Chinese economic policy uncertainty set to rise

Every five years members of the Chinese Communist Party meet for its Party Congress. The event is typically where the ruling party shuffles leadership and addresses economic reform. Previous meetings have coincided with important announcements on investment in infrastructure. Currently scheduled for this October, the 19th such meeting may also be an important marker board for commodity markets.

Over the past couple years officials have embarked on a series of measures to try and cut production capacity across a range of industries including steel, coal and more recently aluminium. Cuts to domestic capacity have caused seaborne prices for these commodities and others related to them to soar as supply struggles to meet China’s infrastructure investment. One of the aims of these capacity slashing measures has been to improve environmental conditions, particularly those located in urban areas on the east coast that have had to contend with thick smog on a regular basis. However, more pertinent are Chinese authorities attention on financial stability and deleveraging as a critical objective.

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Any backtrack on this focus may be a signal that markets may have got too far ahead of themselves. Look for any change in China’s commitment to a GDP target. There is a wide expectation that the Party will reiterate its commitment of doubling GDP by 2020 from the 2010 level, which requires the economy to grow at an average rate of 6.5 per cent in 2016-2020. Also important will be the level of support President Xi’s agenda. If his power is seen as weakened it may be interpreted as a negative for commodity markets and a sign increased volatility.

Previous Party Congress meetings have got some form in dashing expectations for higher prices. The chart below looks back at how copper prices performed before and after the past 5 Party Congress meetings. Copper prices typically rise in the twelve months preceding the meeting, and then peak 1-2 months before declining over the next twelve months to end below price levels seen 24 months earlier.

For sure, previous meetings have coincided with some tumultuous economic events. In 1997, just a few months before the Party Congress, the Asian Financial Crisis was just getting started with Thailand abandoning its currency peg against the US dollar. A series of currency devaluations by other countries in the region caused stock market declines and sharp drops in economic activity. And then in 2007 the Global Financial Crisis got underway as troubles emerged at Bear Sterns and interbank lending markets froze. The knock-on impact on confidence caused copper prices to fall initially and although they later rebounded, further bad news on the scale of the crisis caused copper prices to drop several months after the CCP. Nevertheless, both 1992 and 2012 exhibit the same trend even though China’s importance to overall copper demand radically changed during the intervening 20 years.

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The mocha hedge: Long planting cycles point to moribund soft commodity prices

The price of sugar, cocoa, coffee and orange juice have all suffered large declines over the past 6-8 months in the order of 30%-40%. Investor sentiment is poor and in the case of sugar at a record low with funds net short for the first time. The sharp price falls and poor investor sentiment has many investors anticipating a sharp reversal of fortune. But what does history suggest should happen this time?

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The key to understanding the market for soft commodities such as these is the production outlook. The risk with soft commodities is that production is concentrated in particular regions of the world. Two thirds of the world production of cocoa comes from West Africa with Ivory Coast the biggest producer. Meanwhile Brazil dominates sugar and coffee and to a lesser extent orange juice supply. The impact of this concentrated production is that any disruption to supply can often have an disproportionate impact on prices.

The difference between soft commodities such as coffee and cocoa compared with grains like corn and wheat are their long agricultural supply cycle. The agricultural supply cycle describes the process of activities relating to the growth and harvest of the crop. These include loosening the soil, seeding, watering and harvesting etc.

It takes cocoa trees 3-5 years to yield a crop. In the case of coffee it will take approximately 3-4 years,depending on the variety for the newly planted coffee trees to bear fruit. An orange tree grafted onto rootstock may take three years to begin producing, while a tree grown from seed can take up to 15 years. Sugar cane has the shortest cycle of all the softs – the typical cycle from planting to harvest takes about 12-18 months.

This means that farmers price expectations (i.e. whether they expect high or low prices to continue sometimes 3-5 years in the future) are vitally important in determining future supply and prices. Coming so soon after a period of high prices, farmers are unlikely to have hit rock bottom in their expectations just yet.

The long lead time between decision to expand supply and the eventual harvest, combined with the risks (disease, weather, exchange rate and conflict) means that supply does not expand quickly enough to respond to higher prices and / or signs of higher demand. This can result in a boom-bust market where farmers only feel confident enough to expand right at the top of the market.

