Monday, February 9, 2009

China and the Baltic Dry Index - What's Really Going On?

I'd like to write a comprehensive entry about the recent love for all things China and commodities in the past few days. (warning if you are not interested in China, global growth, commodities, or dry bulk shipping please move along to the next post, pass Go, and collect $200 now) Before I begin let me throw a few disclaimers out there: (a) I could be wrong (b) it doesn't matter what I think, as long as enough people "believe" anything can happen to stock prices in the short run - perception is reality on Wall Street and (c) ironically, I am arguing against myself.

Let me delve into (c) a bit ... unlike most of the punditry who take a very narcissistic view of "USA! USA! USA!" I was never on the bandwagon of "first in, first out" i.e. "the United States got into this mess first, so therefore it will emerge first". In fact I touted that as Kool Aid for all of 2008 as people told us this is why we must by stocks - the U.S. would lead the world in recovery because... well, it's the U.S. I outlined in [Dec 15, 2008: The "Recovery"] why we have a long road ahead, but simply put let's split the world's countries into two. Those (a) facing recession and those (b) facing recession and financial emergency. Which group would you bet on would have an easier time coming out of this? A simple common sense answer would be group (a) - they only have 1 thing to deal with, rather than 2. But the view commonly thrown out is - as a special country who apparently exists in a parallel universe - we'll rebound first. The most common reason is the massive government interference. But isn't the better question to ask... how dire indeed are things if we need such excessive "help" from government? I would assume it must be terribly bad (it is).

I've theorized that Asia will indeed rebound first... so this post might sound like I am arguing with myself. But only partly. I do think Asia will rebound first.... but not yet. In fact I still think Asia is on a downward slope - even the magical place we call China. But Wall Street, in all it's need to find "something, anything" to play has seized on a rebound in the Baltic Dry Index, and nascent rebounds in copper and the CRB (a general commodity index). That, along with a Purchasing Manager report out of China (said report is in its infancy) that showed a slight uptick is enough to cause the bulls to roar: "we're baaaaaaack!" I think this is premature. So while agreeing with the general thesis, the timing is all off. These are the same folks who ignore all the evidence on the ground (both in U.S. and China) [Feb 4: China is Getting Bad] [Jan 26: NYT - College Educated Chinese Feel Job Pinch] [Jan 13: AP - China Trade Slump Worsens; Exports Fall - So Do Imports] [Jan 8: NYT - As Trade Slows, China Rethinks Its Growth Strategy] [Dec 7, 2008: NYT - China's Economy, In Need of Jump Start, Waits for Citizens to Loosen Fists] to grasp to any one or two indicators that fit THEIR thesis, and run up stocks.... i.e. they fit the round peg to square hole to provide justification - rather than facing reality. That's my view but going back to point (a) I could be wrong, and point (b) it doesn't matter if I am correct if the herd believes otherwise. The herd moves stock prices...

But let's look at a bevy of data posts shall we?

The bulls have as evidence the fact that the Shanghai stock market is up strongly in 2009. We can see this via Morgan Stanley A Share Fund (CAF)

Bulls also point to the rally last week in iShares Xinhau China 25 (FXI)

Not to be a conspiracy theorist but the Shanghai exchange is a closed (to any outsider) exchange which restricts shorting. It is hard to call this a reliable indicator - especially since (if you want to go the full conspiracy route) it could be easily ummm... "supported" by the central government. In fact citizens of China were asking the government to do just this thing last year (buy stocks! prop em up!). So I have a hard time "taking this as a sign that things are on the upswing in China". As for FXI - you have traders jumping in on "thesis" the past 4 days... it should look familiar - see early January; they were buying on the same theory just a month ago. In fact the index was higher. Oh yeh - December as well. Why? Same theory. So if we want to take the ful monty of "stock prices are all knowing about the future!" am I to take it there was a stronger China recovery 4 weeks ago then the one we see now? But it then fell off a cliff during mid to late January? But suddenly restarted 4 days ago? (ahem)

Or am I to take it this is just idle speculation by HAL9000 and his hedge fund momo computers; and their human counterparts jumping in where the "trading is good!". I'll let you decide. (disclosure: let me say I do think the China stimulus will be more effective than the American version shall be; all things being equal)

There is also a nascent recovery in copper (a metal who is considered the best 'economist' of all) which at least is an open, global market.... and the much ballyhooed Baltic Dry Index. Oh lordy, an index that traded in the 3000 to 5000 range during "normal" times in 2005-2006 (don't even ask where it was in 2007 and early 2008) has now rallied from 700s to 1500 ... and this is the signs of a "China recovery" or global "growth" recovering? Hence a reason to jump back into all commodities?

I wonder why oil was completely dead last week if global growth is back... ah maybe this is next week's speculation - you know, quant fund computers push up the easy stuff this week and then momo players put two and two together. Hey we forget oil - let's push that one up too!

But let's not skip the Baltic Dry Index - I assume $BDI will never reach zero. That would be a "small" issue for global growth; and almost every bull market bubble that implodes overreaches to the downside. Once more, as I wrote last week - we could DOUBLE from here (1500 to 3000) and still be at the LOW end of where this index traded during "normal" economic trade years (2005-2006) pre China Olympic commodity build up.

