Inflation is the buzz word that is currently echoed around all trading floors. One can hardly blame those getting worried, given the most recent year-on-year print of more than 6%.
This is no longer just the transient or "passing by" phenomenon the Fed has continued to claim all of this year. It is very real and very much alive. There are some parts that may ease from their extended levels, but all in all, there is an underlying shift higher in secular inflation.
After the near $5 trillion plus in fiscal and monetary policy boost in just one year, this should hardly come as surprising news. We all know central banks keep uttering what needs to be said to keep the markets in check and traders to "buy the dip."
Look at commodities. This is one asset class that often benefits from inflation, especially as the price of physical goods and hard assets rise. But it would be naïve to think of all commodities in the same way. After all, a commodity first and foremost depends solely on its inventory balance, the difference between actual demand and actual supply at any given time. It is a constantly evolving function of those two parameters and one must not mistake looking at past trends to predict the future, as we know how demand-supply economics work, one usually plays catch up to the other when there is a price discrepancy. The only question is over what period of time. It is all just a timing game. Most confuse cyclical strength from secular strength and therein lies the problem. Oil prices are a great example of that phenomenon.
Let's look at iron ore in particular.
China buys 70% of in the iron ore global seaborn volumes, and produces about half of the world's steel. Iron-ore prices have been on a one-way path since May, falling 62% since its high of $235 per ton back in May to now trading closer to $90 a ton. It is one of the main components in steel making. With China cutting back on its steel production limits, it directly impacts iron ore's price. The country has ordered that 2021 production must be no more than 2020's record 1.06 billion tons. Steel output for the first 10 months of the year came to 877 million tons, down 0.7% on the same period last year. China wants to make sure that its energy usage goals and desire to limit pollution in Beijing ahead of the Winter Olympics are met. Chinese steel demand from the building sector has also fallen as new construction starts by floor area have dropped 7.7% year-on-year in the first 10 months of 2021.
With China cutting back on its steel production limits, it directly impacts iron ore's price.
Given the post-COVID excess stimulus, China's main focus is to curtail price rises in some key areas to avoid inflation, especially when it comes to energy and resources exposed to the domestic consumer. This deleveraging has been seen in the slowdown of its credit impulse since late last year. But in the case of iron ore, the supply side has also played catch up with the rising prices earlier in the year as Australian and Brazilian export disruptions ended. Commodities may look "tight" in a certain period of time, but it is important to evaluate how much is real secular demand and how much is just the lack of supply in a short period of time.
For now, Beijing is focused on slowing down boosting investments in construction and infrastructure, this hits not only iron ore, steel, but copper, too. Iron ore stockpiles have climbed to 147.6 million tons now, these are well above the pre-winter peaks of the past two years. If China does not want it, and there is too much of it, there is only one way for its price to go. A commodity can be "cheap" for as long as there is just too much of it around. There is no "floor value" support as an equity, one either needs it or not but there is some long run marginal cost of production.
Cheap can always get cheaper. For now, the bigger question is how does China's GDP growth and investment spending look going into first quarter of next year, for that will determine the path for commodities exposed to its economy. Until then, it is best to focus on commodities that have very tight physical market balances and actual fundamental support.
