Commodities Are Key as China Continues to Call the Shots

By: Money_Morning

Jon D. Markman writes: China ended up being the big story this month, as investors looked past Europe to the Far East for clues about what shape the global recovery - if you can even call it that - is taking.

Markets around the globe tanked yesterday (Tuesday) after the Conference Board revised its leading economic index for China to show the smallest gain in five months in April. The index rose just 0.3% in April, which was a significant reduction from the 1.7% gain the Board reported on June 19.

The news of the error contributed to the biggest sell-off in Chinese stocks in more than a month, and sent U.S. indices into a dizzying downward spiral. The Dow Jones Industrial Average plunged 268.22 points, or 2.65%, to close at 9,870.30 and the Standard & Poor's 500 Index tumbled 33.33 points, or 3.10%, to close at 1,041.24.

Indeed, that sobering episode stood in sharp contrast to the festive response that greeted China's announcement last week that it would proceed with exchange-rate reform.

Governments in Washington, London, Paris and Berlin have begged Beijing to ease its currency restrictions for years, but they were repeatedly rebuffed. The idea is that with the yuan kept artificially low via its hard peg to the dollar, Chinese goods have been unreasonably cheap on world markets. This has led to many gross imbalances, such as China hollowing out the industrial base of the West due to the unbeatably low cost of manufacturing there.

A revaluation of the yuan probably means that the currency's hard peg to the dollar is coming to an end, and the yuan will be allowed to appreciate against a basket of other world currencies - something much of the world viewed as a positive development.

If the yuan is allowed to rise in value, U.S. and European industrial manufacturers may find it just as cheap to keep factory jobs at home. China naturally has wanted to avoid this because it believes its stability depends on keeping all those jobs for itself. It has placated the West by spending the money received from those manufactured goods on the sovereign debt of U.S. and European countries.

So there's been this bizarre and ultimately destructive loop: We can keep borrowing from China so long as we keep giving them our jobs. It's a Faustian bargain.

China did allow its currency to rise in a similar announcement on July 21, 2005, but only by a relatively small amount over time, about 17.5%. The current revaluation may or may not be larger; it's impossible to tell, and there's nothing in China's comments that would allow us to know. Analysts at Capital Economics in London believe the change will be very slow, and might only amount to 2% by the end of 2011.

World markets will take the news as a positive for some but not all risk assets for two reasons: Investors will assume that it means China thinks it is strong enough to withstand the pressure of losing some Western jobs, and also commodities, which are priced in dollars, will get cheaper - which should in turn goose demand. It is also expected to drive the price of U.S. Treasuries down since smaller Chinese surpluses should result in weaker demand for our debt.

Yet, you need to know that a similar move by China back in 2005 really didn't do much for Western stock markets. Of course there were many other factors at work in the marketplace from July 2005 to March 2006, such as the U.S. housing boom and intensifying Chinese infrastructure build-out, but at the very least this could provide a starting roadmap for what could happen next.

So how did it go? In the following months following that decision:

•Gold rose dramatically.
•Silver fell for five weeks before rising strongly.
•The iShares FTSE/Xinhua China 25 Index (NYSE: FXI) rose for two weeks, fell for three months, then rose steadily.
•The iShares MSCI Brazil Index (NYSE: EWZ), which is driven in large part by commodity companies, almost doubled.
•The S&P 500 fell for three months then rose for five months.
•The U.S. dollar zigzagged.
•And copper was a big winner.
This time around, my expectation is that gold and copper and the resource-rich countries of Canada, Brazil and Australia, again will be winners from the change in the yuan.

More importantly, commodities - especially gold - will stand to benefit the most if the global recovery suffers another serious setback and equities continue to lose momentum.

Source : http://moneymorning.com/2010/06/30/china-commodities-2/

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