Barron's : Get Ready for China’s Commodities Crash

Get Ready for China’s Commodities Crash

China’s commodities rally has extended beyond its futures market into equities. But now the government is putting on the brakes—and investors could be hit hard.

China’s commodity futures markets are looking like its stock markets a year ago, when hordes of investors bet huge sums, setting the stage for a painful crash.

Money started to pile into metals futures in March, after China’s rubber stamp National People’s Congress expanded the country’s fiscal deficit to pump up growth, and approved reforms to reduce overcapacity in the steel and coal industries. Trading momentum got a further boost after China’s real estate market showed green shoots in the form of home-price increases in lower-tier cities.

“Most investors believe the government will do whatever it takes to meet its short-term GDP growth target,” says Bank of America Merrill Lynch strategist David Cui. And what’s a more direct bet on this phenomenon—also known as the “Beijing put”—than commodity futures?

By late April, daily trading volumes of five major futures contracts in steel and coking coal—essentially bets on an extended building boom—grew fivefold from a year prior. On April 21, when steel-rebar futures hit a year-to-date peak return of 53%, 225 million tons changed hands on paper, greater than China’s entire 2014 output of 215 million tons. On the same day, turnover of this futures contract alone reached 606 billion yuan ($93.5 billion), bigger than the combined transaction value of China’s two stock markets.

The commodities rally has extended beyond the futures market into equities. Across Asia, this year’s best performers are metals miners and steel makers. Australia’s iron-ore miner Fortescue Metals Group (ticker: FMG.Australia) has soared 76%, Korea’s steel maker Posco (005490.Korea) is up 42%, and India’s Tata Steel (500470.India) has gained 34%.

Last week, Beijing suddenly got cold feet. The Shanghai and Dalian Futures Exchanges increased transaction fees and warned repeatedly against speculative trading. Rebar futures dropped 7% from their April 21 high, but were still up 41% this year. Trading volume almost halved.

ANALYSTS ARE NOW WONDERING if this rally has fundamental support. Even if the government manages, as promised, to cut 150 million tons of steel capacity—which would trigger millions of job losses and cost billions of yuan in asset write-downs—China’s steel industry still has about 300 million tons of overcapacity this year. Steel mills have to keep their furnaces empty about 30% of the time, or we will see too much steel flooding the market again, according to Credit Suisse.

Next to its massive stock markets, China’s commodity futures market is still very small. Security deposits stand at only CNY400 billion, a fraction of the CNY1.7 trillion deposited in stock-brokerage accounts. That means a small inflow into the futures market can create a lot of trading momentum, says Merrill’s Cui.

China’s opaque asset-management industry likes leverages and simple narratives. Last year, it was a liquidity-driven stock bull, and this year, a cyclical recovery story. In the first quarter, China’s money supply grew 13.4% from the year prior, well above its gross-domestic-product growth rate. That money has to go somewhere. For China’s fund managers, if their bets pay off, they win big; but if they lose, Cui notes, it’s “the investors’ shirt anyway.”

>>> Medivation suitors need to account for oncology pipeline, Xtandi upside

MergerMarket

Medivation suitors need to account for oncology pipeline, Xtandi upside - sources

Medivation (NASDAQ:MDVN) does not have an incentive to sell if suitors do not take into account upside in its oncology pipeline and its marketed prostate cancer drug Xtandi (enzalutamide), a source familiar with the matter and industry bankers said.

On 28 April, France’s Sanofi (EPA:SAN) launched an unsolicited takeover proposal to acquire San Francisco-based Medivation for USD 52.50 per share in cash. The pharma company on Friday rejected the offer, which it said “substantially undervalues” the company.

A industry investor agreed the offer is low. He pointed to Abbvie’s (NYSE:ABBV) acquisition of Pharmacyclics, which was a competitive auction, as a comparable transaction, although he agreed that valuations in the pharma sector have come down over the past few months. In that deal, Abbvie paid USD 21bn to acquire Pharmacyclics, which had a partnership in place with Johnson & Johnson (NYSE:JNJ) on lead cancer drug Imbruvica (ibrutinib).

Medivation has Phase III assets that could get approved in a number of late-stage cancer indications. Furthermore, Xtandi, which is being marketed for metastatic castration-resistant prostate cancer (CRPC), is being submitted for approval in earlier-stage prostate cancer indications, which would increase sales of the drug, one of the bankers said.

Medivation is a scarce asset, the investor said, with the other product being J&J’s Zytiga (abiraterone acetate). A fair valuation for Medivation should be in the low to mid-USD 60s against the current USD 52.50 offer from Sanofi, the investor claimed.

Aside from Medivation there are few companies that could compete in prostate cancer, among these being Celgene (NASDAQ:CELG) and Incyte (NASDAQ:INCY), the source familiar said.

