China’s Black Box, Plus Three Reasons Why Energy and Base Metals Are Strong

October 1, 2012
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The simplest way to describe China? It’s a black box, in the style of a Lehman or a Bear Stearns. On the surface, China appears profitable and prosperous. But we have very little idea of what’s going on inside, the leverage is opaque but clearly off-the-charts, and the economics fail to make sense in all kinds of ominous ways. And then, on top of that, the financial reporting sucks (with massaged data that more or less reveals what the authorities want).

We were reminded of this by the following nutty Reuters story, China slides faster into pensions black hole:

Eighty-year-old Chinese farmer Guo Shuhe receives a state pension equivalent to just $9 a month, not enough to buy a month worth of groceries, but enough it seems, to risk punching a gaping hole in government finances.

Guo, whose palms are thick and rough from a life spent hoeing fields in southwest China, is one of over 150 million people covered by a rapidly expanding rural retirement scheme which is accelerating the nation’s slide into a pension crisis

Policy makers and economists have long been worried about the financial burden of China’s expanding patchwork of pension schemes, but those concerns have recently escalated as its rural pension scheme took off in the past three years.

The funding shortage is daunting: economists say it could blow out to a whopping $10.8 trillion in the next 20 years from $2.6 trillion in 2010, towering over China’s $3 trillion onshore savings, the biggest hoard of domestic savings in the world.

Time is not on China’s side. Its fast-maturing society and economy — thanks to a one-child policy and a rapid rise in living standards — demand better pension coverage in future.

Yet China is already straining to hold things up…

Supbrime lending schemes, suicidal shadow bankers, copper collateral ponzi pyramids, deadly demographics, and now a pension time bomb… the Dragon truly has it all…

Black boxes are all too often nasty. When the lid comes open, bad things tend to come out. Those saying don’t worry, chill out, China is strong, invest in China for the long run etcetera display the same mentality as the complacent hand wavers who were buying black box financials in size, and averaging down, in the 2007-2008 period prior to leverage implosion and catastrophe.

All of those black-box-buyers got fried, some of them to career-destroying result (ahem, Bill Miller, cough cough). As Market Wizard Larry Hite once put it, “risk is a no fooling around game.”

In other far less surprising news, China’s official manufacturing number contracted for the second straight month, which hasn’t happened in a couple years… hopes of China avoiding a hard landing now seem pure fantasy.

Those hopes always were fantasy, of course, as we argued in making the case that China is the biggest malinvestment story of all time

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Even as global slowdown concerns continue to mount – China at the forefront – there is increasing evidence of capital rotation into base metals and oil and gas names. One clear example of this is Petrobras, the Brazilian oil and gas major.

There are many energy and base metals charts with this rough pattern:

  • Clean breakout circa early September
  • Multi-week consolidation and retest to breakout support
  • A “cleared for takeoff” setup on countertrend breakout

The oil and gas / base metals strength is strange on its face because 1) crude oil looks terrible and 2) the global slowdown thesis appears to be strengthening, not weakening. So why would energy and metals be looking healthy? What gives?

Here are three interlinked hypotheses (possible explanations):

1) Western central bank activities are EM negative, but resource positive. To the degree that the major currencies (dollar, euro, yen) are on a path to being debased, emerging market economies will be hit with the double whammy of slowing exports (to Western countries) and rising inflation (via higher food and energy costs), possibly forcing a tightening of monetary policy (which further fuels dollar weakness).

And yet, this same phenomenon that is EM negative is resource positive. If everything else starts looking worse, even as inflationary pressures rise with food and energy costs, resource names start looking better on a relative and absolute basis.

Keep in mind that the United States is an agrarian superpower, and that grain, oil etc. are priced in dollars. Thus, as dollars get debased (via the will of Bernanke & co), the output of oil and gas producers becomes more valuable (in nominal inflationary terms) even if the economic outlook for EM economies deteriorates.

2) Energy and metals producers as best house in a bad neighborhood. Institutional capital has a desperate need to be long… and so many areas of the market look overbought, overhyped or just plain lackluster, energy and metals are one of the few areas where relatively decent valuations can still be found, coupled with a longer term thesis that “debasement trumps all” (as Western CBs try to print their way out of this mess) and EM demand / growth eventually comes back.

3) Belief that Draghi and Bernanke will do what they say they are going to do. Not in terms of fixing U.S. unemployment, necessarily, or saving Europe from the throes of recession / austerity-induced depression… but rather in the sense of central banks pre-emptively going “all in” to such a degree that deflation does not take hold… in paper assets anyway…

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In keeping with the above, we are slowly building out the trading book with long-side energy and base metals names… one example is Century Aluminum Co. (CENX), purchased on Thursday. As of this writing, CENX is up more than 4% to start the week… to see all our positions (and our pending new setups) as broadcast and traded in real time, check out the Mercenary Live Feed.

JS (jack@mercenarytrader.com)


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