China – driving the global commodity trade

China is one of the big macro concerns at present. Not because we think there is going to be an all-out implosion of the Chinese economy, the consensus is still that we see growth close out the year at the Government’s set target of ‘around 6.5%’.

Data chart
Source: Bloomberg

However, we are cognisant that financial conditions are purposely being tightened, with a strong bid to promote deleveraging in various markets. This is having an effect on markets like the CSI 300 and certain commodity markets.

We need to get our head around the psyche of the Chinese trader to fully understand why the CSI 300 and certain commodities (such as iron ore and steel futures) have found such strong selling pressure of late. China’s financial markets do not reflect fundamentals, nor do they reflect earnings growth. However, they absolutely reflect traders, investors’ portfolio allocation and the subsequent capital flows. Chinese traders will simply move funds from one asset class to another, in-line with the policy settings from authorities.

So when the government puts restrictions on leverage in the equity market, which is occurring now with a clear focus on deleveraging, we tend to see the CSI 300 under pressure. If we see authorities take measures to cool the property market, we often see money flow into equities and the commodity market and to an extent Bitcoin.

The current deleveraging cycle at present is having a clear negative effect on Chinese assets and is being driven by a more coordinated response from the regulator, central bank and government. On one hand the government is tightening up broadly on the use of leverage in financial products, although the top priority remains maintaining growth at ‘around 6.5%’. Interestingly, we have seen growth in banks wealth management products (WMP) slow to an annualised pace of 19% (from 35%), with the PboC also including these products in their macro-prudential assessment around risks in the banking sector.

We have also seen the cost to borrow funds from the central bank for a short- and medium-duration being raised twice this year and while the authorities have been quick to state this is not tightening of monetary policy, it’s having an effect on liquidity and most importantly tighter financial conditions. We have seen a strong reaction in from Chinese corporates pull back from issuing debt, with 154 bond issuances pulled in April due to a deterioration in market conditions. This is up from 94 in March and 32 in February (Source: FT).

The Ministry of Finance has been active in clamping down on the activities of local government and prohibiting them using certain financing vehicles. Of course the concern here is the money would have made its way into various financial markets and there have been calculations this new enforcement could affect up to RMB4 trillion in fiscal financing through 2017 (source: UBS). There is a view that this tighter financing could lead to lower investment in property and infrastructure in the medium-term.

Potential trades

Perhaps the best two markets to visualise these mentioned concerns are iron ore futures, and the CSI 300. Hone into the daily chart of iron ore and you can see the recent break of the longer-term uptrend, with price consolidating below this trend. A break of the 4 May low would suggest adding to short positions here as Chinese traders love trend and momentum trading and I would look for a move into 380. On the other side of this trade I would look to increase bullish exposure on a move through 493, adding on a closing break above 537.

One suspects upside in iron ore would come from a view that perhaps the deleveraging and liquidity concerns are overdone.

I would also focus on the CSI 300 index, which is effectively the top 300 Chinese mainland companies. After a strong sell-off, defined by the five-day exponential moving average (EMA), we can see buying coming back into the index. Being long is an aggressive trade and I would be placing a hard stop loss below 3288. However, the preference is to let the five day EMA guide, and for that selling rallies into 3340 (just above the average) seems the better trade here.

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