The US dollar has rallied hard against currencies of commodity producers (e.g. Canada, Australia, New Zealand, Brazil) since mid-July. Fed Chair Janet Yellen’s semi-annual testimony to the US Congress on 15 July 2015 was one trigger for the rally as markets interpreted her testimony as signaling that a rate hike in September remains on the cards. Chair Yellen maintained the hawkish tone from her previous speeches and again observed that the Federal Open Market Committee (FOMC) believes an increase in the federal funds rate is appropriate if the US economy continues to progress as the FOMC expects.
Exhibit 1: Appreciation/ depreciation of currencies versus the US dollar (between 02/01/15 and 27/07/15)
Source: Bloomberg, as of 27/07/2015
Events in China put pressure on the commodity complex
The recent rout in Chinese stocks has dealt a heavy blow to the commodity complex (commodity markets, currencies and equities). Events in China’s stock markets raise the level of uncertainty about the extent of the slowdown in an economy whose workings are sometimes difficult to fathom. Weaker demand from China is however unequivocally bad news for commodity producing countries. This was reflected in the fact that the Australian and New Zealand dollars all hit six-year lows against the US dollar in the week beginning 24 July 2015 (the Canadian dollar is trading at a level last seen in 2004, while the the Brazilian real fell to a 12-year low against the dollar).
In recent years, motivated by the desire to avoid the “middle income trap”, China has been seeking to break its dependence on export-led (based on tradables like industry and construction) growth and shift to domestic demand-led (based on services) growth. This necessarily entails a resetting of Chinese demand for the commodity complex which has ridden on the coat tails of Chinese growth. As recent events in currency markets have shown the countries and industries that rely on China’s growth are vulnerable to this change.
It is very clear that the performance of commodities and commodity-linked assets (currencies, equities) that are well correlated with China’s business cycle (China being according to World Bank data the world’s largest consumer of base metals/bulk commodities (50% of global coal, 43% of industrial metals and 23% of grains) and the second-largest consumer of crude oil). It is however not obvious that valuations of assets in the commodity complex sufficiently integrate a scenario involving a secular change in China’s growth model.
Exhibit 2: Price (LME Copper for 3 month delivery) of Dr. Copper (copper is often called “Dr. Copper” – because it tends to be an accurate barometer of global economic activity) for the period from 24/07/2005 through 23/07/2015.