China lets loose the bears

When irrational fear grips a market, as happened with iron ore this week, forecasts are pretty much useless.

Concerns over a serious slowdown in China’s economy are gathering pace after data released over the weekend showed the biggest slump in exports since 2009.

Shipments destined for overseas countries plunged 18.1 per cent in February compared with an expected increase of about 7.5 per cent. This saw the Shanghai composite index fall to near the lowest levels in five years, while China-reliant markets such as iron ore and copper tumbled.

Despite the slew of weakening data, the government continues to maintain its annual growth target of 7.5 per cent. Premier Li Keqiang reaffirmed the target last week at the opening of China’s annual meeting of the National People’s Congress in Beijing, but remains under pressure to release further details on the economic transition that is underway.

We believe the biggest risk to global growth is a sharper-than-expected slowdown in Chinese growth. Should this prove correct some of the biggest impacts are going to be felt in commodities markets and flow through to economies like Australia.

In fact, it has already started to be felt as commodities, especially iron ore, come under intense selling pressure. Following the economic data over the weekend, iron ore officially entered a ‘bear market’ as it tumbled more than 8 per cent to US$104.7/t in one session.

This really shouldn’t come as too much of surprise given both Andrew Mackenzie and Sam Walsh, the respective heads of BHP Billiton and Rio Tinto, warned recently that new capacity would send prices lower this year.

Over recent months stockpiles at Chinese ports have surged to the highest levels in years, sparking widespread chatter that the inventory is being used as collateral for trade finance deals rather than production purposes. If true, this throws into question the truth about Chinese demand for iron ore.

At the end of the day, analysts can release phone book sized reports detailing why and where they think the iron ore market is headed based on fundamental and economic analysis. While this analysis can be useful when markets are rational, they break down very quickly when human emotions like greed and fear takeover.

In reality there are probably only a handful of people on the planet who actually know where the iron ore price is headed and they are the people in charge of buying for the biggest Chinese steel mills.

So with this in mind, there are a couple of different scenarios worth considering.

The bullish scenario sees Chinese slowdown concerns allayed as the economy makes the transition from export driven to internal demand reliant. This would see the iron ore price quickly find a price floor and stabilise around the US$100 – US$110/t range, which happens to coincide with most long-term price forecasts.

The bearish scenario would see selling accelerate, much like it did in September 2012. The fact that inventory stockpiles are being used as collateral for financing arrangements to the struggling Chinese steel industry means that the bear case scenario is likely to be a lot more volatile.

Speculation suggests the first Chinese steel mill defaulted late last week and that this was the catalyst for the plunge in iron ore prices on Monday as the collateral (iron ore or copper) held for the financing was sold on the spot market to recover the loss. When collateral holders sell it drives the price down, forcing others to get rid of their holdings and therefore perpetuating the domino effect.

Ben Potter is the Retail Editor at stockbroker Baillieu Holst Ltd.

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