Sanofi’s approach, however, bodes well for Medivation, as the French suitor does not have a history of doing completely hostile bids, one of the bankers and the investor pointed out. It made unfriendly approaches to Genzyme and Aventis and both of those turned into friendly acquisitions, the investor added. Furthermore, Sanofi has a history with oncology drugs marketing Taxotere (docetaxel) for breast cancer and Jevtana (cabazitaxel) for prostate cancer, a second banker said.

Sanofi appears to be acting opportunistically during a temporary low in biotech valuations, the source familiar and one of the bankers said. The question is whether Sanofi’s approach will kick off a competitive auction process before a standstill agreement that Medivation has in place with Japan’s Astellas (TYO:4503) on Xtandi terminates in September 2016, they added.

Under the terms of the standstill agreement, Astellas cannot acquire more than a 5% stake in Medivation before the expiry date.

Any Medivation bidder would therefore be marketing Xtandi alongside Astellas, the bankers said.

One of the bankers questioned why an auction process has not already kicked off given that Medivation has been reportedly on the block for some time, and interested bidders for its oncology pipeline would have approached the company during this time. It hired former Citigroup investment banker Jennifer Jarrett to serve as CFO at the end of March, this banker said.

Astellas does not have to acquire Medivation, two of the bankers said, given that the Japanese pharma company gets the benefits of the partnership irrespective of any M&A. If anything, having a bigger partner is better for Astellas, the investor noted.

AstraZeneca (NYSE:AZN) and Pfizer (NYSE:PFE) have also been reported as possible buyers for Medivation.

A fourth banker said it was his understanding that Medivation believed it gave too much away or it did not get paid adequately in the Xtandi deal it struck with Astellas. This is the right time to sell, the same banker said, and a time to figure out who will pay the most.

Medivation and Sanofi declined to comment.

Evercore and JPMorgan are advising Medivation along with Cooley.

>>> Weekly Update

Weekly Market Update: Spring Cleaning

The last groans of the dismal first quarter were heard this week, as economic data and corporate earnings showed just how weak things were in the first three months of the year. Meanwhile, both the Fed and Bank of Japan held policy meetings that delivered zero new measures and very little in the way of color on the institutions' views of the malaise. Stocks sank through the week's end, while the dollar softened notably and oil and precious metals soared. However, the prevailing view in some quarters is one of good riddance to bad rubbish, as the decks are cleared for a nice move higher as the cold spring heats up. A hint of things to come were seen in the much improved European first quarter GDP data. US Treasury prices stabilized helping yields back off of recent 5 week highs, largely on the currents coming from the equity selling pressure. For the week, the DJIA lost 1.3%, the S&P500 dropped 1.3%, and the tech laden Nasdaq slumped 2.7%.

Annualized US GDP growth in the first quarter skidded to a two-year low of +0.5%, surprising nobody as Q1 showed seasonal weakness for the third year in a row. Business investment fell sharply, which did surprise many observers. On the positive side, residential investment and personal consumption saw much stronger-than-expected gains. In any case, the weak overall number was widely expected.

The mildly more hawkish notes in the FOMC statement seemed to leave the door open for a rate hike at the June meeting, although the preponderance of its very cautious language largely remained in place. The committee removed from the statement a warning about risks from "global economic and financial developments," saying that it was now monitoring such developments. For the third time in a row, Fed officials refrained from providing guidance on the balance of risks. The statement provided a mixed picture of the economy. It emphasized the improving labor market and noting that "strong job gains" likely herald a further pickup but acknowledged that economic growth "appears to have slowed." Fed Funds futures saw the odds of a June hike fall to 12% following the GDP report from around 21% after the end of the Fed policy meeting the day earlier.

The yen's big move higher in the last week of March and the first week of April saw USD/JPY break below the key level of 110, inspiring talk that either the government or the Bank of Japan would have to do something to bolster the economy and cool off the currency. Neither side has budged this month, with the BoJ resorting to verbal intervention and the government merely hinting that the sales tax might be hiked slightly less than planned (and only then because of the Kumamoto earthquake). The yen had come off its 18-month highs in the middle of April, thanks mostly to rumors that more BoJ easing could not be avoided, with talk of the bank authorizing more asset purchases or even lending to banks at negative rates. The BoJ authorized neither at Thursday's policy meeting and kept its policy stance unchanged. Markets reacted swiftly: the yen jumped and the Nikkei index slumped. By Friday, USD/JPY was at fresh 18-month lows around 107. There was ominous economic data out this week: March Core CPI fell by 0.3% y/y, the biggest drop since the BoJ launched its easing campaign three years ago.

