureaus and through outlets, such as China Cable TV, rather than formerly announced. We do not expect a broad proclamation or major stimulus akin to 28 s 4 trillion Renminbi plan, as this could increase the risk of inflation. MONETARY POLICY We expect monetary policy will be used to facilitate acceleration in new infrastructure-related projects. The benign February inflation (Exhibit 5) reading of 2.% versus consensus of 2.1%, coupled with January's 2.5% inflation rate provides the government the leeway to loosen credit. The government is targeting inflation of 3.5% for 214, the same target as in 213. Given the weakening economy, we have little concern that the government will bump up against this target, but we do see this as a key indicator that the government will be unwilling to cross. We look for the PBoC to reduce the Reserve Requirement Ratio (RRR) from 2.%, a move that would be logical in our eyes, given low levels of inflation and the need for increased liquidity to achieve the 7.%+ growth rate. We expect the decline in Total Social Financing (TSF), Exhibit 6, resulting from the slowdown in shadow banking, will be largely offset by bond issuances by larger banks to fund the infrastructure projects. The government has announced tax incentives for small and medium sized enterprises to encourage their participation in the stimulus projects, likely encouraging growth in private enterprise and a shift from the government-linked corporations or State Owned Enterprises (SOEs). EXHIBIT 5 EXHIBIT 6 RRR CUT TO BE IMPLEMENTED? SHIFT TO MORE ACCOMODATIVE STANCE? China Reserve Requirement Ratio vs CPI China Total Social Financing 22 7 Required Reserve Ratio (%) RRR (LHS) CPI (RHS) CPI % Change YoY % Change YoY (.5) (1.) Source: Bloomberg, People's Bank of China, National Bureau of Statistics of China Source: Bloomberg, National Bureau of Statistics of China 3

4 FISCAL STIMULUS On April 2,Premier Li s Council officially confirmed that the government would, indeed, sponsor infrastructure projects to stimulate the economy. Prior to this confirmation, we had anticipated that water, railway, and road projects in the less developed central and western region of the country would be the most likely targets for government spending. The 15b Renminbi package announced by the government in April was specific to rail and noted that 8% of the planned spend would target the central and western regions. We believe this 15b bond financed project is the same as the 14b of rail projects that had been leaked to the press in late March. Incremental to this is a 2-3b Renminbi development fund that will be used to fund rail projects over the coming years. The government is targeting 6,6km of new track for 214 which would mark an 18% increase compared to 213. In regards to social housing, we expect the government to more carefully allocate capital given excess realestate stock in many third and fourth tier cities. On March 17, 214, a 1 trillion Renminbi initiative, shantytown redevelopment, was announced with China Development Bank issuing bonds to fund the project. We believe the term shantytown redevelopment is being utilized to convey that the levelling of current sub-par units will not result in incremental housing stock coming to market. OUR TAKE ON THE DATA A marked slowdown in China s economy is evident when combing through the data. MANUFACTURING The manufacturing slowdown is most evident in the HSBC PMI data. The March HSBC Flash PMI, which provides an early, independent reading on the manufacturing economy, missed consensus forecasts by 6bps. It was 48.1, a 4bp decline from February s 48.5 reading, the third month of sub-5 readings (indicating contraction) and reaching an eight-month low. We would caution investors from taking a more optimistic view on the economy given the 1bps month-over-month (mom) increase in the official headline PMI. This seasonal trend has been in place since 25 (ex the global financial crisis). We would attribute much of the difference in trend between the HSBC (down 4bps mom) and official PMI (up 1bps mom) to sampling, with the former more focused on small and medium sized companies and are likely to be the first to feel the impact from tightening credit availability. While the government and HSBC PMI headline numbers often present contradictory