These long production lead times are reflected in the chart patterns too with periods of high prices often 3-5 years apart, inter-spaced as they are with periods of volatile, but ultimately lower prices.

History suggests that investors positioned for prices to rebound significantly based on the notion that just because poor sentiment is likely to reverse this means prices will too are likely to be left disappointed.

Related article: Cocoa prices: The top 10 most important drivers

Related article: Sugar prices: The top 10 most important drivers

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Cocoa prices: The top 10 most important drivers

1) Concentrated production: Two thirds of the world production of cocoa comes from West Africa with Ivory Coast the biggest world producer. This means that price is chiefly driven by supply issues in cocoa’s major producers. Any hint that supply may be worse or better than expected can have a disproportionate impact on the price of cocoa.

2) The weather: The right mix of rain and sunshine, at the right time, is needed for cocoa pods to mature properly. Climate disturbance at any phase of the growth process (from flowering to the maturing of the pods) can have a direct impact on crops by yielding shrunken or rotten pods. For example, long periods of dry weather are not conducive to cocoa bean growth.

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Cocoa traders need to be on the watch for winds from the Sahara desert that typically bring dry weather and coolness to the largest producing countries from December to February.  Known as the Harmattan winds, strong dusty winds can dry out pods and damage crops.

3) Disease: Fungi and various diseases can also reduce output by reducing the yield from cocoa plantations. The most damaging disease is known as ‘Black Rod’ which was estimated to have resulted in the loss of almost half a million tonnes of cocoa in 2010. Its not just diseases afflicting the cocoa pods that can affect supply. The Ebola outbreak in 2014 forced farmers and their families to flee cocoa plantations in Sierra Leone while international buyers of cocoa refused to visit the producing areas.

4) Geopolitics: The major cocoa growers are accustomed to geopolitical uncertainty. When previous economic booms have led to bust, unrest has typically followed. As with many other countries that rely on commodities as a major part of their export revenue, the Ivory Coast has been plagued by corruption and unrest in the battle for power. Although citizens may be placated when times are good, as soon as the economic tide turns the population can turn if they do not feel that they are getting a good deal compared with those in power.

5) Infrastructure: The biggest producers of cocoa do not exactly have world class infrastructure. Something as seemingly benign as unexpected rain in December has proven to be a significant bottleneck in Ivory Cost. When crumbling roads are unadapted for trucking in the rain, transportation becomes costlier, and additional costs are shifted onto the commodity.

6) Consumer tastes: The trend towards dark chocolate (particularly in light of potential health benefits) has helped drive demand. Dark chocolate requires a higher cocoa content than milk chocolate. Meanwhile, chocolate has become increasingly popular in many emerging economies, adding to demand for cocoa.

7) Farmers: The price paid to cocoa farmers is set by the industry regulator. If farmers incomes are cut (perhaps due to a decline in the price of cocoa) then they are less likely to invest in new trees and are likely to cut back on fertiliser and other important inputs that ensure high quality cocoa beans. All of which means that both near-term and future supply prospects are lower. Lower incomes for farmers also raises the risk of civil unrest.

8) Flowering cycle:  It takes cocoa trees 3-5 years to yield a crop. But before that significant investment needs to take place by the farmer to clear and prepare the land for planting. The long lead time between decision to expand supply and the eventual harvest, combined with the risks (many of which are described above) means that supply does not expand quickly enough to respond to higher prices and / or signs of higher demand. This can result in a boom-bust market where farmers only feel confident enough to expand right at the top of the market.

9) Currency movements: Cocoa is typically priced in British pounds while the London cocoa futures contract long been used as the global benchmark for the pricing of physical cocoa. Since consumption of cocoa centred in continental Europe, and a large part of the cocoa processing industry based in the Netherlands and Germany a drop in the Pound versus the Euro increases demand for cocoa since it is now relatively cheaper to import cocoa for processing into chocolate.

10) Stocks: As with other commodities high stock levels may indicate that demand for cocoa is weak, putting downward pressure on the price. Cocoa is perishable however, and depending on how it is stored the quality (and the value) of the stocks may quickly deteriorate.

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