Inaction from both the Fed and the BoJ has reinforced the weaker dollar trend and sent the Dollar Index lower every day this week. By Friday, the index was around 93, the lowest level since last June. Also on Friday, China's PBoC set the yuan at its strongest level since the beginning of April, and the daily fixing moved up by the biggest margin since July 2005. The weaker dollar helped propel commodity prices higher, with crude pressing on to fresh six-month highs. Brent rose to $48 and WTI was above $46. Gold prices rose 4% on the week to fresh 15-month highs, while silver hit 12-month highs. Note that certain industrial metals were hammered by new regulations implemented by the Chinese to curb speculation. Iron ore prices in China fell more than 10% after China's Dalian Commodity Exchange raised trading charges, vowing a clampdown on what it termed "excessive speculation."

Europe saw contrasting, perplexing data reports on Friday. The Eurozone slipped back into deflation in April, with prices dropping 0.2% y/y (core CPI was +0.8% y/y). Germany's EU harmonized CPI figure was -0.1% y/y. Meanwhile, the first reading of Eurozone Q1 GDP was +1.6%, a bit ahead of expectations. Advance GDP readings for Q1 were also very robust in France and Spain. The euro remained strong this week, but did not manage to top the 1.1450 level seen in mid-April.

Nearly 60% of the S&P500 component companies have reported first quarter results as of Friday, and the focus has been on lower profits and slower global growth. Overall earnings for the S&P500 are expected to decline more than 6% y/y in the quarter, and are still expected to decline even when energy companies are excluded from calculations. Notable exemption from this trend with earnings out this week included tech giants Facebook and Amazon, both of which crushed expectations on excellent rates of growth. In addition, consumer goods names Ford and Whirlpool both did strikingly well, even given the broader weakness in the manufacturing space. Apple was a story all its own: Cupertino saw its first q/q decline in revenue since 2003, thanks to lagging iPhone sales in China.

Troubled pharmaceuticals firm Valeant named a new CEO, tapping former Perrigo chief Joseph Papa to replace the embattled J. Michael Pearson. The choice is somewhat odd, given that Papa and Perrigo have recently faced their own challenges since Papa helped fend off a hostile takeover by Mylan last year. At his Senate committee hearing, outgoing CEO Pearson admitted that Valeant had been too aggressive in raising prices on certain drugs. In addition, Valeant filed its long-delayed 10K and replaced most of its board. Shares of PRGO closed out the week down 20% on the week on its CEO departure and on poor preliminary Q1 guidance.

Abbott Laboratories surprised markets by announcing a totally unexpected megadeal to acquire St. Jude Medical for a total of $25 billion, or $85/share in cash and stock. Analysts say the acquisition is very positive, as the deal fills an obvious lack of cardiovascular products like pacemakers and defibrillators in Abbot's lineup. The deal came as Abbott's merger pact with Alere got closer to falling apart. Last month Alere had deferred its annual 10K filing, citing some revenue recognition troubles. There was talk Alere could be facing defaults, and this week it disclosed that Abbott pressed the company to withdraw from its merger deal. For its part, Abbott said it would be perfectly capable of handling both the St. Jude acquisition and the Alere issue without problems. Shares of both ALR and ABT were down about 10% on the week.

>>> US Close Do-0.32%w S&P-0.51% Nasdaq-0.62% Russell-0.84%


Closing Market Summary: Indices End Off Lows as Heavyweights Underperform

The stock market ended a downbeat week on a lower note as the major averages surrendered to month-end selling pressure. Today's trade featured a slew of economic data, a downturn in oil, continued strength in the yen, and the underperformance of the heavily-weighted health care (-1.5%), technology (-0.9%), and financial (-0.7%) sectors. The Nasdaq Composite lost 0.6%, extending its weekly loss to 2.7% while the S&P 500 fell 0.5%, losing 1.3% for the week.

Today's session opened under selling pressure as weak international and domestic economic data dampened investor sentiment. On the home front, March PCE Price Index (+0.1%; consensus +0.1%) was largely in-line while Chicago Purchasing Managers Index (50.4; consensus 53.3) and the University of Michigan Consumer Sentiment Survey for April (89.0; consensus 90.0) each came in below consensus. Additionally, oil slipped out of the gate as WTI crude fell from the $46.76/bbl (+1.6%) price level.

The major averages briefly rebounded following comments from Dallas Fed President Robert Kaplan. The non-FOMC voter stated that a potential "Brexit" would be need to be factored into the Fed's rate decision when it meets next on June 14 and 15. This short-term rally faded as heavily-weighted health care (-1.5%), technology (-0.9%), and financials (-0.7%) weighed.

The major indices would lift from their lows in the final hour as utilities (+0.6%), consumer discretionary (+0.5%), telecom services (UNCH), and energy (-0.1%) tried for gains. Conversely, health care (-1.5%), technology (-0.9%), and financials (-0.7%) rounded out the leaderboard.

