China, The End Of History And The Last Great Commodities Boom

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Includes: ANRZQ, BBL, BHP, BTUUQ, CLF, CPER, FCX, FQVLF, FSUMF, HBM, NINI, RIO, SCCO, TCK, USO
by: Caiman Valores

Summary

China's economic deceleration is occurring because it has reached a particular point of development where the easy economic gains have been made.

Significantly lower economic growth in China is now the way of the future.

The greatest commodities boom ever known has come to an end, with sharply weaker commodity prices now the new normal.

The drivers of global economic growth have changed with the end of emerging markets as the key engine of economic growth.

It was only just over two decades ago that philosopher Francis Fukuyama released his controversial book, The End of History and the Last Man. In it, he expounded his theory that the collapse of communism and adoption of liberal democracy in Eastern Europe, through a series of velvet revolutions, broke the traditional paradigm through which mankind viewed history. These revolutions, he argued, symbolized the end of mankind's ideological evolution and the adoption of the final form of government.

Now we are witnessing events of equal magnitude, with the last major socialist stalwart China emerging from the economic darkness and embracing the central tenets of capitalism and the free market system to become a global economic super power.

The completion of this transition, I believe, signifies the end of one global developmental epoch and the emergence of a new global economic system which needs to be viewed through a different conceptual paradigm. This paradigm shift brings with it considerable changes for the global economic system and financial markets with it signifying the end of the last great commodities boom witnessed in modern times.

The creation of the greatest commodities boom ever

After the end of the civil war and the accession to power of the communists under Mao, China's economy stagnated. Then from the 1970s, China initiated a series of policies aimed at modernizing the nation. It was these that led to China's eventual rapid economic and social transition, triggering the greatest commodities boom ever witnessed in modern times.

As China modernized, and the required infrastructure was developed and put in place to support its economic transition, its consumption of iron ore, coking and thermal coal, base metals and other raw materials skyrocketed.

It pays to be a 'catch-up economy'

The boom really heated up in the early 2000s as Beijing's economic reforms started to gain traction and the experiment with the free market began in earnest. It is easy to see why China's rate of modernization and economic growth was so rapid and fueled what is probably the greatest commodity boom of all time.

Most importantly, at the start of the development cycle it pays to be a 'catch-up economy'.

You see, provided that other factors are equal, poorer less developed economies grow far more rapidly than partially developed or developed countries. This is because they are coming from a lower economic and developmental baseline.

They also have the advantage of being able to rapidly close the development gap by following the lead of developed nations through technology transfers and capital injections to achieve 'catch-up growth'.

Another key factor in China's rapid development was the immense physical capital that it was able to access and mobilize resources in order to develop new productive assets and infrastructure.

This is because both the size and accessibility of a country's physical capital significantly influences the pace of growth. In the case of China, these are tremendous and can never be replicated by another nation with them being specific to China.

Foremost among them is China's copious population which is the largest of any country, thus endowing it with tremendous human capital. This human capital for a variety of socio-economic and cultural reasons was ready to be mobilized with a range of catalysts putting in motion the greatest wave of rural-to-urban migration the world has ever seen.

In fact, this rate of migration was unprecedented, causing the population of the majority of China's major cities to double or even more between 1990 and 2000. The scale of this migration continued to grow throughout the 21st century, with an incredible 145 million migrants in 2009 alone.

Urbanization is an important driver of economic growth, and for it to be occurring on such an unprecedented scale is one of the decisive reasons for China's rapid economic transition.

As a population migrates from country to city seeking better lives and higher incomes, consumption patterns change. This is because a higher income per person results in a marked increase in demand for consumer goods, food, services, and accordingly, the raw materials required to produce them. Once incomes start to rise they create a growing middle-class that causes demand to surge.

China's massive wave of urban migration created unprecedented demand for the resources to build cities as well as the transport, technology, energy and logistics to support them.

It fueled an unparalleled construction boom that was responsible for China's construction industry becoming the single most important consumer globally of a range of commodities, including steel, copper, zinc and nickel.

Such a massive population shift only added additional momentum to China's rapid pace of economic development with it providing a readily available and super-exploitable workforce to support the process of industrialization. Between 2001 and 2011, China's industrial output more than doubled and this rapid growth further stimulated the already swift rate of rural-to-urban migration.

Rapacious commodities demand triggers once in a lifetime bull market

As China industrialized and wages as well as the standard of living improved, there was even greater consumption and demand for resources. By 2011, China had become the world's single largest energy consumer and the second largest consumer of crude after the U.S. This ardent appetite for energy caused China's consumption of thermal coal and oil (NYSEARCA:USO) to double between 2001 and 2011.

