Precious Metals Vs. Base Metals: The China Risk Factor

by: Geoffrey Caveney

Natural resource investors are interested in both gold and precious metals, and copper and base metals, but the key question is which is the focus and priority?

Since this July and August, my answer is that gold and precious metals are my focus and priority in today's market.

Select junior gold miners are the better value and more likely to make much bigger gains faster in the next 3 months, 6 months, and 12 months.

The downturn in the global copper market alongside the Chinese stock market in 2018 should set off alarm bells: something is wrong here.

There is an unknown but significant risk that China's economy may be in far worse shape than anybody realizes, and this is a huge threat to the global copper and base metal market.

Many of us are natural resources investors: we see extremely high value in commodities (DBC) (GSG) (RJI) (USCI), metals, and the companies who mine and produce them. And right now, we see their stock prices at extremely low bargain valuations, especially compared to the generally overvalued broader stock market.

But within the natural resources sector, and metal miners, in particular, there is a critical and difficult decision to make: Does an investor focus on gold (GLD) (PHYS) and precious metal miners (GDX) (GDXJ) (ABX) (NEM) (GG) (KL) (AEM), or rather on copper (JJCC) (JJCB) (CPER) (DBB) and base metal miners (COPX) (FCX)?

Of course, the obvious answer is "both", and I agree. I invest in both gold and precious metal miners, and also in copper and base metal miners. My portfolio of junior miner stocks in the Stock & Gold Market Report right now includes 11 precious metal miners and 7 base metal miners.

But then, the question becomes, do you divide up these investments 50-50, or do you prioritize and focus on one sector over the other?

And, my answer today is to focus on gold and precious metals. Since July and August, I see select junior gold miners as the better value, and more likely to make much bigger gains faster in the next 3 months, 6 months, and 12 months, compared to copper and base metal miners.

Copper and China: Alarm Bells in 2018

Something bad happened to the global copper market in 2018, and it happened alongside a huge decline in the Chinese stock market (ASHR) (FXI):

According to the popular and official narratives of the long-term growth of China's economy, and the global copper and base metal market along with it, these declines should not be happening in 2018. But they are. This should set off alarm bells among astute investors.

Yes, the "trade war" narrative between Trump and China is the most common explanation of the market downturn you see in the chart above. That is natural. But I don't think this is enough to fully explain the severe and surprising decline that we have seen in 2018.

I fear there is something more and deeper that is going on beneath the surface: I am very concerned about the unknown but significant risk that China's economy may be in far worse shape than anybody realizes. If this is true, it is a huge threat to the global copper and base metal market.

The headline numbers about China's economy are negative enough, but not so much as to be considered "alarming" in and of themselves. We all saw China's annual GDP growth rate decline to 6.5% in Q3 2018, as announced in October. That is its slowest growth rate since the 1st quarter of 2009, during the financial crisis and the Great Recession:


Now, the natural and common answer to this is that such a large and growing economy cannot continue to expand at higher and higher growth rates forever. A 6.5% annual growth rate is still a lot of growth, even if the growth rate is slowing down. This is true.

But much more concerning to me is the analysis provided along with this chart. Not the part about the "intense tariff dispute with the US", we all know about that, and it is already baked into the markets. Rather, the much bigger concern is the second main part of the analysis:

"Alarming Off-Balance-Sheet Borrowings By Local Governments"

That is the real story in this analysis, and the real concern here. As the article continues:

"Recently, S&P Global Ratings said off-balance-sheet debt by Chinese local governments could now be as high as CNY 40 trillion (USD 7.95 trillion), representing a “debt iceberg with titanic credit risks”."

You read that right: almost 8 trillion US dollars in debt, that is not officially recorded in any official balance sheet or reported economic statistics. And this is not by China's national government, this is just by the local governments in China.

China's Consumer Spending Slowdown

A key part of the long-term China growth story is the rising tide of wealth in the growing middle class, who have been driving a rapid increase in consumer spending in recent years. But suddenly, this year, we see signs that this consumer spending is slowing down.

I know it's just Starbucks (SBUX), but when Starbucks is making a big, big effort to expand in China, and yet its same-store sales there fell 2% in Q2 2018, and only bounced a mere 1% in Q3, along with a 1% decline in the China Asia-Pacific segment, that should be a cause for concern.

Likewise with Apple's (AAPL) latest numbers cited in the same article: Sure, it's still 16% growth, but this is a slowdown from 19% last quarter, when one would expect an increasing growth rate with all the new iPhone models just released.

