The shortest commodity supercycle ever?

Has anybody else noticed how nobody is talking about a "commodity supercycle" anymore? There is a good reason for this. A commodity supercrash has begun instead.

According to bulls over the past six months, an endless delight of commodity super prices was ahead. Everything from oil to iron ore would stay higher for longer because there was so little of it.

According to the thesis, futures were irrelevant, demand infinite, and China obsolete as developed economy stimulus took centre-stage.

If you'll pardon me for saying yet again, the only commodity this had any relationship with was manure.

Oil and iron ore

Suddenly, and as if out of the blue, China is slowing. Commodity demand is falling away. And futures are pulverising spot prices lower in everything from oil to iron ore.

The one thing about commodities that bulls did get right is that, although financialised, prices still hold a relationship to underlying fundamentals. As opposed to, say, asset prices like stocks or houses.

And, as the COVID stimulus cycle turns, these 'hard assets' are now increasing in abundance, and prices are getting flogged. I could point to many commodities to make the point but let's stick to two of the biggest, oil and iron ore.

Oil is now in abundance. From this month, OPEC will lift output 400mb/d ad infinitum after its recent deal with higher baselines for all and sundry. Iran is set to return nearly 2mb/d sometime soon as it gets a deal with the Biden administration or pushes forward anyway. US shale is ramping rigs more slowly this cycle, but production efficiency gains mean it is bouncing back anyway and will add another 1mb/d over the next year at oil prices above $50.

All of this oil will land on a global economy that is slowing. In particular, the Chinese recovery is fading fast. The US recovery is next as it sails off the fiscal cliff. The European reopening will provide some offset, slowly increasing travel but not enough to prevent the end of the global COVID inventory cycle.

The post-COVID oil rally will need to deflate from $70 to $50 to cap US shale, or the price will have to crash much lower instead!

The post-COVID iron ore rally has run into a triptych of factors that are crashing the price as we speak.

China is crunching the market via its steel output cuts. This is nicely timed because Chinese demand is tanking as the "pig in the python" that has dominated Chinese construction for 12 months has been pooped out. Supply is also rebounding strongly with a huge pipeline of more ahead despite miners pretending otherwise.

The same applies to many base metals, including copper. Softs are all over the place but will probably fall as well.

There are three reasons to think that the entire commodities space will worsen before it gets better: macro, micro and China.

Macro

On the macro, we are entering a classic global deflationary bust driven by China and exacerbated by the US.

It's passe these days to cite the Chinese credit impulse (even though the sell-side bulls dismissed it again), so I won't bother. What I will say is that slowing Chinese credit is doing what it always does, dragging the credit-heavy Chinese economic aircraft down faster than bulls expected.

This has begun to turn Chinese authorities towards further stimulus but only very slowly. They are still very focused on reform and crushing commodity prices first.

Turning them away from these priorities is a process of creeping panic that takes time. Real stimulus, the kind that is needed to lift the credit-heavy Chinese aircraft genuinely higher again, is still a 2022 story.

The one hope of earlier is the Delta outbreak, which gives policymakers cover to backflip.

Meanwhile, the US central bank has been spooked by catch-up inflation. It is moving towards a taper announcement at Jackson Hole later this month. This will lift the US dollar.

Yet, as China slows, the Chinese central bank will be forced to cut the cash rate, and the yuan will fall.

This establishes the worst-case macro scenario for emerging markets and commodities. A stronger US dollar draws capital back into the US and away from emerging markets. Their interest rates rise and choke off growth already pressured by Delta. A weak yuan at the same time threatens emerging market competitiveness. And emerging market external accounts come under strain.

Both circumstances hammer commodities fundamentally and financially. And as they fall, the inflation arguments and desire to hold hard assets collapses as well.

China

Moreover, the idiosyncrasies of this commodity cycle are also bearish.