Furthermore, the surge in demand for basic materials is particularly evident when looking at China's consumption of iron ore and other metals.

China was responsible for 53% of the world's iron ore consumption in 2011, or more than four times the amount of iron ore it had consumed a decade earlier. For the same year, iron ore imports amounted to 61% of the global total or almost eight times more than China's iron ore imports in 2001.

The consumption of copper (NYSEARCA:CPER) grew more than fourfold for the decade from 2001 to 2011 when China became the largest single global consumer of copper.

This swelling demand for raw materials caused the prices of commodities such as iron ore, coal and copper to soar to stratospheric heights, triggering an investment frenzy among miners as they sought to cash on the 'boom that would never end'.

The price of iron ore peaked in 2011 at $187 per tonne or more than 14 times higher than it was a decade earlier. Coking coal, another key ingredient in steel manufacturing, peaked at $147 per tonne at the end of 2008 or almost four times its value in 2001.

Other metals also grew exponentially in value, copper more than doubled in value between 2001 and 2011, while zinc's price by 2008 had quadrupled in comparison to 2001. Nickel (NYSEARCA:NINI) also wasn't left behind, with its price peaking in 2007 at eight times higher than it was in 2001.

Meanwhile, China's insatiable thirst for energy saw thermal coal, its primary energy source, peak at $192 per ton in 2007 or six times its value in 2001.

This rapacious demand for commodities triggered a soaring commodities bull market that many industry insiders claimed would never end.

The end of the greatest commodities boom ever

Nonetheless, like all economic bubbles, it eventually did end for one key reason, China's economy came off the boil and its economic growth began to slow markedly. By the third quarter 2015, China's GDP growth had slumped to 6.9% or 50 basis points lower than a year before and its lowest level since the global financial crisis.

It is expected that this decline will continue and I certainly don't expect to see any return to the double-digit figures recorded during the heady days of its economic boom between 2004 and 2010.

There are a number of reasons for this rapid economic growth and then decline.

Key being that once a particular point of development is reached economic growth slows as the advantages of being a 'catch-up' economy decline.

China has now reached that point on its developmental journey where rapid industrialization, urbanization and expansion of the economy has peaked and is now falling into decline. This means that future economic growth will never again reach the heady double-digit figures of the past decade, which triggered a massive demand for basic materials but will instead continue at a more sedate rate.

The latest data out of China confirms this. China's third-quarter GDP growth rate dipped to 6.9%, its lowest rate of growth since the global financial crisis. Analysts and economists expect China's growth to slow even further, with full-year 2015 GDP estimated to be 6.5%, which will decline to 6.2% annually by 2017.

With China being a leading buyer of commodities, it certainly doesn't bode well for their outlook and explains why commodities prices have plunged.

In fact, I believe that what we are now seeing is a paradigm shift among commodities and the move to a 'new normal' with indicators highlighting that double-digit growth is a thing of the past for China.

Two economic sectors that are among the largest consumers of raw materials in China are caught in intractable slumps.

The all-important construction sector is in terminal decline as is real estate development. By November of this year, investment in real estate development was less than a tenth of what it was at the start of the year and there are signs this downward trend will continue. Substantial inventories of vacant housing, coupled with slowing rural to urban migration, means that it will be some time before there is any uptick in demand for housing.

This reduces the pressures on infrastructure which means the demand for new and/or additional infrastructure is declining, further placing pressure on the demand for commodities.

I expect the rate of rural to urban migration to slow even further. This is because declining rates of industrialization, reduced labor intensity in manufacturing because of technological advancements, and falling industrial output are reducing the demand for labor and keeping a cap on wages, thereby removing probably the most important incentive.

The decline in industrial activity is already apparent. For December 2015, China's industrial activity contracted for the fifth successive month. Then there is the decline in industrial growth, with output for 2015 having halved in comparison to 2011. Not only is this impacting the rate of rural to urban migration, but it is also having a sharply negative effect on the demand for commodities, particularly steel, base metals as well as energy such as oil and coal.

There won't be any uptick in industrial activity for the foreseeable future because of softer global demand for China's manufactured products coupled with the considerable excess productive capacity that arose during the boom years.

Significantly lower economic growth is the way of the future

There are a range of indicators that highlight that economic growth in China will remain sharply lower for the foreseeable future and that the days of heady double-digit growth are well and truly over.

Key among these is that China's rapid modernization and expansion has come to an end.