messages, we note that both the government s official PMI and HSBC PMI reflect a slowing domestic economy somewhat offset by stronger export demand. By dissecting the official government March PMI data, we saw significant strength in new export orders (up 19bps mom), while new orders in aggregate were up only 1bps mom. This indicates meaningful weakness in the underlying domestic economy. February s Industrial Production (IP) reading, up 8.6% year over year (yoy), was a wide miss from consensus 9.5% estimate and December s 9.7%. Of note, this is the lowest reading since April 29. POWER GENERATION February s power production, up 5.5% yoy, was a marked slowdown from December s 8.3% growth. This is not surprising given that the government curbed power availability for other industries such as steel, aluminum, and textiles to help tackle the pollution issue. 4

5 FIXED ASSET INVESTMENT (FAI) February s FAI reading of 17.9% yoy was a 13-year low and represented a sharp slowdown from December s 19.6% a wide miss to the consensus 19.4% estimate. Weakness came from a slowdown in investment in manufacturing capacity, utility spend (power) and transportation. We look for a pick-up in both utility and transport spends as the government invests in nuclear projects and new rail lines. REAL-ESTATE The slowdown in the property market is of great concern. Given worries about oversupply, the central government is conducting analysis on more than 3 cities, up four-fold from the number analyzed in 213. New housing starts slowed markedly, falling 27.4% yoy from the 35%+ growth seen in December. We would note that weather was not a factor. We believe the slowdown reflects credit availability to developers, pricing trends, slowing demand growth and concern over excess inventory. Total property transactions in March were down 33.3% yoy, accelerating from the slowdown seen in January and February (down 11.6%). Of note, the slowdown was not specific to a geographic region or city tier. Some reports have recently surfaced, indicating that Beijing is reducing credit availability to developers and temporarily suspending loans at smaller banks. We are now seeing property developers going insolvent, such as Zhejiang Xingrun Real Estate s collapse in early March. The developer defaulted on CNY1 billion that had been drawn from China Construction Bank, a stateowned enterprise (SOE). We note that price cuts have been announced in several markets, including new residential projects in Hangzhou (southwest of Shanghai). Slowing price appreciation will likely temper investor interest in the real-estate market. Housing has been a driver of economic growth and wealth creation in China, however, this pillar is less stable than many may presume given that real-estate is being used for speculative purposes an investment/savings vehicle for the wealthy. RETAIL SALES Consumer resiliency is not evident. We have concern that the government s retail sales target for 214 (14.5% growth) could be at risk as consumer spending is coming in softer than market expectations. Retail sales were up 11.8% yoy in February (January and February data are aggregated to normalize for the Lunar New Year), well short of the consensus 13.5% estimate and December s reported 13.6%. This represents the slowest growth rate since 24. In our view, long-term viability of the economy is dependent upon a shift toward a service/consumer-based model. February s datapoint is not reassuring. Breaking apart the retail data, unfortunately, reinforces our concern regarding the outlook for the property market and the potential for a further negative feedback loop. Spending on furniture was down 8 bps yoy and spending on household appliances was down nearly 4 bps yoy. However, we believe this weakness will be partially offset by increased spending from the emerging middleclass on healthcare and non-discretionary items. CAPITAL EQUIPMENT We would caution investors from focusing too much on capital equipment data in the first quarter as a barometer of China s economy. Given the scrutiny on pollution, emissions regulations that were supposed to go into effect in July 213 have only recently been enforced. We think this could be spurring demand for equipment (a pull-forward, that is not sustainable), most notably in heavy trucks where sales were up 28% year to date (ytd) and excavators were up 26% ytd. 5