Perhaps a more significant sign of China's consumer spending slowdown is in last month's very weak growth reported by Kweichow Moutai Co., China's largest liquor company. This article points out that both Chinese consumer discretionary and Chinese consumer staples stocks are declining sharply, with the Consumer Staples Index down 22% in October alone.

Important point: a steep overall decline in all Chinese consumer stocks, both discretionary and staples, cannot be explained by a tariff dispute or a trade war.

The Significance Of Xi Jinping Becoming President For Life

The news in March that the National People's Congress removed China's two-term limit on the presidency, allowing Xi Jinping to remain President for life, was of course reported widely around the world. But I think it is striking how little attention it has gotten among most investors and financial analysts commenting on the Chinese stock market in 2018.

Of course, Xi could have served as President until 2023 anyway, so one can argue this news should not have a direct impact on China in the short-term and medium-term view. But the issue here is a Big Picture question: What is going on in China, that made President Xi feel the need to take this step now? What exactly was such a big concern, that Xi does not feel comfortable preparing for a transfer of power even 5 years from now, even to another figurehead while he would still exercise power behind the scenes?

On the surface, it seems rather strange and unnecessary. But Xi knows what is going on in China better than we do, and he clearly felt it was necessary. That should tell us something. We may not know exactly what, but it should tell us something.

Also, we investors in the West should reflect on our own lack of a big reaction to this news and think about what it says about how accustomed we have become to China's strictly centralized government and its role in the global economy. It has gotten to the point where we all see this as simply the natural order of things, and we accept it as normal in a way that we would not accept it from any other country or any other government.

Of course, I am not talking about making a moral or ethical or political judgment here. That is not the purpose of our analysis and discussions on Seeking Alpha. I am just talking about our investment decisions, our calculation of expected returns, and the balance of potential risks and potential rewards that we must take into account. Geopolitical risk is one of those potential risks. But our view of China has gotten to the point where we do not see the leader of 18% of the world's population and 15% of the global economy becoming President for life as a particularly significant geopolitical risk.

Put it this way: Imagine what investors' reaction toward South Africa would have been if Jacob Zuma had declared himself President for life rather than resigning this year? Or what investors' reaction toward Brazil would have been if Michel Temer had declared himself President for life this year? In China, however, such a development is accepted as normal by global investors everywhere.

Is Democratic Dissent in China a Black Swan Investment Risk?

Once again, the purpose of this article is NOT to make any kind of moral, ethical, or political judgment. In the past, I have invested in Chinese stocks, recommended Chinese stocks, and made money on Chinese stocks. If this is a sin, then I will not cast the first stone. I am just trying to make an objective analysis of the real risks and rewards involved in investing in China, including copper and base metal investments, which are highly dependent on China's economic growth to support future global demand.

But once again, I fear that global investors have gotten so used to the Chinese government's efficient effectiveness at maintaining strict political control and stability, for so many decades, that we have almost forgotten that this is happening at all.

Think about it this way: If another Tiananmen Square style democratic protest movement arose in China next year, what would the consequences be, strictly from a global investor's point of view?

The shocking reality is this: We now take the Chinese government's centralized control for granted so much, that we no longer even imagine that such an expression of democratic dissent could ever even be possible again in China. "Surely, the government would nip it in the bud before it went anywhere." "Nobody would even dare to try anything like that now."

And that is the real reason why the geopolitical risk of investing in China's economic growth seems small to most global investors today. Democracy can be messy, and that is one mess investors think they don't have to worry about in China.

But if a democratic protest movement in China did break out somehow, what would the government do, and what would the consequences be for global investors?

In 1989, the government simply massacred from 1,000 to more than 10,000 civilians to solve the problem. Back then, although China's economy had begun to grow in the 1980s, it was still a tiny fraction of what it has now become as a result of the growth of the past 30 years. The Soviet Union still existed. East Germany still existed. The Berlin Wall would not fall until 5 months later. It was a different world. The Chinese government at the time didn't really have to worry about what global financial investors would think about its actions.

But if the Chinese government tried to carry out another Tiananmen Square massacre, say in 2019, what would be the global financial and economic consequences now? Would the American public tolerate the likes of Apple or Starbucks or any well-known American company doing business in China after that? And if not, what would that do to the Chinese economy? What would it do to the global economy?

