Is the main driver of industrial metal demand about to shift into reverse?

The Chinese manufacturing purchasing managers index is closely watched for signs of an uptick in demand for commodities. The reason for this is that it gives a forward view of the potential demand for industrial metals such as copper, nickel and aluminium and to a lesser extent energy and agricultural commodities. Since the start of 2016 all the signs have pointed up as Chinese manufacturing activity surged higher, and metal prices have followed in lockstep.

But what if there is a more important, even more forward looking indicator of potential demand?

A recent note from PIMCO highlights the role that credit plays as a leading indicator. China’s “credit impulse,” as its known measures the change in the growth rate of aggregate credit to GDP, bears close watching: It has tended to lead the Chinese manufacturing Purchasing Managers’ Index (PMI) by 9-12 months and the U.S. Institute for Supply Management’s (ISM) manufacturing index by about 14 months.

Whats been happening to the credit impulse? Here’s PIMCO.

The sharp downturn in the Chinese credit impulse starting in 2016 portends a material drag on Chinese growth in the year ahead. Looking back on the past three years, the Chinese credit impulse turned positive sometime between late 2014 and mid-2015. Given China’s exchange rate volatility in August 2015, it took longer than normal for credit to gain traction. The Chinese credit impulse peaked in March 2016 and slowed sharply after the second quarter. It is only now that the impact of that reduced stimulus should be felt. PIMCO has already factored credit-related drag into its Chinese growth outlook, but the decline in the credit impulse has been sharper and more extreme than many expected.

The question now is not if China slows, but rather how fast. Equally important perhaps is the extent to which commodity prices will correct lower, especially in light of the current enthusiasm about the potential strength of the global growth cycle. The impending slowdown in China could be compounded by ongoing government efforts to rein in shadow bank credit; the cost of policy mistakes rises once the credit impulse goes into reverse.

All of which means the outlook for industrial metals could look a lot bleaker in the second half of 2017.

Related article: Where do we stand in the commodity cycle?

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