6 Given concern over credit availability to the mining, construction and broader commodity industries, we are not surprised to see these very strong sales numbers. We think firms are buying while they still can. CHINA TRADE DATA Export data surprises to the downside. Exports were down 18.1% yoy, the largest decline since the first quarter of 29, a meaningful miss compared to the consensus estimate of 7.5% growth and down sharply from January's 1.6 yoy growth. Lower value-add exports were hit hardest, with apparel trade down 37.1% yoy while high-tech was down 13.4% yoy. We note that the year-over-year comparisons are likely being skewed by over-invoicing that occurred last year and, as such, we would not be placing weight on this one data point in isolation. Having said that, the PBoC s actions in the foreign exchange markets may suggest the government is concerned about export competitiveness; depreciating the Renminbi to make China s exports more competitive globally. MONETARY POLICY & BANKING Credit availability has tightened and corporate defaults have increased. TSF (aggregated credit indicator) was down 12.3% yoy in February. The reported billion Renminbi was a meaningful miss to consensus expectations of 1,312 billion. The government continues to tighten credit availability as it attempts to tackle shadow banking. Of note, onshore (China) banks have started to tighten loans to steel, cement and other property-related sectors. Premier Li acknowledged that financial product defaults are inevitable. We concur and believe the day of reckoning is fast approaching. For perspective, shadow banking has grown from representing 11.3% of China s aggregate financing in 29 to 29.9% in 213. Non-performing loans (NPLs)at the major commercial state-owned government banks were up 13.1% yoy in the fourth quarter 213, accelerating rapidly from the 3.3% yoy growth rate seen in the fourth quarter 212. NPLs are now at levels last seen in the 28 financial crisis. Shanghai Chaori Solar Energy Science and Technology indicated in early March that it may not be able to make a payment on a CNY1billion bond issue. This marked the first meaningful default in China s onshore bond market. The second occurred on March 28 when Zuzhou Zhongsen New Board Company, a building materials co, missed a coupon payment. Provincial governments had been encouraging local banks to defer and extend credit terms to prevent defaults. An adviser to the PBoC released a statement: We need to be more accepting and allow such defaults to happen. We believe this sharp change in government strategy in allowing defaults is necessary to prevent the continued misallocation of capital and the increasing risk of a credit crisis. We expect defaults in areas that are failing to generate free cash flow, are subsidized by the local provinces and involve industries plagued by excess capacity and lack of pricing power. This includes steel, aluminum, coal and lower value-add products where China lacks a competitive advantage. In this vein, we would highlight China s Steel PMI, which hit 39.9 in February from 4.7 in January, showing further contraction. Highlighting the concern by the populous over the stability of the banking system, we note that that on March 24, 214, there was a run on Jiangsu Sheyang Rural Commercial Bank. This is the second such rush on a bank in March as depositors have become increasingly concerned over the solvency of smaller financial institutions. 6

7 THE COMMODITIES Our key investment rationale remains unchanged: Look for commodities with cost-curve support; Look for commodities where we expect demand will outstrip supply; Focus on sectors where capacity is to be shuttered (aluminum) and/or new regulations (bauxite exports from Indonesia banned) reduce supply; Demand will clearly remain a key driver to price and we would focus on those commodities that will benefit from stimulus within China; and Ultimately, focus on the bottleneck this is where pricing power and margin should be captured. COPPER Net imports (Exhibit 7) in January were up 53% yoy reaching a new high. However, we do not see this as an indication of improving fundamental demand. To the contrary, we see this as an indicator of tightening traditional credit availability