China and Copper divergence – a sweet sorrow?

One of the benefits of writing a blog on finance and markets is that you have an excuse (if any were needed) to roam widely amongst the world of research and comment looking for points of interest. One such piece took my eye last night when I came across a tweet and related article about the relationship between Copper and Chinese equities. After being inseparable for many years, such that you could scarcely mention one without the other, it seems that they are in fact now thinking about going their separate ways! 

Chinese equities and the price of Copper have been closely correlated for much of the last decade. It was the trade du jour amongst fund managers who bought them together initially due to the intertwined dynamic growth in Chinese infrastructure and its reliance on the copper metal in this increasing industrialisation. Of course China was to lay witness to the largest construction boom the world has ever seen. 

Their relationship was soldered further as China rose to become a principal centre of manufacturing for consumer electronics, of course an industry in which copper as a conductor is an intrinsic component. More recently their affair has become even more entwined as Copper became common currency as collateral for many Chinese firms who needed to finance their business, but were constrained by tightening capital controls placed on the traditional banking sector by the Peoples Bank of China. In effect, companies would buy Copper, pledge the metal as collateral against loans that were available for “trade finance” and then deploy those funds in their day to day business, whatever that may have been. 

China is the world’s largest consumer/ importer of Copper but at the same time it has the world’s largest stock piles of the red metal; a pile that is estimated to total as much as 1.9 million  metric tonnes – as much as the USA consumes in a whole year.

Indeed, such is China’s appetite for Copper that some in Washington believe that this all part of the so called “resource war” aimed at depriving the US of access to an important if not essential industrial commodity (ee http://thehill.com/blogs/congress-blog/foreign-policy/321939-chinas-copper-stockpile-americas-metals-deficit). Whilst that view is likely to be held by relatively few “free  trade zealots”, it does show just how important Copper is for both the emerging and developed world; as with all commodities there is a finite supply and no one wants to be left out in the cold whether they are a consumer or producer.

Copper prices have been trending lower since the autumn of 2011 – the downward drift accentuated by occasional sharp falls, such as those seen in September 2011, again in May 2012, and then in February and June 2013. Over that time frame, the price of Copper as defined by the A grade 3 month contract on the LME has fallen from a high of $9257.5 to $7060 per metric tonne  (as of the close on 12/09/13) a drop of more than 22%. (See chart below)

Risk Reversals chart and associated comments do not offer an explanation for the divergence which has developed between Chinese equities and that of Copper, and many participants believe that the correlation will be restored sooner rather than later.

Personally, I would speculate that the divergence comes as a result of a clampdown by Chinese authorities on the shadow banking and finance sectors which are a continuous cause of concern to the authorities in Beijing as they undermine their attempts to control monetary expansion which some would see as a hopeless task in such a rapidly expanding economy that is undergoing unprecedented social and economic change. In addition to that, I would postulate that the sharp fall in Copper prices since 2011 has actually allowed Chinese industry to make productivity gains, as one of their major input costs has fallen. Thirdly, it may also be part of the unwind of close cross asset correlation which is what we would expect to find happening as QE  and asset purchases come to end.

The charts below show us what has been happening. The first shows the performance of  Chinese “A” shares listed in Shanghai plotted against the LME A grade 3 month Copper contract. The divergence is clear to see and goes completely against the run of play seen over the prior six months.

Our penultimate chart aims to contextualise these events and plots the ratio between LME A grade Copper and Chinese Equity prices. The price of one is simply divided by the other.

One doesn’t need to be an expert in commodity markets to determine that we are moving back towards an area of key horizontal support found at around and just below a ratio of 3. Furthermore if that support should give way, then we could retrace back to the low points seen the last quarter of 2009 and the opening months of 2010. If we plot the same chart with its 20, 50 and 200 day EMA lines, we find that have recently posted dead crosses (a sign of  negative price momentum) as the faster moving 20 day line crosses down through its slower moving 50 and 200 day  counterparts.

Finally, what might this mean for major Mining stocks listed in London? On the face of it, it looks quite positive for the sector. The FTSE 350 Mining sector index has also diverged from the price of Copper and if we draw a ratio chart between the sector and the price of LME Copper we can clearly see that that this trend is likely to continue. Note that in this chart we have posted a golden cross (a sign of rising price momentum) as the 20 day EMA line crossed up through its 200 day counterpart. Readers might like to note that back in June 2010 this ratio was almost a third higher at 3.31 points. In short, we are happy to remain long of the Mining sector.