Let's look into this one a bit deeper, starting with an article and blog entry from Lloyd's List

Dry Bulk Freight Surge "Could Be Shortlived"
  • THE surge in dry bulk freight driven by a jump in Chinese iron ore imports could be shortlived warns a report Macquarie Research. The Baltic Dry Index jumped 14% yesterday, pushed up by renewed demand for capesize vessels. The cost of shipping iron ore from Brazil to China has risen from a low $6.80 per tonne in mid-December to $21.60 per tonne.
  • What it reflects is a more general recovery in Chinese steel production from the lows of June-October 2008 following an end to steel destocking and a flurry of trader-buying of steel,” said a report by Macquarie. “In addition, temporary iron ore shortages appeared to develop at the end of 2008, following a collapse in domestic iron ore production and a reduction in port stocks.”
  • This has resulted in restocking by Chinese steel mills, with 55 vessels now reported to be outside China ports waiting to unload cargoes.
  • The recovery could prove to be a shortlived one, as there is no evidence of an increase in demand for steel in China. A major downturn in iron ore imports continues in Japan and Europe as hefty steel production cuts are implemented.
  • “There is also a risk that Chinese iron ore stocks will start rising, which could reduce short-term demand for ships, and this may soon cap the mini-rally in freight,” the report said.
So the inference is this is a restocking event after China effectively went on strike post Olympics. Remember, 40%+ of China's economy is exports... and their export markets are in free fall. Hence the bull argument is that domestic needs will not only stabilize their economy but also make up for the destruction of exports. So nascent recovery? Or restocking event?

Blog entry on Lloyd's List
  • NEWS that the Baltic Dry Index enjoyed its biggest rise in 24 years with a hefty 14% rise on Thursday has brought much cheer to beleaguered dry bulk shipping stocks. However the upturn needs to be kept in context. This pushed the BDI to just under 1,500 points, a level which if forecast a year ago would have been low enough to turn the average shipowner white.
  • In effect what has been seen over the last week is a very welcome bounce in freight rates driven largely by a pick-up in Chinese iron ore imports that crumbled dramatically in the last quarter of 2008. Chinese steel traders and mills are now restocking, which has boosted shipping demand. Looking though at the longer term demand trend, major Chinese steel mills are still cutting production 20% to 30% and the figures for the industry in Europe and Japan are even greater.
  • Such figures do not point to a sustained recovery rather a short term spike in demand, with shipping volumes trailing off again once stockpiles are replenished.
I am not an expert in shipping; but Lloyd's has been around "a while" (1700s) so I'll lean on those who live and breath the industry. Rather than live and breath Kool Aid.

Reuters weighs in....
  • "The question is whether this is long-term," said a shipping broker. "There is no push from anywhere else, other than China." BHP Billiton Plc, the world's biggest miner, said earlier this week a build-up of iron ore stockpiles in China, which had prompted suppliers to defer millions of tonnes in shipments last year, was ending. This was pushing up spot prices. Brokers said it was too soon to say whether the rise in the index, a leading indicator of economic vitality, reflected the start of a recovery in the world economy. They said the shipping market was volatile.
  • One trader said the market improvement was enough to allow shipping companies to avoid going out of business, but was still modest. "It's not necessarily a good indicator of the health of the world economy, it's a great indicator of what demand for bulk commodities there is from importers, basically China," the trader added.
  • A shipping broker said it was conceivable that once the Chinese ore imports faded again, the index would drop again.
  • Apart from iron ore demand, China, the world's top consumer of wheat, has been buying grain from the United States and Australia as well as other sources in recent months. The country has declared an emergency over a drought that could threaten its wheat crop. There has been a marked increase this week in freight rates especially for panamaxes, mid-size vessels that are often used for grain, notably on the trans-Pacific route that carries grain from Latin America to China and the rest of Asia.
So this gives a good overview of what is driving the index. No one - but China. And China appears to be (a) restocking iron ore after a buyer's strike and (b) purchasing wheat due to drought conditions. Is that a thesis for the nascent stages of a China driven global recovery? Not in my book. But for the short term, all that matter's is the herd's book. Fit square peg into round hole.

Now let's look at China more specifically. Another key "selling point" for said thesis of "recovery" is a Purchasing Manager's report in China. You know my take on government reports - whether they be U.S. or otherwise. How anyone could accurately measure such huge economies on 30 day basis is beyond me; but since traders take these reports as gospel you have to acknowledge them even if you scoff at them. All the anecdotal evidence suggests China is in a serious slowdown but since a government report says some uptick, forget all the evidence. Not very different than the way traders treat U.S. reports.

