Is China back in the metals market?

The Baltic Dry Index, which tracks worldwide international shipping prices of various dry bulk cargoes, crashed from 4,209 in May to a low of 1,700 in July this year. This ardently watched indicator of global economic activity has since surged by 62,1%. What does the surge mean?

Interestingly enough, China’s bulk freight rate indices for metal ore and coal rose last week by 3,4% and 1,0% respectively, according to Dr Prieur du Plessis, chairman of Plexus Asset Management and author of the Investment Postcards blog. “A glance at the relationship between the manufacturing PMI for stocks of major inputs and the Baltic Dry Index suggests China’s manufacturers are again rebuilding commodity stocks as the August PMI is likely to edge towards the 50 level and beyond,” says Du Plessis.

He believes the rebuilding of stocks of major inputs is probably due to higher export orders. “The rebuilding of stocks and higher export orders are likely to boost China’s CFLP manufacturing PMI for August, to be announced this week,” says Du Plessis. “That will be right in line with what is expected from a seasonal point of view.”

“The Shanghai containerised indices are slowly drifting, though. After slavishly following the seasonal pattern of the first seven months of the previous two years, the jury is out regarding the CFLP non-manufacturing PMI for August. A significant drop will mean the non-manufacturing industry is slowing considerably and therefore indicates weakness in the coming months as it did in 2008. As the containerised freight indices are holding up in a normally weak seasonal period with the Northern hemisphere holidays, the non-manufacturing PMI is expected to again come in at an elevated level of just below 60. China’s GDP-weighted PMI (manufacturing and non-manufacturing) can therefore be expected to continue following 2009’s seasonal trend and not to fall back to the trend set in the second half of 2008.”

According to Du Plessis, the outlook for the US GDP-weighted PMI (manufacturing and non-manufacturing) has also improved with the recovery of the Baltic Dry Index. “With China’s GDP-weighted PMI for new export orders leading the GDP-weighted PMI for imports by one month, the higher Chinese PMI suggests the US’s GDP-weighted import PMIs in August and September are likely to rise after the drop in July,” says Du Plessis.

According to Du Plessis, there are several possible investment implications based on this scenario:

· Metal prices are likely to head higher in the coming weeks.
· Global equity prices could bottom out.
· Emerging-market assets are set to outperform.
· The gold price could fall back.
· US dollar to weaken against the euro and strengthen against the yen.
· Government bond yields to bottom.

The indicators could be signifying some potential short-term profits in riskier assets, such as equities and specifically resources-based emerging-market equities, and a pull-back in safe-haven investments such as bonds and gold. However, Du Plessis believes it may be too early to put too much risk back on the table.

“The economic and debt woes of especially developed nations have not been resolved and the possibility of the global economy going into a double-dip recession is still a reality,” warns Du Plessis. "Unless you have the stomach for volatility and a long-term time horizon, a degree of caution should still be exercised in these markets.”

Graph A
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Source: StockCharts.com.

Graph B
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Sources: CFLP; Li & Fung; ISM; Plexus Asset Management.