Material Evidence: Research

MATERIAL EVIDENCE
Sean Corrigan Chief Investment Strategist

Diapason Commodities Management Ltd
J U L Y 1 8

Research Strategies Solutions
MATERIAL EVIDENCE BY SEAN CORRIGAN
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2 Please refer to the risk and legal disclaimer at the end of the document.
DCM LLP is authorised and regulated by the Financial Conduct Authority
DCM SA is authorised and regulated by the Swiss Financial Market Supervisory Authority

Money, Macro & Markets

O Mirabile dictu! Just as Premier Li and a whole host
of other members of the Madarinate told us handily
in advance, the Chinese economy showed signs of
stabilization, nay, actual improvement in both the all-
important the GDP release for QII (7.5% v 7.4%) and
the industrial production data for June (9.2% v 8.8%).

And why not when, pressured from above to front-
load their outlays, local government expenditures
rose 16.4% year on year in the first half (and 6.1% in
June alone) while basic tax revenues (i.e., receipts not
including land sales) declined by around 4%?

Why not, again, when under the approach of Every
stimulus of a macro import begins with a micro step,
the credit spigots were once more liberally opened as
the quarter wore on, to the point that June combined
the second biggest jump in M1 on record with a 32%
yoy leap in shadow finance (admittedly that latter
calculated from a base which included last years
quarter-end liquidity shock)?

The first begs the question of quite how we are to
reconcile such actions with Lis brave words about
how the market must lead the way - reiterated in a
get-together with company bosses on Monday when
he came over all Friedrich Hayek by telling them
that:

The Chinese market is booming, the economy strong
[sic]. Enterprises are the mainstay of the market. The gov-
ernment must be firm in decentralizing and should aim to
make bold moves but must still allow business to respond
fully to the market. We should never assume that we few
at the top have more insight or power but should try to
mobilize the intelligence and creativity of the many
thousands of our people so as to create unrivalled
value.

As for the second development, it is all very well
and good perpetually bewailing the grand
mistake which the binge of 2009/10 entailed and
publicly vowing henceforth to stay off the hard
stuff, but if we are going to treat ourselves to a
snort for medicinal purposes every time we start
to sniffle, we can hardly be said to be properly on
the wagon, now can we?

In trying to parse the numbers themselves, as
ever with China, discrepancies abound. For in-
stance, a US-style quarterly-annualized count of
GDP supposedly shot from 6.1% to 8.2% between
the first and second trimesters, yet the increase in
overall electricity use (on a YOY basis) dropped
from 5.4% to 5.2% making that either a glaring
sign of fiddled numbers or glowing testimony to
a remarkable improvement in energy efficiency. I
wonder which it might be?

Similarly industrial production is said to have
gone from 8.6% annualized to 9.2% annualized,
yet power consumption in that area slowed from
5.3% to 4.9%, apparent oil demand edged up by
less than 1%, the CISA said steel consumption
showed no growth whatsoever to May, and. all
the while, rail freight tonne-kilometres fell 4.5%
over the first five months of the year.

