Commodity prices have eased here in June from the highs in May, especially for lumber, copper and iron ore, which were extremely stretched. China has been vocal about its commitment to sell state reserves in copper, aluminum and zinc in order to curb any speculative trading and hoarding of positions and to ease prices given the inflationary pressure evident not only in the Producer Price Index but in the Consumer Price Index as well. China cannot afford an inflation scare as the consumer will not be able to handle it, nor can an economy that is geared over 3x net debt to GDP.
China started stimulating its economy aggressively last year as the pandemic hit by boosting its infrastructure plans, which led to a massive increase in the demand for raw materials. This sudden surge in a short period of time caused prices to rally from their all-time lows, which caught the supply side by surprise.
Today, iron ore is down 20% from its highs in May and copper fell 15% from its peak.
If one were to look at China's credit impulse, we know it has been slowing a bit since the excess of last year. Demand is not falling as it is still robust; it is the rate of change that is slowing.
This negative credit impulse tends to have a negative impact on prices; it just takes time to filter down.
As China was slowing over the first half of 2021 demand in the U.S. and European Union (EU) was picking up as they emerged from their locked-down economies. Those rebounds helped prices to stay anchored as those counties embarked on their respective infrastructure spending plans.
China indicated at the start of 2021 that it didn't want steel production to exceed the record 1.05 billion tons in 2020 as it aimed to contain energy pollution. But in the first five months, steel output reached 473.1 million tons, hitting a record high of 99.45 million tons in May.
Weather and lockdowns have impacted supply, causing delays in iron ore from Brazil and Australia. There are signs of supply coming back, but we are far from reaching pre-COVID levels. Australia exported about 76.59 million tons in May, which was the second-strongest month this year behind March's 76.73 million tons. Brazil shipped 29.58 million tons in May, its best month since December's 32.01 million tons. But unless steel demand in China falls substantially, the market remains relatively tight.
Stepping away from the market fundamentals for a moment, there is a much larger debate on the macro side in the market currently. It is whether inflation is transitory or more permanent. If it is the latter, then the Fed would veer toward raising rates sooner or at least easing up on the accommodative monetary policy. This is one of the reasons why the cyclical reflation trade has eased back in June as we saw several members elude toward higher rates earlier than expected. This caught the market by surprise, together with the record short dollar and U.S. Treasury positioning, which saw a quick unwind that caused cyclicals to be hit extremity hard.
China is extremely strategic when it comes to buying and selling resources. It always buys low and sells high. It was busy buying oil back in November 2020 when Brent crude was trading below $40 a barrel. The fact that it has eased now as refineries go into maintenance only makes sense, as why pay up for Brent closer to $75 a barrel?
It is important to see what China does, not what it says it will do. But unless demand globally falls off a cliff, the demand for raw materials in a short space of time does not leave a lot of room for the supply side to be able to meet this demand. Commodity inflows have aided this sector given the inflation backdrop. End of the day, supply will catch up; it is just a matter of timing.