Biotechnology weighed on the health care space (-1.5%) as the sub-group moved lower in sympathy with Gilead Sciences (GILD 88.21, -8.79). The company declined 9.1% after missing top- and bottom-line estimates for the first quarter. The iShares Nasdaq Biotechnology ETF (IBB 267.95, -7.32) declined by 2.7%, extending its weekly loss to 7.1%. This compares to a loss of 3.0% in the broader sector over that time.

In the technology space (-0.9%), data storage names displayed relative weakness after Seagate Technology (STX 21.77, -5.13) missed bottom-line estimates for the quarter and lowered its third quarter revenue guidance below-consensus. Elsewhere, Skyworks (SWKS 66.82, -4.96) lagged other high-beta chipmakers after lowering guidance for its third quarter below analysts' estimates. Separately, Apple (AAPL 93.75, -1.08) extended its post-earnings losing streak, as it declined 1.1%. Since reporting on April 26, the stock has declined 10.8%.

Travel names demonstrated relative strength in the consumer discretionary sector (+0.5%). The sub-group moved higher following better than expected quarterly results from Expedia (EXPE 115.77, +8.78). Meanwhile, Amazon (AMZN 659.59, +57.59) ended its day on top of the Nasdaq 100 (-0.5%) after beating analysts' estimates for the first quarter. Conversely, retail names underperformed, evidenced by the 1.3% loss in the SPDR S&P Retail ETF (XRT 44.20, -0.56).

On the commodities front, WTI crude ended its day lower by 0.2% to $45.96/bbl. This represents a gain of 5.0% over the last week, and 20.0% in April. This compares to respective gains of 0.4% and 8.6% in the broader energy sector (-0.1%) over those periods.

The U.S. Dollar Index (93.04, -0.72) extended its recent losing streak as the yen and the euro gained against the greenback. The move higher in the yen followed yesterday's decision by the Bank of Japan to maintain its monetary policy stance. Investors had been looking for signs of monetary policy intervention given the recent run in the yen. On that note, the dollar/yen pair declined 1.6% to 106.40.

The Treasury complex climbed off its low throughout the day as the yield on the 10-yr note dropped from 1.87% (+5 bps) to 1.82% (UNCH). The 10-yr note ended at 1.83% (+1 bps).

Today's participation was above the recent average as more than one billion shares changed hands on the NYSE floor.

Today's economic data included Core PCE Prices for March, Personal Income for March, Personal Spending for March, the Q1 Employment Cost Index, Chicago PMI for April, and the final reading of the University of Michigan Consumer Sentiment Index for April:

  • The Personal Income and Spending report for March showed a 0.4% increase in income (consensus +0.3%) and a 0.1% increase in spending (consensus +0.2%).
    • The income and spending data were embedded in the advance estimate for first quarter GDP released yesterday, so that left the PCE Price Index as the focal point of today's report -- and that metric was supportive of the Fed's patient stance on raising the fed funds rate.
  • The PCE Price Index, which is the Fed's preferred inflation gauge, was up 0.1% month-over-month. That resulted in a 0.8% year-over-year increase, which was down from 1.0% in February and well below the Fed's 2.0% longer-run objective.
    • Core PCE, which excludes food and energy, was up 0.1%, as expected, in March. That left the year-over-year change at 1.6%, down from 1.7% in February.
  • The first quarter Employment Cost Index increased 0.6%, which was in-line with expectations, and followed in the wake of a 0.5% increase for the fourth quarter.
  • The Chicago Purchasing Managers Index (PMI) fell to 50.4 in April from 53.6 in March. The April reading was below the consensus estimate of 53.3 and disappointing primarily because the downturn was driven by a drop in the New Orders Index, which isn't comforting knowing there was also reportedly a big drop in the Order Backlogs Index.
    • The added disappointment in this report is that it is a second quarter reading. There is a lot of hope tied up in the idea that the U.S. economy is poised to rebound smartly in the second quarter after growing at a seasonally adjusted annual rate of just 0.5% in the first quarter. While the Chicago PMI is a survey, as opposed to hard data, it nonetheless sets a bad tone.
    • The dividing line between expansion and contraction is 50.0, so manufacturing activity in the Chicago region, which has important ties to the auto industry, was barely expanding in April. The soft start to the second quarter has reportedly made respondents more anxious about the impact of another rate hike in the next six months than they were in March.
  • The final reading for the University of Michigan Consumer Sentiment Survey for April checked in at 89.0 (consensus 90.0). That was below the preliminary reading of 89.7 and the final reading of 91.0 for March.

Monday's economic data will be limited to the April ISM Index (consensus 51.4) and Construction Spending for March consensus -0.5%), which will each cross the wires at 10:00 ET. 

  • Dow Jones +2.0% YTD
  • S&P 500 +1.1% YTD
  • Russell 2000 -0.4% YTD
  • Nasdaq Composite -4.6% YTD