Each reform cycle in China – there have been three in 2012, 2015, 2019 – has left a legacy of increased market participation in capital allocation. It's probably not the case that this process has advanced to the point where Beijing has lost control of credit allocation. But it has put some serious structural roadblocks in the path of the type of cyclical stimulus that was possible in the past when the government just ordered the banks to lend.

For instance, the 2015 reform period shifted a great deal of local government borrowing from bank balance sheets to bond markets. This made a lot of sense if efficiency and productivity are your goals. It added market rigour to the allocation of credit, rather than relying on crony capital banks. Such reform will diminish misallocation and graft.

But, potentially, it also stands in the way of stimulus for infrastructure given so much of it is directed via local government borrowing. If those markets are spooked, then spreads will blow out.

This brings me to the greatest reform of the 2019 period: the Three Red Lines. This policy aimed to deleverage China's greatest corrupt capital misallocater – the property development sector – which is now capped by various hard debt ratios. Three Red Lines is in full swing and so intensely applied that towering household brands are shuddering from the ground up.

Evergrande was once China's greatest property developer. It is now an unbelievably over-leveraged tottering edifice with fewer and fewer friends and a near-impossible equity value below 10% of its debt load. This $300bn debt monster is potentially China's Lehmann Brothers, trading in subterranean junk debt to Chinese (and global) counterparties (which may include Bitcoin via Tether) at spreads that imply insolvency. There is no realistic scenario for restructuring Evergrande in which market dislocation is avoided. It is only about how much pain the Chinese government can bear.

And there is a conga-line of Evergrandes queuing up in the property sector.

Finally, these two sectors – local governments and property development – are intimately linked. The former relies upon the latter for a material portion of its revenue via land sales and graft. This year, land volumes and prices are down heavily as developers liquidate land banks to meet the Three Red Lines. Also down hard is local government borrowing. The two may be much more closely linked than it even appears, with stress is one pouring contagion into the other.

So, for Beijing to reverse course and stimulate, it must now roll over the top of its most prominent reform success stories. It can certainly be done. But the psychological bar is commensurately higher than past cycles, given there's a loss of face in such backflips. Which means more delays to stimulus.

Between them, Chinese property development and infrastructure comprise nearly 70% of Chinese steel demand, not to mention vast quantities of base metals.

Micro

Finally, today's supposed commodity supercycle is very different to that which came before for a very important technical reason. During the genuine Millennial China supercycle, global cost curves for new mines lifted over years. This new and more expensive production was eventually shaken out as the Chinese supercycle ended from 2012-2015. The expensive production had to be displaced via bankruptcy all the way down the cost curve. This took years as producers fought for survival and lowered costs.

The recent COVID-inspired price spike was based on a temporary demand spike that was delivered around stimulus and COVID-limitations to supply. Both are now steadily disappearing (at different paces for different commodities).

As demand/supply balances normalise, prices will fall back to the marginal cost of production in all commodity markets. Unlike the last price shakeout, there is no high or mid-priced production to shake out. Prices will therefore crash back to marginal costs far below today's prices.

This process is now underway in iron ore and oil, but it also applies to many other commodities.

Conclusion

At a certain point, the commodity crash that is underway will probably deliver a deflationary shock of sufficient magnitude to force the Fed back from taper and China towards more hard asset stimulus. When this happens will depend upon how quickly falling commodity prices bleed contagion into junk debt, emerging markets, and, ultimately, developed economy equities via a growth scare.

That will end the rout and herald another round of commodity inflation, depending upon how aggressive policymakers are. COVID may play a positive role in bringing this date forward.

But ahead is a very different business cycle to the last several.

As commodity bulls have supposed, it will be led by the locomotive of developed market fiscal stimulus, especially in the US. But this will NOT be commodity-intensive and will deliver a US dollar bull market.

Meanwhile, China's reform questions will intensify. China's commodity-intensive growth falls away, turning it into the caboose of global growth and posing constant challenges to emerging market competitiveness via a falling yuan.

This is certainly not the stuff of commodity supercycles or bull markets.

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