Once a certain point of economic development has been reached, the benefits of being a 'catch-up economy' decline. This is because the easy gains have been made, while the higher standards of living attained increase the costs associated with industrial activity, making these economies' exports less competitive and investment more expensive.

As a result, economic stagnation can ensue. Industrial growth starts to languish because of declining returns and a lack of investment, while higher incomes and standards of living lead to a lack of innovation and declining productivity.

It is clear that this is occurring in China. Industrial profits continue to decline, falling for the tenth consecutive month in November, while manufacturing investment in 2015 is down by 80% from where it was in 2011.

Then there is the risk of China falling into the 'middle income trap'. This would see it caught in a permanent state of economic stagnation interfused by extreme boom and bust cycles, much as Brazil has experienced in recent years. The middle income trap is where a developing economy's growth slows sharply and per capita income levels stagnate, thereby trapping the economy in the middle income category. There are many causes for this, but key among them is an over-reliance on driving economic growth through the extraction and export of minerals as well as the manufacture and export of low tech goods.

With signs of this occurring, Beijing has moved quickly to adjust its policies in an attempt to prevent China from being permanently caught in this rut and make the transition to a developed economy. This has meant creating an environment conducive to the development of wealth and emergence of a broad-based middle class.

To achieve this, Beijing needs to rebalance China's economy from one focused on investment in infrastructure and industry to consumption-driven growth, requiring it to reverse many of the policies that were responsible for its rapid economic development.

As a result, Beijing has instituted a range of policies aimed at fostering growth in the country's weak services sector, reining in the excessive growth of the past and promoting consumption. This means that economic growth can only slow further and that the demand for commodities will continue to decline.

Can other developing nations pick up the slack?

Some analysts and industry insiders are touting the emergence of a range of other developing economies as being capable of picking up the massive excess capacity that now exists globally and fueling a new commodity boom.

Among those countries are Indonesia, Vietnam, India, Pakistan and Nigeria. But this appears highly unlikely with each of them lacking the unique characteristics that fueled China's massive and rapid economic growth, triggering the greatest commodities boom of modern time. This is because each lacks the dynamics of China as well as the massive population base, access to vital resources, broad skill and educational base and geographic size of China.

These factors along with each of them being substantially further along the developmental curve than China when it first started to modernize, means that the rate of industrial growth, infrastructure development and urbanization will be slower and not last as long.

What does this mean for investors?

Despite the claims of some analysts that commodities are long overdue to rebound, what we are witnessing is a fundamental paradigm shift in how to view the global economy and commodities. The shift to weaker commodities prices is reverberating across global markets.

Not only has it triggered the end of rapid growth among some of the world's fastest growing emerging markets such as Brazil, but it has endangered the sustainability of the global financial system. This is because many miners and emerging economies have gorged themselves on cheap debt in order to live above their means along with the forlorn hope that an imminent recovery in commodities will fund repayments.

Clearly, there is no recovery on the way and this has left a number of commodities miners in precarious financial positions.

Mining heavy weights BHP Billiton (NYSE:BHP)(NYSE:BBL) and Rio Tinto (NYSE:RIO) REMAIN determined to grow production while cutting costs through economies of scale to drive higher cost producers out of the market

Among the hardest hit are coal miners, with Alpha Natural Resources (OTCPK:ANRZQ) seeking bankruptcy protection and Peabody Energy (BTU) among others that could potentially be on the way.

This is also applying considerable pressure to smaller iron ore miners such as Cliffs Natural Resources (NYSE:CLF) and Fortescue Metals (OTCQX:FSUMF). It also makes beleaguered coking coal and base metals miner Teck Resources (NYSE:TCK) an unappealing investment, particularly when its exposure to the increasingly uneconomic Fort Hills oil sands project is considered. Other copper miners such as Hudbay Minerals (NYSE:HBM), Freeport-McMoRan (NYSE:FCX), First Quantum Minerals (OTCPK:FQVLF) and Southern Copper (NYSE:SCCO) offer little upside because of this macroeconomic backdrop.

Bottom line

China's emergence as a global economic super power and the abrupt end to its catch-up growth phase has created a paradigm shift for the global economy and financial markets. It signifies the end of the greatest commodity boom of modern times and a fundamental shift in the growth drivers of the global economy, with the emerging markets growth model that had dominated global growth now seemingly broken. This means that investors need to become accustomed to significantly lower commodity prices that, with the exception of crude, now appear to be the new normal.

Disclosure: I am/we are long BHP, RIO.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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