Thematic Capital LLP

Managing Partner and Co-Founder - Former Global Head of Markets for HSBC and member of HSBC Group Executive Committee. A seasoned Global Macro investor with extensive strategic management experience, and excellent contacts amongst senior Hedge Fund managers, bankers and regulators. Mike serves as a non-executive director of Jadwa Investments. Mike has also served as a senior Advisor to Moore Capital.

Currency wars a reason to be positive on global resources

February 15, 2011 by Mike Powell   Comments (0)

There has been much news, debate and questions around the significant issue of relative exchange rates. Many argue, with some justification, that the RMB is being kept artificially weak to support China’s exports. This debate is at the heart of the tension between China the US, Japan and a number of other nations. There is no doubt that the level of foreign exchange is an important issue-but is it going to be the most important issue in the long term? Although there have been many instances of  tension around exchange rate issues, manifesting itself in the introduction of protectionist practices by sovereign states and currency intervention, the fact remains that there has never been a war over the level of a countries exchange rate.

Whilst this debate rages on China is mopping up large tracts of mineral and natural resources in many emerging nations, particularly Africa. Last year alone China spent USD32bn on resource based assets-a record for China itself and a figure that towers over all other nations and is larger than the total reserves of many.

The perceived wisdom for the reason behind this rapid acceleration of resource demand out of China, lays in the urbanisation and modernisation of their economy; developing an ever expanding manufacturing base and building infrastructure to support a large population with a fast increase in GDP per capita. There are endless stories of the number of new airports, roads, railways and shopping malls needed to support this growth and sustain the demands of a large, growing Chinese middle class. It is imperative for China to create wealth and meet the demands of the population in order to create social stability in  a nation that has more than its fair share of domestic instability.

This is certainly true and forms the origins for the belief in what many, such as Jim Rodgers, call the start of a super cycle in commodities.

However, additional events are creating more reasons to be long term positive on commodities and natural resources.

The financial crisis in 2008 has created an environment that is also supportive of commodities and fuelling its demand. Firstly it has underpinned the view within China that financial assets are not the most optimal use for its large reserves.  The logic of China holding the majority of its reserves in USD when it operates a constant trade surplus with the US is difficult to understand and not sustainable. It makes much more sense for China to reposition its reserves into those commodities that it requires to support the manufacturing base that creates the surplus, and those commodities critical to support domestic growth and development.  The impact on China of a large USD devaluation or default by one of the US housing agencies is a very serious  and a large move into real assets provides a cushion against that and the long term security it craves. China is therefore moving into physical commodities as a means of utilising its reserves and not just to fuel its current infrastructure needs. This has important implications for other nations, the significance of which by far exceeds the currency issue which currently preoccupies many. China has the economic clout to control a large part of the commodities that form part of the manufacturing supply chain. This will enable China to remain competitive even after its  currency appreciates. Indeed once its currency is allowed to float and it strengthens, that strength affords even greater buying power abroad. Note the impact an advancing Yen had on Japans ability to buy overseas assets in the 1980’s.Other countries that rely on manufacturing in competition to China, or own resources will have to respond to this threat; this is already starting to happen. For example;

Alarmed by China's move to cut shipments of critical metals used by high-tech companies and auto makers, Japan is scrambling to find alternative supplies, particularly by developing new mines abroad.
 (Wall Street Journal October 2010).


 As other nations become increasingly aware of Chinas grip on resources they will need to respond by securing access to commodities overseas. It will not be sufficient for a sovereign wealth fund to have a portfolio of interesting investments if they do not include the strategic assets required to support its manufacturing base or domestic infrastructure needs. This has the potential to push up the value of mining and mineral rights as other nations compete for scarce resources at the source.

The other reason that the financial crisis has helped commodities is the extent of QE, particularly in the US. Bernanke has a stated policy of forcing rates down; rates have fallen across the curve, quite dramatically. The intention for lower rates is to force up asset prices and avoid deflation. Logically investors seek a home for better returns up the risk curve and buy equities and other risk assets. However the normal transmissio0n mechanism, the banking sector is not lending due to its own problems caused by the financial crisis. As a result rates will have to stay low for longer. An unintentional consequence of this is that the opportunity cost of holding physical assets is much lower than historically has been the case, for example the opportunity cost of holding gold now is 1-2% as alternatives such as the US 5 year T bonds yields only 1.25 %.

In conclusion there are a number of converging macro events that are making commodities attractive, particularly at the source via mining, mineral and exploration rights. China’s real demand to support growth, the transfer of reserves form financial assets to physical assets, the inevitable and nascent response to this of other nations and the long term low interest rate environment  are a powerful cocktail  that only emerge once in a lifetime and us such provide a mixture of opportunity to some and a threat to many.