Investors expecting that trade tensions with Washington will soon prompt additional stimulus by Beijing may be disappointed. Concerns over government debt, we believe, will limit additional stimulus – unless trade tensions weaken growth dramatically.
Chinese policymakers have been moving towards a more flexible monetary policy stance in recent months, with the People’s Bank of China (PBOC) making its third reserve requirement rate (RRR) cut this year in July, reflecting fears over a slowdown in growth given continued U.S.-China trade tensions and softer economic data.
Some are speculating whether this marks the start of a period of greater stimulus, such as increased spending on infrastructure projects, which could boost commodity prices down the line. This is reflected in firmer Chinese iron ore and steel prices, even though global prices for zinc, copper and aluminium are at or close to year-to-date lows.
Property and infrastructure data have been diverging
Infrastructure and property sales are key indicators of Chinese demand for commodities, but they have painted a mixed picture in 2018.
Strong demand pushed property sales (as measured by floor area) up a robust 4.2% in the first eight months of 2018, according to the National Bureau of Statistics of China (NBS). New property construction (property construction starts as measured by floor area) increased 15.9% over the same period.
In addition, while property starts and property sales were strong this year through August, we hold some doubt as to whether the previous months of strong property starts are translating into construction levels of the same magnitude, given that we have seen a clear divergence in the trend line between properties started and properties completed. Property construction completed, as measured by floor area, declined by around 10% in the first eight months of 2018, according to NBS.
One explanation is that winter pollution controls in northern China have delayed construction and completion. Another is that developers have rushed to register projects under construction to improve the sales pipeline without necessarily initiating building works. If this is this case, property construction activity should be solid in the second half of the year.
Based on NBS data, we believe fixed asset investment for infrastructure grew only 0.7% in the first eight months of the year, and fell 5.9% in August compared with the same month a year earlier. This reflected the negative impact that tighter Chinese credit conditions in the first half of the year had on infrastructure spending. PBOC’s latest round of credit easing has yet to flow through to the sector, and the impact of the recent credit easing on real activity is unlikely to be seen until September or October at the earliest, when the high season for construction begins.
This year’s weak property completions and infrastructure data also explain why demand for later-stage commodities like copper, aluminium and zinc, while positive, has been weaker than expected. If the data recover in the second half, we could see better demand growth for these commodities, barring an escalation in trade tensions. However, we believe any rebound in infrastructure construction will be more subdued than in the last few cycles given the government’s desire to contain leverage.
Iron ore and steel better supported
Prices for zinc, copper and aluminium listed on the London Metal Exchange (LME) have fallen close to year-to-date lows due to weaker-than-expected demand and trade tensions. However, iron ore and steel prices in China have fared better.
Firmer prices for the latter reflect expectations that Beijing will engage in further fiscal stimulus, ramp up infrastructure spending and potentially loosen housing purchase restrictions if Chinese growth slows due to domestic and trade factors. In addition, market expectations are that winter pollution controls will lead to supply-side steel output cuts in Q4 2018/Q1 2019, which is helping to support pricing for higher-quality iron ore and steel.
In our view, however, steel demand is not entirely immune from an escalation in trade tensions because this would negatively affect capital expenditure decisions, which in turn would affect steel demand globally. Given that we expect a decision to stimulate to be reactionary, weaker market sentiment in the short term would likely drive down prices. In addition, fiscal stimulus may not fully offset weaker growth, although it should put a floor under any decline in commodity demand stemming from U.S.-China trade tensions.
Given the macroeconomic uncertainty, we are cautious on metals and mining issuers. We will look to opportunistically re-enter this sector on further spread widening because negative economic developments may prompt further policy easing. We prefer metals and mining issuers that have deleveraged their balance sheets. We believe spreads are not attractive enough to compensate for investing in more highly geared issuers at risk of underperforming if U.S.-China trade tensions escalate and commodity prices weaken meaningfully.
For more information on China’s property market, read our recent blog post, “China’s Property Market: Bubble or Balloon?”
Emily Au-Yeung is a credit analyst in PIMCO’s Hong Kong office.