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David Coffin

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Chinese Opera

By David Coffin
& Eric Coffin            Printer Friendly Version
April 28, 2004

You’ll hear plenty of explanations in the coming days for what’s happening in all markets, and particularly the metals, but there was really only one reason that mattered today. Early this morning, Chinese Premier Wen Jaibao made it clear in an interview before a trip to meet European leaders that Beijing plans to step on the brake, hard, to slow the Chinese economy. Interestingly, he also made it plain yet again that these measures would not include upping the value of the Yuan any time soon.

Though we obviously wish we could, we don’t make any claims to having predicted today’s market action. But we have penned our fear of more concerted dampening action by China for some time now. As we mentioned in the last Journal, China’s government made it plain earlier in the month that it would keep tightening if it could not otherwise get the irrational exuberance under control. Wen gave no indication what specific measures are to be expected. It’s safe to assume that we’ll see further increases in reserve requirements for the Chinese banking sector, which will effectively curtail its lending ability. Beijing is concerned (and it should be) that a boom and bust cycle could all but wipe out its financial sector. We have been saying for years this is a much, much weaker sector than some outside observers claim it to be. China has problems similar to those that plagued Japan. China’s crony-capitalism is official-sector “loans” to a myriad of state enterprises that are unlikely to ever be repaid. Many of China’s larger banks would probably be near bankruptcy if their books honestly dealt with these loans. Beijing has to earn its way out of this problem, and ease those loans off the asset side of these ledgers.

As soon as Wen’s interview hit the wires the selling started in London, first base metals and then precious metals getting sold hard. The heavy precious metal selling didn’t actually occur until New York opened. Clearly, American and European traders had different opinions about the follow-on effects of Chinese tightening. On the base metals side, the largest losses were reserved for nickel, which fell 10% and is mirroring the precious metal situation where the biggest former gainer is seeing the heaviest selling. Copper also took it on the chin, which is not surprising given China has been the main argument for those who, unlike us, thought that copper still had a lot of immediate upside in its price.

Clearly, today’s action included some massive program trading when downside stop-loss levels were hit, and we’re sure some fresh short selling was added to this nix. Gold’s weak comeback before New York closed sums up our expectation of near term direction, after the Aussies have their way with the hedge market on Thursday and Japan catches up Friday from its Thursday holiday close.

So where do we go from here? There’s no getting around the fact that some significant technical damage has been done today, damage that’s going to take time for the markets to recover from. Many of the stocks we follow trade mainly, or only, on Canadian exchanges where many traders also saw margin calls today due to the meltdown of Nortel Networks, far and away the most widely held stock in Canada. The industrial metals (essentially everything other than gold and silver) will have to rebuild their price bases from here, once the selling settles down. Traders will be watching daily warehouse stocks closely to see if the trend of falling inventories continues. One of the reasons nickel had such a bad day, relatively speaking, was that nickel inventories in London ticked up today, though both the increase and the absolute level of those inventories remains very low. Nickel supply will be constrained quickly enough at the current price level.

** (If you want to track base metals go to the new site that went live a few days ago. Kitco has done as great a job with the new site as they did with the gold site. It is one of the only places to find free real-time data on base metals. This is one metals recommendation we can strongly make today with no reservations. Should you be wondering, the group does have a history with base metals trading, and in fact first came to our attention during the copper-long squeeze that broke one of England’s oldest banks in1995.)**
The markets will be more keenly interested in real news from China. China’s economic stats are iffy at best, but anecdotal items that point to more tightening will now garner quick reactions by the market. One such piece of news-rumour this morning was a report that a number of individuals were fired and/or arrested when they were caught trying to sneak through loan approvals for Chinese cement and steel projects. Clearly, Beijing is serious about countering what it sees as dangerous overbuilding in some sectors. This show of intent probably just increased the selling pressure after Wen’s interview, though perversely since it sounded to us like a positive development. If China is serious about keeping the basic materials sectors from overbuilding, that’s good news in the medium term for commodities. However, the short term will be a blend of fear and greed mixed with a large dollop of volatility. Copper and steel, those construction stalwarts, are likely to continue to be under pressure. Assuming the world economy and not just China continues to strengthen, metals will find their feet again. That said, the rebuilding process would take some time since much of the recent speculative metals buying has almost purely been focused on “the China card”.

As of today, we simply don’t know the actual impact on demand China will have in the next few quarters. We assume demand will fall. By how much depends on the growth rate China feels it can comfortably handle for an extended period. Our guess is something in the 6-7% range, very high by North American standards, but not extraordinary by China’s. Add this to a new sense of unease among miners and we think the lack of new major capacity will continue to be a factor. As we have been sceptical about its gains to begin it won’t surprise that we expect copper will weaken further. The other major metals, particularly gold and silver, may be quicker to come back than many probably assume today. China has been a big story for precious metals too, but it’s a story about potential rather than actual demand. Chinese buying has not, in our opinion, been a big factor in terms of marginal demand fuelling the run up of gold and silver. As that fact sinks in the selling based on fears of a Chinese slowdown should wane. We still expect demand to increase there due to both increased jewellery demand and, partially, as a currency hedge. Many Chinese seem to have the opposite opinion to the US Congress about which way the Yuan would move when and if China ever loosens its’ peg to the greenback.

Added to concerns with the metal markets is our belief that the major markets continue to be on the razor’s edge due to the potential for interest rate increases and continued weakness in the bond market. Today was a good example, with all the indices getting hit hard even though there was a number of strong profit reports out this morning. We think it is highly significant the 10 year Treasury bill index (the TNX) is actually up over six ticks to a yield of 4.47% on a day when all the competing markets were selling off. Notwithstanding more happy talk from Greenspan today, the fear of inflation is growing. As noted in the last Journal, a more inflationary environment is one that commodities generally do well in. But the transition will be bumpy. That is equally true for the major markets. The revised Q1 GDP figure for the US is due out tomorrow. If the growth number exceeds 5% by any great amount, expect a bond market sell-off and another pummelling or at least stalling for the S&P and NASDAQ. It may seem perverse at first glance given the day commodities had, but most bond traders understand the real push for inflation comes from wages rather than from basic materials. They also suspect as we do that, given US CPI numbers are about as reliable as Nortel’s accounting, US inflation is likely already ticking up. The simple fact is that Greenspan is losing his grip on the fixed income markets. His calming words may help some, but that help will be temporary at best. If the bond markets don’t get some real comfort soon the 10-year rate looks headed for 5%. Under that scenario, the major markets may well have already put in their highs for the year. Gold and silver, on the other hand, would be consolidating for the up-leg we have been calling for in the second half of the year.


Regards for now - Eric Coffin and David Coffin


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