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Episode 147: China could spoil the Fed pivot party

This week Jamie looks at the recent jump in commodity prices and discusses what it means for the Fed if the rumours coming from China are true. There are various forces at work here, but with some expecting a Fed pivot soon, a reengaged China might well reverse the pullback in commodity prices we’ve seen over the past several months, and keep rates higher for longer

  • Jamie [00:00:00] This past Friday, copper soared over 7.5% and even oil had its own little party up 5%. So what happened?

    Jamie [00:00:09] Well, you wouldn't be faulted for thinking there were some rumblings of the long awaited Fed pivot, especially in light of the substantial weakness in the US dollar. But really it had everything to do with something else, something far from U.S. soil in fact; unconfirmed rumours that China is warming up to the idea of easing its Covid-Zero policies.

    Jamie [00:00:31] Was Friday the warning shot of a renewed bout of commodity strength. And if so, what might that mean for the Fed's battle with inflation?

    Jamie [00:00:39] That's this week's Big Conversation.

    [00:00:46] The reason Friday's action should be on all of our radars is really quite simple. Over the past several months, commodities have eased off the torrid pace they began the year with.

    Jamie [00:00:57] In many people's opinion. It's been the ongoing monetary tightening starting to play its part in the Fed's objective of softening economic demand. And yes, the pullback in commodity prices has helped to ease some of the inflationary pressures the world was facing earlier in 2022.

    Jamie [00:01:13] But if China's potential reopening is as bullish for commodities as the market has suggested over the past few days, then there's a very real risk that the infamous "Fed Pivot" has been delayed.

    Jamie [00:01:24] Let's be crystal clear, though. The rumours that had the markets so excited on Friday were just that, rumours. In fact, Chinese health officials held a press conference this past weekend to address their targeted COVID prevention policies.

    Jamie [00:01:38] According to one National Health Commission official, China's practise has worked. They've apparently proven that their pandemic prevention and control strategy is the correct one, and as such, their measures are proven to be the most economical and effective.

    Jamie [00:01:54] So much for ending those COVID lockdowns...

    Jamie [00:01:56] To be fair, buying too much into unconfirmed social media posts carries its own risk. But, the constant back and forth on this topic is enough to make anyone's head spin.

    Jamie [00:02:06] Now, come Monday morning, various news outlets reported that China was indeed weighing a gradual exit from its Zero-Covid policy. They stated that it expects to proceed with caution and without a fixed time frame.

    Jamie [00:02:21] But instead of racking our brains about whether or not China will actually abandon their current COVID strategy, it's helpful to simply think through the ramifications so we can be better positioned for the ultimate outcome.

    Jamie [00:02:32] So let's go back to the commodity complex.

    Jamie [00:02:35] There are some beliefs that China's Zero-Covid policy has contributed to the softening in oil prices as a result of reduced Chinese demand. Same could be said for copper. Well, that and the significant deleveraging that we've seen play out through stress in major developers such as Evergrande over the past year.

    Jamie [00:02:55] But what if both of those forces are about to reverse course?

    Jamie [00:02:58] According to recent data released by the People's Bank of China, the broad money supply - as measured by M2 - climbed 12.1% on a year-over-year basis as of the end of September.

    Jamie [00:03:11] So, yes, Chinese policymakers appear to be back with fiscal supports, which should lend support to industrial commodities.

    Jamie [00:03:18] On the other side of that coin, though, there are deflationary aspects to consider as well. For starters, easing measures at a time when the rest of the world is still engaged in monetary tightening, could bring about weakness in the Chinese yuan.

    Jamie [00:03:32] A weaker yuan is broadly thought to be deflationary for the rest of the world, in the sense that other countries are now importing cheaper goods.

    Jamie [00:03:39] And then there's these supply chain issues, which are still all too real, as evidenced by Apple's recent announcements that COVID restrictions in China has led to significantly reduced capacity and thus slowing shipments of its iPhone.

    Jamie [00:03:54] If you remember, reduced capacity across manufacturers in ports operates, as was largely pointed out as the root cause for major shipping bottlenecks, which ultimately translated into a surge in shipping costs in 2021.

    Jamie [00:04:08] Again, if we are to believe that China will slowly emerge from drastic lockdown measures, that's another feather in the cap of those hoping for smoother operations within the global shipping complex.

    Jamie [00:04:19] So basically, which one will it be? Will China's potential reopening create additional inflationary pressures? Or could the deflationary aspects be enough to offset those concerns?

    Jamie [00:04:32] Well, that's the looming question that will require further investigation. The Fed has already performed a significant amount of monetary tightening. And as Jerome Powell always reminds us, their measures act with long and variable lags.

    Jamie [00:04:46] The real answer is likely to be far more nuanced than just one overarching implication.

    Jamie [00:04:51] And take, for example, the shipping sector:

    Jamie [00:04:53] If U.S. demand is slowing, while supply-chain bottlenecks are set to ease with China's exit from Zero-Covid, then we could be looking at a difficult environment for shipping stocks, which have enjoyed an enormous boom over the past two years.

    Jamie [00:05:08] On the other hand, global materials stocks could be facing another demand surge due to China's increased fiscal support.

    Jamie [00:05:15] All in all, if you are in the firm camp that the Fed pivots soon, then this episode should give you reason to pause and think. The recent developments in China, or should I say rumours of developments could muddy the picture for an already uncertain outlook. While the deflationary aspects might be enough to offset the renewed inflationary pressures, the Fed may not need to do a whole lot more. But maybe it's an argument that rates will simply need to stay higher for longer.

    Jamie [00:05:42] And if rates do indeed stay higher for long. Well, investors might actually need to dust off those old fundamental analysis textbooks after all.