Furthermore, the 3mma YOY output numbers for
a range of major industrial products came in as
follows: glass, +5.1%; cement, +3.8%; motor vehi-
cles, +5.0%; chemical fibres, 4.9%; non-ferrous
metals, 5.7%; steel, 6.6%, and coking coal, -2.7%.
No sign of any 7-, 8-, or 9-handles in there, you
will note.
Coming at it from another angle, H1 Nominal
GDP was supposedly up 8.5% on the comparable
period in 2013, with QI up 7.9% and QII a faster
9.0%. Though this is perhaps a bit racy, it is a
pace which is not entirely out of keeping with the
path of the SOE revenue data (5.9% in HI, split
5.6% QI and 6.2% Q2). The quickening sits a little
less comfortably, however, with the first five
month tally of sales of the universe of above
scale industrial companies which is running at
8.1% YTD after putting in an 8% clip during first
three months and 8.2% for the next two.
If problems lie as they usually do in Austrian-
style busts - up in the higher orders of production
where the SOEs tend to be bunched, an under-
shoot of business revenue to end-consumption
focused GDP is in no way anomalous (just look at
the GFC in the States where NGDP only dipped
3.2% peak-to-trough even as private non-financial
revenues plummeted by nearly a fifth) and the
specific application of a minus-1% PPI deflator
could even get us back to the (real) 9% given for
IP (ignoring the slower pace of sectoral increases
mentioned a couple of paragraphs ago).
What this does not do, however, is leave much
room for any more general price rises in the com-
pilation of the final numbers, even though their
presence is a constant source of complaint when-
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Micro, macro, mega...
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ever the locals are surveyed. Such use of artificially
favourable deflators to boost the real GDP number is
a charge that is commonly levelled against the NBS
by any number of respectable commentators, but that
is to take us into very murky waters, indeed.
In any case, what is clear is that, taking the numbers
at face value, debt levels are still rising with destruc-
tive rapidity in order to achieve even such spotty
results as these. Coming from the broadest perspec-
tive, Nominal GDP in the June quarter was an annu-
alized CNY4.7 trillion greater than that of a year a
year ago, but in that like period the stock of total
social financing outstanding mounted almost four
times as much, or by CNY17.7 trillion.
More narrowly, SOEs revenues in QII14 were
CNY2.6 trillion ahead of those in the equivalent
quarter in 2013 and overall profits were up CNY200
billion (though note that operating profits were effec-
tively unchanged), but liabilities showed a worrying
rise of no less than CNY7 trillion with finance costs
up 20.6% compared to the first half of last year.

And then there is the housing market, from whence
so much GDP boosting fixed investment arises and
wherein so much of Chinas distorted financial net-
work is entangled.

Again reading through the GDP release, one can see
that residential real estate equivalent to 7 months
worth of current sales lies available for purchase
while another 8 months is currently under construc-
tion. In terms of area, 544 million square meters
stands ready to welcome its proud new owners, with
another 566 million on the way. At a generous 100 sq
m per apartment, that would be enough to ac-
commodate 11 million families say 33 million
people or not far short of the entire population of
Canada straight away . Not bad when prices for
new homes are now falling in 55, and those for
existing-homes in 52, out of the 70 cities surveyed
by the NBS ,or when we hear that banks in what
is traditionally the hotspot of Shanghai extended
40% less mortgage finance in QII than in QI.

Nor is the squeeze confined to the housing mar-
ket, it seems. The latest report shows that the
amount of office space sold in the first half was
off by 2.8%, but that the receipts for such sales
were a whopping 12.1% lower, implying the price
of the average square metre fell by 9.6%, surely a
drop of sufficient magnitude to merit the epithet,
crash.

No wonder the response on Chinas bustling
commodity exchanges to all this good news was
for iron ore to drop as much as 4.6% and rebar by
3%, for coking coal to hug the lows, for PVC and
PE to sag, and for copper to suffer a fourth con-
secutive day of decline.

Scanning the Chinese press, the sense one has is
primarily that problems related to the nations
dysfunctional financial system and to the gross
lack of personal accountability in its exploitation
are being detailed everywhere.

The press is replete with accounts of the troubles
involving mutual guarantee companies in When-
zhou and Sichuan and commodity shippers in
Qingdao; with revelations of hefty losses and
even outright fraud at several insurers; with lurid
headlines about BOC/CITIC 'money launderers'
in Guangzhou. There are ongoing tales of woe for
steel execs, coal barons, and trust sellers; stories
of stockbrokers front running orders via their per-
sonal accounts and of real estate developers col-
luding with their local government buddies not
least by diverting billions from the affordable
homes programme. Even the official organs have
been openly wondering whether the motivation
of many of those who have flocked to take advan-
tage of the newly liberalized company formation
rules (capital requirement: 1 yuan!) is simply to
abscond or to otherwise leave behind unpaid bill
and wages. Warnings are coming out of HK (and,
in a lesser fashion, Taiwan) of multiple trillions of
Yuan in semi-licit, cross-border lending dressed
up as lease financing and there is the abiding sus-
picion that warehouse fraud has become en-
demic.

