It's all About EM Demand, China and India

With all the sturm und drang of the US political season, it is excusable that investors are looking less to emerging markets (EM). However for commodities traders and investors, that is not possible. The fact is that almost all the growth in commodity supply and demand comes from EM. And right now EM is in serious trouble.

This article will focus on commodity demand. Over the medium term, there's not much that can happen to supply. Putting in a new world class mine or plantation province takes many years. These were cut back sharply starting in 2013, and will not revive for quite a while. So over the shorter term commodity prices will be set by demand.

Here's a table of the World Steel Association's forecast for steel demand in 10⁶  tonnes:

	2016	2017	Change
Developed Markets	406	410	4
Emerging Markets	436	457	21

So EM is the growth driver for steel. The numbers are similar for virtually all industrial commodities. DM economies expand in the commodity-light service sectors. EM economies expand by building things.

The two biggest EM economies are China and India. Both of these are having problems, for different reasons:

China is experiencing massive financial outflows. It's impossible to get exact numbers, but Barclays thinks it was $207 billion in the third quarter. Data from the Federal Reserve TICC report shows that China and Belgium (China holds treasuries in Belgium for some reason) liquidated $184 billion in treasuries during Oct alone. So the outflow may be speeding up.

Analysts have varying reasons for the massive movement out of China. Rising US interest rates, the falling Yuan and a clampdown on corruption in China are mentioned. But my view is that this is wealthy people in China seeing the end of the Chinese growth model. China is going through the same process that Japan went through in the 80s. The export-led growth is maxed out, but China still has a huge savings rate. So the capital is seeking a better and safer home. Trump is speeding this up, since he will certainly reduce China's exports to the US. But it would happen anyway.

The Chinese leadership realizes this and is steering the economy toward services. Long term this is the right path, but the process will be bumpy. Basically, a lot of heavy industry will have to be shut down. Services are much less capital-intensive than manufacturing, so the returns on capital will be lower. Also, services are far less commodity-intensive, so that demand will be muted.

So China will not have a need for incoming capital. It has also massively expanded its higher educational system, so it probably won't have much of a need for foreign technology either. History tells us that if a nation doesn't need foreign assets for growth, it doesn't let foreign companies make much money. So my advice is to avoid Chinese stocks as an asset class. This is also negative for US companies that have major operations in China (GM, WYNN, YUM).

India is a somewhat different story. It is at an earlier stage of the growth cycle. Exports and construction have a large place to play in future growth. Because of the rule of law and English language, it also has a major stake in service exports, a particularly good sector. The problem here is self-generated. Like many EM countries, much business is done in cash. This is done to avoid taxes as well as distrust of the financial system. India wants to change this. So the government has called in all large denomination bills. But business culture doesn't change overnight. So a lot of business has ground to a halt. In time this will dissipate, and India will resume its growth.