Let's look at how fantastic these Chinese government reports (that are moving trillions of dollars of net worth in world markets) are. AP: China's Official Figures Obscure Sharp Declines
  • Plunging exports. Factory closures. More than 20 million people thrown out of work. Official data showing that China's economy is cooling but still growing strongly obscure what economists say is a sharp recent decline that has inflicted obvious pain. What is happening matters far beyond China. Whether the third-largest economy is stalling or still growing could affect how quickly the world recovers. A stagnant China would mean less demand for industrial materials and consumer goods from the United States and others.
  • The difference lies in the way growth is measured. Beijing uses a method that compares growth in one quarter with a full year earlier and says its economy expanded by a healthy 6.8 percent in the final quarter of 2008. But experts say that compared to the previous three months — the system used by most other major countries — China's growth fell to as low as 1 percent or possibly zero. "The recent weakness is much worse than the long-term trend," said JP Morgan economist Frank F.X. Gong. Merrill Lynch economist Ting Lu said fourth-quarter growth from the previous three months was "close to zero." The gap in measurement is well known to private sector economists, who try to estimate China's quarter-on-quarter growth based on skimpy government data. "China's statistics system is really in a mess," said Merrill's Lu. "It's extremely difficult and close to impossible to calculate the quarter-on-quarter growth rate in China."
  • The pain is evident on factory floors and in empty restaurants and shops. Sales at the Laiwu Sheng Yuan Building Materials Co. have plunged 50 percent from a year earlier, said general manager Wang Jian. He said construction companies are in such bad shape he is reluctant to fill orders. At Kamboat Chinese Cuisine, a Shanghai restaurant, business was so lackluster for last month's Lunar New Year, usually a busy period, that some waiters were told to start vacation before the holiday, said executive chef Chen Zhenjiang. He said that was despite cutting prices so low they wiped out the restaurant's profit.
  • Other Asian economies such as Japan and South Korea are contracting, which would make Chinese growth of even 1 percent encouraging. (encouraging? perhaps - but certainly no panacea!)
  • A key indicator of manufacturing improved in January, suggesting the slump might be reaching its bottom. But the purchasing managers index of the China Federation of Logistics and Purchasing said manufacturing still contracted. "Despite the sunny headline figure, we believe it signals not a recovery, but rather continued weakness," Standard Chartered economist Stephen Green said in a report. "Less bad news is not the same as good news." (not in stock market world, where less bad news = recovery "in 4-6 months"!)
  • Exporters and China's trade-driven southeast coast have been hit hardest but weakness has spread to other regions and industries such as real estate and auto sales.
What do private economist believe is happening?
  • Fourth-quarter growth compared with the previous three months fell to 1 percent at an annual pace, down from 4 percent the previous quarter, according to Green. "We sharply decelerated in November and December," he said. "There are no clear signals we have accelerated."
  • JP Morgan gave an estimate of 1.5 percent quarter-on-quarter annualized growth. But its figures also highlight a sharp decline: That rate is just one-tenth of the 15 percent quarter-on-quarter growth the bank says China achieved in early 2007.
I hate when facts get in the way of a good thesis.

So let's end with a blog entry (I will only highlight a few items; it's a long in depth piece) from Professor Michael Pettis who actually is on the ground in China. Unfortunately everything he says stands in stark contrast to the "thesis mongers". The title is aptly named "Hooray! China has Bottomed Out"
  • Have we reached a bottom? A lot of analysts are pointing to the improvement in both measures of Chinese PMI to suggest that Chinese manufacturing may finally have reached a bottom, even though both PMI measures are still well below 50 and so indicate a contraction in manufacturing. More impressively the stock market has rebounded...
  • I have three very serious problems with the optimism associated with the latest numbers on credit expansion. (see his blog if you want the full scoop)
  • Basically Chinese corporate profitability in China is dropping sharply, and nearly everyone expects the trend to continue over the rest of 2009. If nearly two-thirds of investment in China was funded by retained earnings, a sharp drop in profitability should result in an equally sharp drop in investment funded by retained earnings.
  • Aside from doubting the beneficial impact of credit expansion a larger part of the reason for my continued skepticism is that I am much more impressed by the expectations of hordes of workers returning to work after the Spring Festival and not finding jobs.
  • Any attempt to understand China’s economy without situating it firmly within the global context, and especially within the contraction in global demand (remember as a major trade-surplus country China needs foreign demand to absorb its huge overcapacity) will not get the picture right.
So there you have it. Now in full disclosure - I have an opinion and a thesis (China/Asia will lead the eventual recovery but we are nowhere close to that time) and I could be biased and picking news items to support my case. But I try to have an open mind and read everything - including stories that disagree with my thesis. The problem on the China angle is I find very few stories that disagree; the main variant view comes from shouting heads on financial TV. The only true "bullish" potentially long lived evidence I can find is the decent uptick in copper (from extreme depths mind you). Since I trust copper more than pundits or shipping rates that are 50% depressed below "normal times", I'll keep an eye there.

This puts us in a tough position as investors.... we can (a) drink the Kool Aid to try to capture short term investing gains as the herd rushes in on (what I believe to be) false premise; knowing it most likely will end very badly or (b) shake our head from afar at the behavior of mobs, but miss out on some potentially lucrative short term gains.... i.e. intellectually correct but poorer for it?

There is never an easy answer to that question - as it's been a dilemna we've been facing many times over the past year and a half as we watch "thesis" smack "reality" for short periods, many a time.

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