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Commodity Investing Shell Shocked
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It was a rough week for stocks and commodities as the S&P 500 ushered in its biggest retreat since November 2012, while commodities slumped 7 percent as China reported a weaker-than-expected growth rate of 7.7 percent. Gold futures tumbled to $1,395.60 an ounce and copper retreated 5.6 percent, to end the week in bear market territory with the largest decline since December 2011.

The news of China’s surprisingly slow growth rate put a chill over global commodity producers, which had previously enjoyed years of relentlessly strong demand and prices as the building boom in the world’s second largest economy went on unabated. But with China’s growth cooling, so too will its appetite for coal, iron ore, copper, nickel and many other commodities, calling into question the notion of a continuing commodity supercycle.

More worrisome than the short-term quarterly noise for commodity investors is the longer term shifts in China’s economy as it transitions away from its role as a manufacturing juggernaut. This past weekend, People's Bank of China Governor Zhou Xiaochuan was quoted as saying “We need to sacrifice short-term growth for the purposes of reforms and structural adjustments” and that the 7.7 percent first quarter GDP growth posted by China was “normal.” China’s leadership is actively trying to stimulate domestic consumption at the expense of export-led manufacturing growth. As well, the Chinese economy is transitioning toward an increased service orientation, further cutting demand for natural resources as labor and capital shift from manufacturing to services. This year will mark the first time that services will surpass industrial output in China.

At the heart of the transformation is China’s new leadership, led by President Xi Jinping and his early determination to restructure the economy. Also telling, was the fact that most of the posturing surrounding the release of this key economic data point was focused on concern over the rising property market, rather than on the relative weakness of the quarterly growth numbers. But the pace of economic growth in the first quarter marked the first time in two decades where four consecutive quarters of sub-eight percent expansion was recorded.

Environmental concerns, declines in the working-age population and income gains that are pushing up costs also suggest that Chinese growth may need to slow to a new normal of closer to 7.5 percent, rather than the greater-than 10 percent growth rates of the recent past. Adding to the concern over slowing Chinese growth is sharply dropping exports to the U.S. and Europe. Iron ore stocks are a third greater than average, piled up in three-storey mounds at the Qingdao port, while copper stocks at Shanghai’s bonded warehouses are double the usual average.

But so far, Chinese officials seem determined to stay the course on badly needed reforms for the economy. This spring a 20 percent “windfall tax” on property sales was introduced in an attempt to cool the overheated property market that is rife with speculators, and the government has promised further reforms to state-owned enterprises and the banking sector which is teetering under a mountain of bad debt.

Further impacting Chinese growth is a sluggish Europe, which is a much more important export market for Chinese firms than America. While the Cyprus issue appears to be on the back-burner for now and no new political flare-ups are in the offering, the Eurozone is likely to be stuck in the slow lane for the foreseeable future. Uncompetitive economies such as Greece and Italy are still shackled to the euro, which is too lofty to help them enjoy the boost from exports which comes from a devalued currency.

I have been reducing my exposure to the resources sector for some time now, and believe that the best vantage point is from the sidelines. Gold will likely slump in the years ahead, falling to $1,100 per ounce in 2014 and beyond, while base metal demand will continue to falter as China transitions to a service-led economy. Energy is the only bright light in the resource sector however energy tends to be a late-cycle performer when global economic growth is on an upswing.

The U.S. economy and stock market will rebound in the months ahead, driven by the renewed vigour of the U.S. consumer. Initial economic indicators are showing that the U.S. economy accelerated at 3.1 percent in the first quarter, led by the biggest gain in consumer spending in the past two years. I’m looking forward to a great 2013, but my gains won’t be coming from the commodity sector rather they will be coming from U.S. stocks that are poised for even loftier heights, driven by a resurgent America.

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