with copper being used as a financing tool acting as collateral to secure credit. Increasing copper imports into China, coupled with increasing inventories and falling prices (Exhibit 2), suggest weak underlying fundamental demand. February import data was more in line with our expectations but did not sit well with investors, as volumes were down 29.2% month over month. As the second panel in Exhibit 7 shows, we believe the LME/Shanghai arbitrage spread, which moved into negative territory, contributed to the decline in imports. We see risk to pricing over the medium term, given inventory levels (Exhibit 8) and a price that rests meaningfully above the marginal cost of production. Our expectation is for a market surplus over the next couple of years as: (1) volumes that are currently tied up in the financing trade become liquid and (2) significant new capacity comes online in the period. However, we do see a shorter-term buy point due to: (1) supply disruptions, most notably, exports of unprocessed copper ore from Indonesia and (2) stimulus from China. EXHIBIT 7 EXHIBIT 8 CHINA COPPER IMPORTS DECLINE IN Q1 CHINA COPPER STOCKPILES ARE ELEVATED China Copper Imports & China Import Arbitrage China Copper Stockpiles Tonnes ('s) Arbitrage Spread (CNY/Mt) (3) (6) (9) Tonnes ('s) 1,, 8, 6, 4, 2, China Bonded Warehouse Inventory Shanghai Futures Exchange Deliverable Stocks Source: Bloomberg, Customs General Administration PRC Source: Bloomberg, Shanghai Futures Exchange 7

8 IRON ORE There is no change to our negative outlook for iron ore over the medium-to-longer term, as we expect the commodity will move toward the marginal cost of production. We see the market as oversupplied with inventory levels even higher than indicated in Exhibit 1, as volumes have moved to private warehouses. Major miners are pushing as much material as possible into the market under the logic, which we agree with, that demand growth has peaked and prices will decline. However, given the correction in price (Exhibit 9), coupled with the stimulus from the Chinese government, we believe the risk-reward is increasingly compelling in the shorter-term and would anticipate a move upward in price through mid-214. We estimate that somewhere between 15% and 4% of ore at China s ports is tied up in financing transactions, with the iron ore being used as collateral to secure lines of credit. Banking and FX Regulators in China are scrutinizing these commodity financing transactions knowing the default risk is high, as there are documented cases of cargo being used as collateral for multiple loans. With the steel makers typically using iron ore to secure financing, we see the primary risk to the iron ore price coming from the unwind of these financing trades. To the contrary, we see the situation as a positive for steel prices as the unwinding of the trade will push the steel companies into bankruptcy and thereby reduce steel production. EXHIBIT 9 EXHIBIT 1 IRON ORE TO INCREASE ON STIMULUS CHINA INVENTORIES ELEVATED Iron Ore Price ($/mt) $145 $14 $135 $13 $125 $12 $115 $11 $15 $1 4/8/213 5/8/213 6/8/213 7/8/213 Iron Ore Prices Price (LHS) 8/8/213 YoY (RHS) 9/8/213 1/8/213 11/8/213 12/8/213 1/8/214 Source: Bloomberg, The Steel Index Ltd. China Import Iron Ore Fines 62% Fe Spot per Dry Metric Tonne 2/8/214 3/8/214 6% 5% 4% 3% 2% 1% % -1% -2% -3% Y/Y Change in Price Inventories (1, Tons) 11, 1,5 1, 9,5 9, 8,5 8, 7,5 7, 6,5 Chinese Iron Ore Port Inventories Source: Bloomberg, Shanghai Steelhome Information Steelhome China Iron Ore Total Ports Inventory STEEL Hebei, China's key steel-making province, produced 5.7% less steel in the first two months of 214 yoy, and exports hit a 12-month low. With bulldozers physically dismantling the blast furnaces, we push back on those who argue that capacity is simply being idled and could therefore come back online and depress pricing. We do not believe that the producers have experienced a significant philosophical shift, rather, banks and provincial governments are finally cutting off credit. Shanghai Haixin Iron and Steel Group will likely be the first of 15-plus privately owned mills that will shutter given its RMB2 billion debt burden. Despite falling input prices (iron ore and scrap) and increasing imports, U.S. mills have successfully maintained price above that of input price trends (Exhibit 11). We see low steel inventory levels and producer discipline as key to the solid pricing outlook trend. Key drivers moving forward include increasing European Union demand as reflected by improving German manufacturing data, strength in the U.S. market from the steel-intensive auto and non- 8

