Copper points to EM rebound

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Led by currency crises in Turkey and Argentina, not to mention US dollar strength, the MSCI emerging markets index has lost nearly 7 per cent of its value between the first of June and the end of August. Since summer has drawn to a close, however, we’ve seen the index pare back most of the damage and more or less stabilise. Whether today’s lull means an imminent rebound remains to be seen, but according to Nafez Zouk of Oxford Economics, copper prices indicate as much.

Since mid-September, prices have climbed over 5 per cent — a sizeable reversal considering the 14 per cent fall from levels reached in June:

What happens to the price of copper matters to emerging markets, because the two are tightly linked. In fact, the 52-week correlation between copper prices and emerging market stocks, as measured by the MSCI index, has risen over the past 12 months, reaching a six-year high in August. Emerging economies dominate the list of the world’s largest copper producers, so this relationship should come as no surprise. Chile, Peru and China lead the pack, alongside Congo, Zambia, Mexico and Indonesia.

According to Zouk, what will determine if copper rallies and emerging markets find a bottom boils down to China:

A recovery in China’s imports of copper ores and concentrates, which have had a lead on copper prices [see below chart] is a clear positive. The ongoing strength in China’s real estate activity is yet another favourable impulse, where acceleration in house-price growth is supportive of metals prices, and, consequently, EM terms of trade.

Here’s his chart showing the linkage between Chinese stimulus since 2004 (as indicated by higher copper imports) and commodity prices more broadly:

Fortunately for emerging markets, there’s good reason to believe Chinese stimulus will pick up further. In response to the ongoing trade war, Chinese officials have largely bucked a two-year campaign to rein in excessive debt. New rules forcing banks to recognise non-performing loans and efforts to crackdown on local government lending have since given way to lower reserve requirement ratios for banks, tax cuts and billions in cash injections from the People’s Bank of China.

For both Barclays and J.P. Morgan Securities, these measures, plus the streamlined approval process for forthcoming infrastructure projects, should more than make up for the economic drag produced by the tariff tit-for-tat between the US and China. In its most recent Global Outlook report, published Monday, Barclays affirms its 6.7 per cent growth forecast for China in 2018, and its 6.5 per cent rate for 2019. J.P. Morgan predicts a similar range. Next year the firm thinks that Chinese growth will fall just 0.1 percentage point to 6.1 per cent, as the government’s fiscal and monetary stimuli compensate for the estimated 1 percentage point decline in real GDP growth, should the full tariffs come into effect.

But beyond this tenth of a percentage point change, J.P. Morgan’s John Normand warns that there could be broader implications if China’s growth falters:

.?.?.?the composition of Chinese growth, the balance between Chinese monetary and fiscal stimulus and the relative valuation of asset classes will matter for subsequent market reactions. Looser Chinese monetary policy ensures that the US dollar will become an ever higher yielder versus the renminbi for the rest of the cycle, such that a cyclical negative from rate differentials aggravates a structural negative from China’s ongoing loss of a current account surplus.

If J.P. Morgan’s fears are realised and the renminbi weakens further from here, copper’s recent rebound could quickly unravel. As Zouk shows in the below chart, copper prices correspond closely with the renminbi’s fluctuations:

Many China watchers are calling for Rmb7 per US dollar by the end of the year — just a small leg down from its current level.

Enjoy copper’s rebound while you can.

Related Links:
The EM rout is not made in America – FT Alphaville
Checking up on Dr Copper
– FT Alphaville
China’s currency will not replace the US dollar
– FT Alphaville

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