China ramps up pressure on commodity prices

05 March 2021

There’s no slowing China. Like everywhere else, it suffered early last year from the pandemic but its economy rebounded smartly afterwards. Surging exports were all the more unexpected for the fact of slowing international trade, and ironically exports to the USA rose fastest of all just as Donald Trump’s presidency drew to a close. That battle is far from over, however, and Joe Biden has already started to address the issue by denouncing “coercive and unfair” trade when he spoke to Xi Jinping in mid-February. That raised hackles in Beijing and resulted in Chinese threats to reduce exports of rare-earth metals, particularly to the Americans. These elements are indispensable to defence and high-tech industries.

So far, investors are untroubled by the prospect of heightened international tensions that could build over open conflict between the world’s two largest economies. They are focused entirely on the Chinese-led recovery theme and its implications for the prices of raw materials, whether energy-related or agricultural. But note that commodity price inflation is hitting levels that could well penalise corporate margins and already fragile purchasing power among Western households, thereby stifling the rebound in economic activity that would otherwise gain traction as vaccination programmes make progress. Fears of an early return to inflation are starting to unnerve investors, hence higher bond yields (especially in the USA) and the beginnings of a correction in equity indices late last month.
Following China’s example, world GDP growth should resume this year but forecasts from the major international institutions diverge widely. Taking account of progress in vaccination programmes, we lean towards the IMF’s growth estimates, which are more favourable to the USA (5.1%) than to the euro zone (4.2%). The vaccination rate is three times faster in America than in Europe, producing a logical difference in outlook and resulting in a strong possibility that the euro zone will not do as well as forecast. Given that poorer growth prospects than elsewhere are penalising European equity indices, and Wall Street is suffering from rising interest rates (the US 10-year yield is closing on the S&P 500 dividend yield), Asian and emerging equities have been the best performers since the start of this year (MSCI Japan up 8%, MSCI Emerging Markets up 8.9%).

On the microeconomic front, the news is encouraging. We are almost at the end of the US Q4 results season; 85% of S&P 500 firms have now published, and 80% of them came with positive surprises on profits. As things stand, aggregate S&P 500 earnings will be up 3.1%, and initial guidance for Q1 2021 is mostly positive. An absence of bad news on earnings is essential to keep share prices at least at current levels, especially in the USA, where our model indicates that some market consolidation is required. Our theoretical objective for the S&P 500 is now 3,443 points, compared with its recent peak at 3,925 points (up 3.6% since our letter last month). This implies downside potential of 12% relative to its highs, and the index has already eased 2.9%. From a fundamental point of view, our model effectively emphasises the need for this index to pause after an almost uninterrupted 68% gain since mid-March 2020. This is all the more pressing in a context where investors are probably too aggressive on the interest-rate outlook in the near term. In the circumstances, we recommend caution on US equities. The situation is very different in the euro zone, where our model suggests that equities are fair value irrespective of the scenario. We are therefore overweighting European equities against Americans in the near term.

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