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(Only) Commodities don’t reflect Chinese slowdown risk

|Includes: DBA, PowerShares DB Commodity Index Tracking ETF (DBC), GLD, SLV
While commodities have performed extremely well post crisis, the risk remains its way too depended on China. Chinese share of global demand for many critical commodities like copper, steel, coal and iron ore have reached over 40%. Thus any slow down or hard landing in China will have adverse impact on commodity prices.
 
What’s interesting is while commodities market has been strong, other markets have been pricing in problems in China. The major issues debated are inflation and local government debt.
 
Chinese banks equities pricing in risk
 
The valuation of Chinese banks stand out distinctly that all is not well in china. The main reason for this comes from their exposure to local government debt. The average PE of the major four Chinese banks based on trailing 12 months earnings is just 8.64 and based on forward EPS is just 7.84.
 
Bank
PE
Est PE
ICBC
9.17
8.21
Bank of China
7.05
6.88
China Construction Bank
8.34
7.56
Agricultural Bank of China
9.99
8.70
Average
8.64
7.84
 
Compare this with Indian banks, where there average PE is 19.90 and 16.53 based on trailing and forward looking EPS.
 
Bank
PE
Est PE
HDFC Bank
29.84
22.15
ICICI Bank
19.69
18.69
State Bank of India
14.69
12.56
Axis Bank
15.39
12.71
Average
19.90
16.53
 
Clearly the Chinese banks are pricing in some significant risk at valuations lower than half of Indian banks. If the market is discounting risk to the Chinese banking system, is it possible that economy will go unaffected when that risk materialises? If the answer is “NO”, then commodities prices should also discount the risk.
 
USD/CNY Options market pricing in risk
 
Even FX market is showing some red flags. When view on a certain currency is one directional then its priced into the options market. For example, if the market believes that CNY can only appreciate against the USD, the implied volatilities of USD put/CNY call option will be higher than USD call/CNY put option as CNY call writers will charge a premium to write them.
But this is not happening is USD/CNY options. For example the 25 Delta Risk Reversal (25D RR) is positive and has moved higher for USD/CNY. 25 DD RR is the difference between implied volatilities of 25 Delta USD call/CNY put minus 25 Delta USD put/CNY call.
 
A positive number means USD call/CNY put is more expensive than USD put/CNY call. This again is not consistent with the secular china growth story. This means market is buying USD call/CNY put options more than USD put/CNY Call options.
 
The below is the historic chart of 25D USD/CNY RR which moved positive in June and is inching higher.

Again if FX market is pricing a risk for the currency, should it also have some impact on commodity prices if it materialises.
 
Commodities don’t seem to care
 
While equities and FX market is discounting some risk in China, commodities hardly seems to think so. CRB All commodities index is well above 2008 highs and looks fine even after the recent correction.
 
Should commodity investors ignore the red flags which other asset classes are waving for China?
 
Chart: Commodity Research Bureau/ Reuters All Commodities Index



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