The Cyclical Battle: Chinese Demand Versus Speculation Junkies

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Includes: ANRZQ, ARCH, BHP, CLF, RIO, VALE
by: Paulo Santos

As we went into the latest Federal Reserve meeting, there was something taking place around most of the World: a considerable cyclical slowdown in manufacturing, which could be seen in every major PMI measure. Usually, such an event would be met with stock market weakness. As it was, though, the expectation of Federal crack kept the speculator junkies on their toes, even if some sectors were indeed showing weakness, such as steel, iron ore, coal and even copper.

With the Federal Reserve's amphetamine intervention, the stock market junkie forgot all its past troubles, even where those seemed more evident. Every cyclical stock took off, no matter what the fundamentals. Copper itself rallied in excess of 15%. But iron ore producers such as Rio Tinto (NYSE:RIO), Vale S.A. (NYSE:VALE), BHP Billiton (NYSE:BHP) and Cliffs Natural Resources (NYSE:CLF) participated as well. As did coal producers Arch Coal (ACI), Alpha Natural Resources (ANR) and others.

The problem

The problem with these stocks participating in the huge stock market bonanza brought about by the Fed, though, is that their end markets at this point stand very little chance of seeing substantial improvement.

While the Fed's actions can have some impact in the US economy, namely through the wealth effect, that impact can't be large simply because moving people to spend more by making them asset-rich doesn't carry as large an impact as direct spending by the State (fiscal policy). It so happens that fiscal policy has its hands tied at the Federal level due to gridlock, and at the local level due to the need to run balanced budgets. Indeed, taking the U.S. (Federal and local) as a whole, at this point its impact is mildly negative - something that's being seen in the employment numbers, for instance.

Since the impact on the U.S. economy can be muted at best, something else comes to the fore. These sectors, be it steel, iron ore, met coal or even copper, have their pricing and volume mostly set outside the U.S. Indeed, at this point all that matters is what happens in China. And China's demands for these materials are not going to change appreciably due to quantitative easing in the U.S. So although there was a clear jump in copper prices, and a somewhat milder jump in steel and iron ore prices in China in response to the market euphoria, the most likely course of events now is for these spikes to fade away as the local fundamentals reassert themselves again.

This makes for an interesting battle

At this point, we will have two currents in the market. In one side, speculators and investors will be pushed towards more risk, as the Fed buys $40 billion in rather high-risk MBS per month, which have to be substituted. $40 billion is a large number: almost $2 billion per market session even if it comes to around half what was bought during QE2. These speculators will give support to stocks, high yield bonds, and importantly, some commodities, of which copper might be an example.

The other current will be the events "on the ground" in China. These events call for slower demand for a host of basic materials, from cement, to steel, iron ore and copper, among others. Not only is demand for those materials slowing down, but in many cases such happens in a backdrop of expanding capacity which was planned for ever-rising demand. It's possible that at this point the destocking in Chinese steel hasn't even started in earnest, and yet the impact on the input prices is already considerable (iron ore price, iron ore stocks).

This battle makes for a situation where there will be intrinsic demand for the equities of the producers of products for which there will be weak demand and excess supply. It's a weird situation to be in.

Conclusion

The fundamentals for several cyclical sectors enjoying a strong rally in the last two weeks are both weak, and likely to stay weak. This is so because these fundamentals are mostly set in China and most of the economic impact of the Fed's action will take place in the US.

However, the Fed's action does increase demand for assets substantially, making for an uncertain direction in the affected equities, even if it's likely that their end markets will continue to show weakness.

This shows how hard it is to trade and invest when the measures taken seek explicitly to manipulate the market's price and signals, regardless of underlying fundamentals. At this point, a fundamental approach would call for caution in these cyclical sectors, while the Fed is doing its very best to force investors into equities including cyclicals.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.