Five Eyes…Finally Open: The West is About to Turn on China

Dear Reader,

China is under pressure.

Its future status as the manufacturer of the world is at stake.

I’ll get to that in a moment.

Despite the major tectonic shifts currently taking place, it’s not hurting Australia’s iron ore miners. They are again rolling in the cash. As The Australian reports:

Iron ore futures traded on the Dalian futures exchange tipped over the $US101 a tonne mark on Thursday, and spot prices for iron ore grading 62 per cent hit a nine-month high of $US98.20 a tonne in Shanghai trading.

And the rampant spread of the coronavirus in Brazil could push iron ore prices back above $US120 a tonne, according to Morgans analysts Adrian Prendergast, given strong steel production figures from China.’

Throw in a weak Aussie dollar, and Australian iron ore companies are earning around AU $150 per tonne from the stuff.

The question we should be asking is why isn’t the dollar higher on the back of this resurgence in Australia’s most valuable export?

It’s an interesting one.

Why isn’t the Aussie dollar higher?

As you can see in the chart below, the relationship broke down in late 2018. The black line shows the iron ore price (right hand scale) and the green line is the AUD/USD exchange rate.


The Rum Rebellion

Source: Optuma

[Click to open in a new window]

There are a few explanations for this.

In late 2018 the global economy shows signs of slowing sharply. The US Federal Reserve had tightened liquidity throughout the year. It was starting to bite.

Financial markets veteran, Greg Canavan reveals the critical factors that affect the rise or fall of the Aussie dollar. Understanding where it’s headed will allow you to adjust your investment strategy early for optimal performance. Click here to download your free copy of ‘Will the Aussie Dollar Enjoy a Post-Pandemic Resurgence?’ to discover where the Aussie dollar is likely headed towards the end of 2020.

When it realised what was happening, it quickly did an about-face and put its foot on the monetary pedal again. So did China, as it attempted to offset the effects of the trade war taking place with the US.

The iron ore price responded. But then it got a real boost from major supply issues coming out of Brazil, the world’s second largest iron ore producer after Australia.

The Aussie dollar didn’t respond though. The Aussie is very sensitive to global growth. It knew the 2019 rally in global markets was liquidity based. It also knew Brazil’s supply problems weren’t long lasting.

So the Aussie continued trending lower. After falling sharply thanks to the economic hit from the virus, it has recovered some of that ground. Meanwhile, Brazil is again given a boost to iron ore prices thanks to COVID-related shutdowns.

Still, if the global economy had decent underlying health, and China’s renewed demand for iron ore wasn’t based on yet another debt surge, I would expect to see the Aussie trading in the mid- to high-70 USD cent range.

Either the Aussie is a buy, or iron ore is a sell here.

I’m betting on the latter…

Let me explain.

The recent price surge largely relates to China’s efforts to stimulate growth again. The economy contracted by nearly 7% in the first quarter. We’ll find out today what the economic growth target is for the year, as the National People’s Congress gets underway.

The Sydney Morning Herald reports:

Most observers’ attention will be focussed on one key number — the economic growth target located in the annual “work report”.

‘”Any numeric target below 3 per cent is likely to be politically unpalatable,” said Capital Economics analyst Julian Evans Pritchard. “So if officials anticipate a more drawn-out recovery, they may prefer to scrap the target altogether.”

Politically unpalatable?

How about economically disastrous?

I know much of this year’s weak growth is really about the deep contraction in the first quarter. So the market will be focused on the rate of growth coming out of the slump, rather than the annual number.

But China’s debt growth is running at a double-digit pace. With such weak economic growth, it doesn’t take a genius to see the debt-to-GDP ratio blowing out even further. It’s already at 317% of GDP (as at 31 March) according to the Institute of International Finance.

And the situation is going to get worse in the years to come.

Why?

The West is about to turn on China

Yesterday saw the release of a potentially very influential report called, ‘Breaking the China supply chain: How the “Five Eyes” can decouple from strategic dependency’.

The Five Eyes refers to the strategic alliance between the US, the UK, Australia, Canada and NZ.

From the introduction:

For three decades, Western nations have pursued a policy of strategic engagement with China. We hoped that by trading and engaging ever more closely with China, it would open up and move towards democracy over time. In fact, if anything, China has become steadily more authoritarian.

This geopolitical endeavour took place in concert with the wider process of globalisation which shifted the international economic playing field.

These processes have carried costs. Jobs once done by proud working men and women who enjoyed fair pay, employment security, and good working conditions, have been lost.

This would be regrettable — if understandable — if these jobs had gone to workers in other countries who outcompeted Western producers. The situation becomes intolerable, however, when those jobs were lost to trade practices that were neither fair nor balanced.

As this paper helpfully illustrates, we have gradually arrived at a situation in which China has assumed overwhelming dominance of the export of certain manufactured products.

China has long shown a willingness to threaten the prosperity of those who question its activities. The seriousness of such threats grows when our economic system leaves us strategically dependent on China to keep our economy turning.

Worryingly, the report identified Australia as being the most dependent on China out of the five countries.

If this thinking gains traction, and the West begins to take back some of its manufacturing capacity, trade with China will slow. Economic growth will take another, structural leg down.

How China can continue its debt-based growth model under this scenario is anyone’s guess. If that’s the case, Australia is in real trouble…

Regards,


Signature
Greg Canavan,
Editor, The Rum Rebellion

PS: Learn about the critical factors that affect the rise and fall of the Aussie Dollar. Download your free copy of this special report: ‘Will the Aussie Dollar Enjoy a Post-Pandemic Resurgence?’


Greg Canavan approaches the investment world with an ‘ignorance is bliss’ philosophy. In a world where all the information is just a click away at all times, Greg believes we ingest too much of it. As a result, we forget how to think for ourselves, and let other people’s thoughts cloud our own.

Or worse, we only seek out the voices who are confirming our biases and narrowminded views of the truth. Either situation is not ideal. With regards to investing, this makes us follow the masses rather than our own gut instincts.

At The Rum Rebellion, fake news and unethical political persuasion are not in the least bit tolerated. It denounces the heavy amount of government influence which the public accommodates.

Greg will help The Rum Rebellion readers block out all the nonsense and encourage personal responsibility…both in the financial and political world.


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