You name your favourite flavour of dirty laundry
and you will see it being aired in the media. Com-
mand economies, which do not permit private
negotiation and unhampered pricing to allocate
resources must always fall back on arbitrary se-
lection, on rationing, corruption and cronyism to
deal with scarcity and, under such circumstances,
the whole of society effectively becomes demoral-
ize if not actively criminalized. Nor is it for us to
condescend to those involved in this maelstrom
of twilight inventiveness. If the natural desire to
cater for ones needs and for those of ones de-
pendants can only be fulfilled according to a
twisted framework of rules and practices, the
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All Sourced:
Bloomberg, NBS
Not many 7.5s in here!
J U L Y 1 8


maintenance of Socratic standards of ethics and
candour can quickly become an expensiveeven a
self-destructiveluxury.

The problem here is therefore as much political and
institutional as it is economic and the attempt to
deal with the problems inherent in the situation
cannot take place other than from within a diseased
architecture which is, of course, intricately inter-
locking and which has hence becoming systemically
fragile. We can all carp from the outside, but it is a
tough task to have to remodel the entirety of this
house of cards without bringing the edifice crashing
down about the inhabitants ears.

Thus, not a day goes by without China's very own
"little Dutch boy" finding that he needs another fin-
ger to plug the new leak he caused by trying to
stem the previous puncture. The very real risk is
that he may soon run out of digits.

Against this backdrop, the regime is trying to
launch reforms while not allowing Lis so-called
'bicycle' economy to slow down so much it falls
over. Hence all the confusion about whether or not
the accursed 7.5% level for GDP is or is not a target.

Li himself must shoulder some of the blame for this
in that, having tried to wean people off their well-
conditioned obsession with the number (as a trigger
for further waves of ill-advised stimulus, if noth-
ing else) by talking of the need to consider the qual-
ity of growth, not just the quantity, and by alluding
to the fact that the datum is but a cipher for the
much more fundamental issue of whether a greater
number of people are or are not enjoying an im-
proved material standard of living (hence the em-
phasis on containing adverse changes in the cost
of living and of promoting both jobs and earned
income), he then started to panic when it was clear
that the economy was running well below this
thoroughly arbitrary threshold at the start of the
year

As the slightly fuzzy target therefore began to
recrystallise into a hard one, off we went once
more with a whole barrage of fiscal and monetary
pump-priming measures, as we said at the head of
this piece. But, now that that critical 0.1% accelera-
tion has been written - however dubiously into
the record books, it seems Li is back peddling the
old line that 7.5% plus or minus a bit is not the
issue as long as everything else looks OK. Fool me
once, Mr. Prime Minister.

A key point here is that Xi's increasingly rigorous
'corruption' purge - or, for the more jaundiced, his
ongoing internal coup - has totally paralysed deci-
sion-making to the point that it is hard to resist the
conclusion that all effort at meaningful reform has
been completely grounded. This has gone so far
beyond the bounds of what is routine that there
was even some speculation to be read that his
next move could come uncomfortably close to
swallowing up Li himself (via the dynamics of
Xi's factional struggle rather than through any
intimation of his deputys personal culpability).

No wonder Li is said to be screaming at officials to
get of their backsides and DO something in his
meetings with them

One element of Xi's extraordinary concentration of
power in his own hands is that he may be putting
the nation on a (precautionary) war footing out of
what he genuinely perceives as a heightened ex-
ternal threat. Here we must keep an eye on events
in HK where the fear of a US-incited 'colour revo-
lution' being instigated can only add to paranoia
over the unrest in the Muslim West and to a some-
what more justifiable sense of strategic encircle-
ment off Chinas eastern and southern coasts.

Perhaps the greater point, however, is that the
problems he has inherited are so entrenched that
every attempted solution becomes a new problem
in its turn, hence all the chopping and changing
and all the conflicting signals being generated as
to the true thrust of policy.

As for his crackdown, if the idea was to scare the
previously unresponsive local cadres into compli-
ance with Beijing's directives, he appears to have
completely overshot that particular mark. There
are no heads above the parapet now and hence
precious little appetite, further down the food
chain to take anything that might be construed as
bold action. We can just hear the Chinese equiva-
lent of Jay and Lynns timeless functionary, Sir
Humphrey Appleby, smoothly deterring his po-
litical chief from taking a given decision by slyly
characterising it as courageous.

