Reasons to be bullish on China commodities

The acceleration in the HSBC China Flash Purchasing Managers' Index (PMI) signals two things — the third quarter slowdown in the economy was just temporary and demand for commodities in the world's largest consumer will remain strong.

The flash PMI rose to 51.1 in October from September's final reading of 49.9, climbing above the 50-level that separates expansion from contraction for the first time since July.

The details were also positive with new orders gaining and input prices declining, setting the stage for a stronger fourth quarter after the hiccup of the last three months.

Of course, one should always be cautious about saying one month's data, and a preliminary reading at that, is enough to snap three months of declines, but in this case there is enough supporting evidence to suggest an economic soft landing is still the most likely outcome for China.

First off, the slowdown in economic growth in the third quarter to 9.1 per cent year-on-year was misinterpreted by some commentators as a sign of a serious slowing in the Chinese economy, especially since it was slightly below the consensus forecast.

It was a history lesson that the monetary tightening imposed over the prior year was working by moderating growth and taking the heat out of inflation, exactly as hoped for.

Annual rate

What was more important out of last week's economic data was that industrial output accelerated in September to an annual rate of 13.8 per cent, beating forecasts, while retail sales also beat the consensus, expanding 17.7 per cent in September in year-on-year terms.

When taken together with the recent flash PMI, the picture that emerges is one of an economy that underwent a much-needed dip and is now poised to remain an engine of world growth.

Picture the Chinese economy as a race car hurtling around a track. When driving at high speed around a challenging circuit, drivers will sometimes touch the brakes while cornering to shift the weight of the car and re-balance it.

This is what has happened with China, and as with racing there are still obstacles needing to be faced, such as other cars on the circuit called Europe and the United States, which may still crash or spill oil across the track or drive slowly enough to hold up the Chinese driver's progress.

Speaking of oil, this appears to be an area of weakness in recent China commodity data, in contrast to robust imports of copper and iron ore and to a lesser extent coal.

Implied demand rose a scant 1 per cent to 8.9 million barrels a day in September, with imports rising only slightly to 4.98 million barrels a day from August's 4.95 million. This confounded expectations that imports would grow and was one of the few arguments the bears could cite in saying the Chinese economy was slowing.

Fairly high

There are a few things to note on oil demand. Firstly prices were still fairly high when September cargoes would have been booked, making it likely Chinese refiners bought only what they needed and weren't rebuilding inventories.

Furthermore, the implied demand figure excludes movements in inventories and it's possible that these were drawn down in September, especially given some refineries were still undergoing maintenance.

JPMorgan analysts said refinery maintenance in the third quarter of 2011 exceeded that of the same quarter last year by 300,000 barrels a day, certainly enough to weigh on implied demand.

Still, crude imports will have to rise in the fourth quarter to sustain a bullish view of oil demand in China, the world's second-biggest user.

Nonetheless, the overall trend in Chinese data in recent weeks is that the bearish view of a hard landing is increasingly hard to sustain, especially if the rest of the world can stave off recession and the Europeans can produce a workable solution to their sovereign debt crisis.

It's still way too early to pump the bulls full of steroids, but there is a fundamental reason to think the recent decline in key commodity prices may have run its course.