China and Commodities, Oil, GBP early elections talk

We agree with Li Wei, deputy director of Development Research of the State council, saying that the disconnect between finance and the real economy is the main problem for China, citing bubbles in financial and property sectors (MNI). These bubbles are domestically funded suggesting that the likelihood of a sudden investors’ strike leading to an economic shock is minor. Instead, China may be due for a long-term adjustment process revealing long term deflationary pressures. Within this long-term cycle, there will be ups and downs. Recent data have continued coming in strong and after having experienced falling producer prices over the past five years, prices have started to increase again.

Chinese producer prices may surprise given the country’s falling capacity utilisation rates suggesting a higher output gap. The increasing slack suggests domestically generated prices may fall. However, ithas been rising input costs coming on the back of the falling RMB and, even more importantly, rising commodity prices that have pushed domestic factory prices higher. What counts for China’s producer prices are the costs for industrial non-oil raw material prices such as iron ore, copper, aluminium, coking coal,etc. These prices have rallied over the past couple of months.

Interestingly, these prices have de-correlated from the performance of the USD. From 2012until the summer of this year, the USD had an important reverse impact on commodity prices. Now the USD and commodity prices tend to rise simultaneously. Even more importantly the higher USD no longer undermines US inflation expectations. Over the past couple of months US inflation expectations and the USD both moved higher. Investors seem to conclude that the US may close its output gap suggesting higher commodity prices increasing the likelihood of the Fed hiking rates. The better US rate outlook is then expected to drive the USD higher.

The previous ‘model’ saw higher commodity prices in the context of better EM demand indicating a wider US – EM growth differential leading to US capital outflows and hence USD weakness. The US potentially closing its output gap suggesting marginal US investment and hence capital demand increasing may have made the difference. Higher US capital demand combined with the US household sector seeing its savings ratio declining from 6.2% to 5.7% over the course of this year suggests higher US yields unless USD supportive capital inflows compensate for the change within the domestic US capital – demand balance.

Oil prices have come under renewed pressure as investors worry that OPEC’s production limitation agreement may not hold. Indeed, Saudi Arabia could raise oil output again. Adding to the potential oil glut has been US oil rig count increasing from 316 in May to 450 suggesting US oil production (currently 8522 mln bpd, peak: 9644mln bpd In June 2015) rising again. Oil no longer trades in line with other commodity prices which may have some important ramifications for oil currencies. The deterioration of the relative oil price outlook does not bode well for traditional producers which explains our bearish NOK, CAD and COP projection.

In the UK, newspapers speculate Theresa May may call a spring election should the Supreme Court confirm the High Court’s verdict giving the Parliament a bigger say within the Brexit negotiations. Our economists also noted that the probability of early elections have increased. Should the government aim for new elections it could signal a tougher negotiation stance, diminishing chances of a ‘soft Brexit’.For now we remain long GBPJPY.