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March 14, 2014 3:14 pm
Decoupling. It is a simple word, into which much hope and fear has been distilled.
The past few days have witnessed the dramatic decoupling of copper. Long a bellwether for the global economy, it dropped almost 10 per cent in just five trading days. It is now down about 14 per cent for the year, and 35 per cent from its all-time peak set in 2011.
Such things happen. Commodity markets are volatile, moving on sudden fluctuations in supply or demand. But there were no obvious disruptions to either supply or demand last week. Meanwhile, other base metals fared poorly, but nowhere near as badly as copper.
Demand for copper comes preeminently from China, which needs the metal as part of its boom in infrastructure building. So it is not unduly surprising that the Chinese stock market fell, along with stocks in several countries that have grown far wealthier supplying China with copper, such as Chile and Peru.
What is more surprising is the effect on stock markets in the developed world. There has barely been one. The MSCI World index, the most widely followed index of developed world equities, hit an all-time high on Friday last week, surpassing a high it set in late 2007 before the credit crisis, even as the copper sell-off was under way. It has dropped 2.5 per cent this week, but sentiment remains calm.
This is quite a decoupling. Commodity prices need not necessarily have much effect on share prices. They are revenue for some companies, but expenses for others. In the very long term, share prices do better in periods when commodity prices are trending downwards.
But in recent history, equity investors have bet the house on the notion that metals in general and copper in particular are a guide for equity prices. For a prolonged period from 2005 to 2011, the MSCI World moved almost perfectly in sync with the Dow Jones-UBS industrial metals index. This pattern broke down about two years ago, and the disjunction has become most dramatic in the past week.
Driving the period of extreme correlation was a thesis known as “decoupling”. Emerging markets, led by China, had reached a stage in their growth where they could continue growing irrespective of any recession in the west. China would expand its middle class, buying raw materials from many other emerging markets to do so, and a recession in the west would not hurt.
But this version of “decoupling” was accompanied by an extreme coupling in markets. US and European companies would also be helped by booming copper prices and the growth in emerging markets. So as developed markets grew in the mid-2000s, copper, and emerging market stocks, grew even more.
The fallacy on which all this rested was revealed once the crisis hit. Emerging equities, along with commodities and currencies, all fell even more than the developed world, as investors rushed to liquidate holdings wherever they could. Copper dropped 69 per cent in barely six months. Then the rebound after the crisis was led by metals prices (copper gained 270 per cent in little over two years), and by Chinese stocks, as China embarked on a stimulus programme. The belief was that China had saved the world by spending so much.
Copper’s steep fall might be a blunt instrument to help the Chinese authorities in their attempt to restore some balance to their economy
But did they take it too far? Total Chinese credit outstanding (including government debt) is now at about 230 per cent of GDP. Saxo Bank point out that it was only 80 per cent of GDP as recently as 2002.
Many now fret about obvious signs of overcapacity – such as the copper sitting idle in Chinese warehouses – and about the risk of a Chinese credit crisis.
This week’s copper fall is intimately connected to China’s attempts to unwind its credit market. In a repeat of the dilemma that hit US authorities in 2008, China is trying to manage a series of defaults. It wants to inflict enough pain on banks to show that they must behave more prudently in future – but not so much that they lead to a crash.
Copper is used as collateral in many Chinese financial transactions. As a debt goes bad, creditors take the collateral, and sell it for what they can get, which means that its price falls. So the credit boom in China that pushed copper up in the first place is now pushing it down.
There is no need for this episode to end in the same way as the last Great Decoupling. Many emerging markets are involved in what could be a healthy rebalancing. And copper’s steep fall might be a blunt instrument to help the Chinese authorities in their attempt to restore some balance to their economy.
But the basics do not lie. It is not long since investors made a huge bet that emerging markets could pull the rest of the world through. It failed. The current bet, almost as emphatic, is that China and the complex of countries that rely on it can slow down without denting the prospects for corporate and economic growth elsewhere.
This second bet sounds barely any more promising than the first.
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