9 residential construction industries, and increasing demand in China coming from government stimulus. We believe the recent increase in Chinese rebar futures (Exhibit 12) is being aided by expectations for pending infrastructure spend. EXHIBIT 11 EXHIBIT 12 U.S. STEEL PRICES HAVE REMAINED BUOYANT CHINA REBAR PRICES UP ON STIMULUS Year-over-Year Change in US Steel Price China Rebar Price Y/Y Change 15% 1% 5% % -5% CNY/Mt 3,7 3,6 3,5 3,4 3,3 3,2 3,1 Source: Bloomberg, Steel Business Briefing USA Domestic Hot Rolled Coil (FOB Midwest Mill) per Short Ton Source: Bloomberg, Shanghai Futures Exchange ALUMINUM We remain positive on aluminum in the short- to medium-term as demand improves(auto and truck being key markets) coupled with supply discipline as high-cost smelters are shuttered. Reduced availability of bauxite, a key input, is also helping to reduce supply of aluminum and further tighten the supply/demand picture. The largest Chinese aluminum producer has announced that it is in the process of reducing its capacity by approximately one-third. With China representing approximately half of global aluminum production, this is not to be taken lightly. The largest U.S. and Russian aluminum producers are also in the process of shuttering much of their high-cost global capacity. We note that the Chairman of the Brazilian Aluminum Association, Tito Martins Jr, stated that rationing of power to the (aluminum) industry is almost certain within a year. While Brazil is only the eighth largest aluminum-producing nation, we see this as indicative of the trend toward supply curtailment. Cancelled Warrants (Exhibit 14), a proxy for physical demand; shows very divergent trends for copper (down 51.2% in the first quarter) and aluminum (up 1.4%). We see this as reflective of the pending unwind of the copper financing trade coupled with an improving demand outlook for aluminum. We highlight the upward trend in aluminum starting in February (Exhibit 13), which is in contrast to the trend in copper. The spike in late March stemmed from the High Court blocking legislation requiring minimum load-out volumes from exchange warehouses thereby reducing the risk of volumes coming to market and depressing price. 9

10 EXHIBIT 13 EXHIBIT 14 ALUMINUM & COPPER PRICES DIVERGE CANCELLED WARRANTS INDICATE DEMAND Aluminum vs. Copper Price Cancelled Warrants - Aluminum & Copper $7, Copper $7, Copper $7, $6, Aluminum $6, $6, 5 Aluminum Aluminum Price ($/mt) $1, 85 $1, 83 $1, 81 $1, 79 $1, 77 $1, 75 $1, 73 $1, 71 $1, 69 $1, 67 $1, 65 $6, 3 1/2/214 2/2/214 3/2/214 4/2/214 Copper Price Aluminum Warrants (Millions) 1/2/214 2/2/214 3/2/214 4/2/214 Copper Warrants (Millions) Source: Bloomberg, London Metal Exchange Source: Bloomberg, London Metal Exchange AGRICULTURE Since the start of 214, we have been positive on agriculture markets as we expected stronger demand driven by exports, ethanol and feed (Exhibit 15). The key tenant to the thesis being the market possibly underestimating the elasticity of demand i.e. falling prices spur demand. As inventories rolled over (Exhibit 16) we anticipated this would push prices higher which indeed occurred during the first quarter (Exhibit 2). The crisis in Crimea is worth flagging as Ukraine is the third-largest exporter of corn and the sixthlargest for wheat, but would note we have yet to see any impact from the evolving situation. EXHIBIT 15 EXHIBIT 16 CORN DEMAND AIDED BY ELASTICITY CORN INVENTORIES PEAKING Corn Demand Corn: Stocks-to-Use & Ending Stocks 16, 18 14, 16 Total 12, 14 Stocks to Use 12 1, 1 8, Feed &Residual 8 6, 6 4, Exports 4 2, 2 Ethanol Ending Stocks Corn Use(Bushels - Millions) Stocks-to-Use (%) 2,5 2, 1,5 1, 5 Ending Stocks (Bushels - Millions) Source: Bloomberg, US Department of Agriculture Source: Bloomberg, US Department of Agriculture FOR MORE INFORMATION To learn more, please visit northerntrust.com or contact your Northern Trust relationship manager. 1

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