All in all, Xi seems to have created his own 'tall
poppy' moment in true Chairman Mao fashion, an
outcome which is hardly helpful when even the
partial change in approach currently being imple-
mented is exposing and undermining so many of
J U L Y 1 8


The German loco is stuttering
even as the DAX goes
stratospheric
Source: Bloomberg
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Source: Bloomberg
Source: Bloomberg
No help here
Prices eating stimulus
What price
capex? Hiring?
Source: Bloomberg
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Source: dolarblue.net
2% a watershed?
Easy money = hot stocks
Source: Bloomberg
Source: Bloomberg
Still 50% to match the
Tech Bubble
Argentinagetting Mess(y) again
Source: Bloomberg
J U L Y 1 8


the shady practices which were previously propping
up the system.

As for the rest of the world, Europes recent disap-
pointmentstogether with Chinas turbulence
seems to be having an impact on the heretofore in-
vincible German industrial complex. Orders have
been spotty, output slipping, revenues down, and
sentiment beginning to turn negative to reflect this.
Not a combination guaranteed to provide any funda-
mental underpinning for the DAXs valuations, one
might suppose.
In Japan, too, the nonsense that is Abenomics is still
taking its toll. The data are still reflecting the noise
from the consumption tax hike, but it is clear that
industrial sales are in trouble, while inventories are
on the uphardly a combination to inspire the CEO
to go out and fund an expansion of either capital or
labour.
What is also clear is that much of the stimulus is now
being eaten up by the imported price rises, in terms
of a slowing real supply of money. Falling LNG quo-
tations and perhaps a fulfilment of the intent to
switch the nuclear reactors back on might just lend
some assistance here, but otherwise the omens are
unremittingly bleak.
Finally, in the US, some good news/bad news in the
form of industrial data which finished June up 4.2%
on a 3mma yoy basis, the fastest lick in a year, with
the manufacturing component up 3.5%, the best pace
since autumn 2012. IPalmost uniquely among the
advanced nationsis now demonstrably above the
pre-Crash peak even though, as we have shown with
several other indicators, this recovery is tardy by
the standards of all bar the previous one.

For us in the commodity world, the bad news
here comes in the form that this improvement
was already threatening to break the euro down
and the dollar up, even before the dreadful events
in the skies over Kiev added a further impetus to
the trade. Moreover, in terms of capital flows, the
US stock markethowever overpriced it may
beis again showing signs of leaving Europes
index behind, while the 10-year Bund-UST spread
is the highest in 15 years and in the top two per-
centiles of the range seen in the whole of the past,
post-Soviet quarter of a century.

From here, the merest 0.8% move would serve to
break the dollar TWI out of the shallow down -
channel in which it has traded since February,
allowing the major rising trend line from mid
2011 to re-establish command over the currency's
direction and so possibly foreshadow the start of
what could amount to a 12% rally to the top of
the past decade's range. That would NOT help
our cause.

Commodity Corner

The odd base metal aside, markets have been
struggling ever since the June highs but the oil
complex has been spared further immediate em-
barrassment by a combination of being heavily
short-term oversold and the knee-jerk reaction to
news of the Malaysian airliner disaster . We are
thus back to watching for renewed direction and
also to seeing whether the Brent contango can re-
establish itself and so reinforce thoughts of ample
supply.

Nothing quite so positive for Natgas, where $4
bcf has given way, eroded by the rapidindeed,
recordadditions to storage being reported week
by week and hardly helped by the current spell of
unseasonably cold weather which holds sway
across the centre and east of the US in what is
supposed to be peak air-con season. More pain
could easily eventuate.

In ags, some of the verve has gone out of the sell-
off partly because, again, things were their most
oversold in the entire record and partly because
there is already a useful short base to want to re-
alise some gains. Whether this is anything more
than a temporary respite remains to be seen, but
if the recent lows do not hold, a further quick,
loss of 10% could readily transpire.

Sean Corrigan

J U L Y 1 8


Source: Bloomberg
Source: Bloomberg
Source: Bloomberg
No shorts, no cash premium
Ranging (and compressing)
between the
larger trends
Topped at trend/HVP
Source: Bloomberg
$3.80 then $3.50 bcf the risk

J U L Y 1 8

12

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MATERIAL EVIDENCE

Sean Corrigan Chief Investment Strategist

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