Other Concerning Political Events in China in 2018

For the record, the removal of presidential term limits for Xi earlier this year did not happen entirely without dissent. The official vote in the National People's Congress was 2,958 in favor, 2 against, 3 abstentions, and 1 invalid vote. A couple weeks before the vote, the former China Youth Daily editor Li Datong wrote a statement against the proposal on Tencent's (OTCPK:TCEHY) popular WeChat messaging app, and so did businesswoman and reform advocate Wang Ying, as reported in this AP news article in late February. At the same time, the government went as far as to censor the phrase "I disagree" on social media such as Weibo (WB).

More recently, just this week, the South China Morning Post reported on "the biggest story in Chinese politics right now" - the lack of any announcement about the autumn plenum of the Chinese Communist Party's Central Committee, which is supposed to take place this fall. The article suggests that the delay might be related to "a lack of consensus among the Chinese leadership over how to battle the growing headwinds facing the world’s second-largest economy." The article notes:

"The Politburo meeting chaired by President Xi Jinping on Wednesday delivered a stern warning on the “growing downward pressure” on the economy and the “profound changes” in the external environment – the first time the Chinese leadership has publicly acknowledged China’s economic slowdown since the trade war."

The article also quotes the following striking analysis by Shanghai political observer Chen Daoyin:

"Back in March, Xi’s administration was still full of confidence about China’s future development, otherwise he would not have been so unstoppable in consolidating his power since the party congress and pushing through the constitutional amendment.

But now, the ordinary Chinese people have started to lose hope on China’s economic development."

A Reminder About Some Basic Facts of Life in China

When we focus on the Chinese economy and "global growth" as investors, it is easy to lose sight of many basic facts about the nature of Chinese society. We know all of these things, we just don't bother to think about them most of the time.

China's extraordinarily rapid adoption of social media and smartphone apps to perform just about every basic social and economic task and function in life, just within the last 5 years or so, has also enabled its government to institute a truly Big Brother-style universal monitoring of almost everything every person is doing in China.

It is called "social credit", and it gives each citizen in China a "social credit score" on a scale up to 800 or 900, like the financial credit scores that we are familiar with, but based on a constant monitoring of everything each person does all the time. This feature article by the Australian Broadcasting Corporation in September, "Leave no dark corner," paints a vivid picture of how the system operates in practice, and it describes it as "a digital dictatorship to exert control over its 1.4 billion citizens."

This is a country where pictures of Winnie the Pooh have been censored because people were comparing him to Xi:

Bringing It Back to Base Metals

Very well, you may be thinking, but haven't we drifted away from the topic of investment decisions and precious metals vs. base metals? Indeed. Let me return to this point to wrap up.

The bottom line is, should we really be so confident that a society such as the one that I have described here, is truly stable?

And if this stability is shaken in the years ahead, if the Chinese Communist Party loses some of its firm grip and control over society, what will that mean for the Chinese economy?

The immediate effect will quite likely be negative. The Chinese centralized government is ruthless, but it is efficient. Without this centralized efficiency, or with a weakened form of it, the initial impact will be a loss of ability to organize economic development. China does not have a well-developed independent private sector that is capable of stepping in and taking over these tasks the way that corporations do in the United States. Most of China's private sector today is so closely tied to the government and state-run corporations, that they will suffer, not benefit, if the government's control over society is weakened. In short, the immediate result of a loss of political stability in China will, quite simply, be chaos.

And chaos in the Chinese economy will be very, very bad news for global demand for copper and base metals. The Chinese government, and the manufacturing conglomerates it controls and influences, are the very best customers that global copper and base metal producers have.

This doesn't mean I'm "bearish on base metals". Not at all. There are plenty of bullish tailwinds for global copper demand, which many analysts have noted repeatedly in recent years, including myself. But 2018 has already clearly shown us that the direction of this market is not a one-way street. And Chinese economic and political risk is a potential unexpected headwind for this market, that I think most analysts are not properly appreciating.

The one huge advantage that gold has over copper, and just about all other commodities, is that an industrial decline has a negligible effect on the demand for gold. This is just as true of Chinese industrial demand as it is of US industrial demand or global industrial demand in general. In a world full of unknown and uncertain risks, such as those in China that I have discussed here, gold provides a safe haven protection that no other commodity on earth can match. That is why, today, my confidence in gold miners has to be greater than my confidence in copper and base metal miners.

Disclosure: I am/we are long PHYS. 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.

Additional disclosure: I am long many junior gold miner stocks. Further details are available to subscribers of the Stock & Gold Market Report.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.