BRAIT CAPITAL MANAGEMENT TEAM

ELECTRONIC RESEARCH BOOK

Arm wrestling in the commodity market

I believe that markets often reflect the “netting off” impact of powerful opposing forces, and while the
resulting price action may historically have been fairly benign, this is actually very misleading. A
relatively small change in one of the opposing forces will have a dramatic reaction on future prices –
think of the sudden capitulation at the end of a marathon arm wrestle! The commodity complex, being
commodity prices themselves, “carry trade” commodity currencies and the basic materials sector
equities, appears to be in this situation currently. The arm-wrestling forces being the powerful flow of
liquidity (to the upside) and the deterioration in the outlook for near-term Chinese demand (to the
down side).

Follow the money

As I discussed in an earlier piece (“Tim Bond v. Hugh Hendry” 2009 08) the attempts by the Federal
Reserve to restart lending to households and business and hence pull the US out of recession have had
some unintended consequences. Market participants have sensibly directed the cheap and easily
available funds provided by the Fed towards already inflating assets, rather than trying to lend to highly
indebted households with declining incomes and impaired collateral. Bank lending in the US is
contracting year on year at the fastest rate since WWII!

The flow of liquidity is driving a powerful rally in risk assets of all kinds, but the epicentre is perhaps
Emerging Market equities and the Commodity Complex. Market participants have been mightily
impressed by China’s rapid transition from export-led growth to credit-fueled infrastructure driven
growth, with the reported GDP growth numbers back above the 8% target by Q2 2009 after the Q4 2008
collapse. Key price moves reflecting that are the big bounce in Copper, the Shanghai A share index
(“SHASHR”), carry trade currencies like the ZAR and AUD and basic material equities such as Billiton and
Anglo American.

In a normal economic cycle as a recession ends risk assets blossom in a period of cheap money and
rapidly improving expectations (Note as an aside the rally tends to happen despite stretched valuations
given the lag in forecast upgrades). This exurburance has normally quickly been curtailed by the
inevitable policy response to an actual improvement in the economy and resultant inflationary
pressures, higher interest rates. What makes the current flow of cheap funds such a powerful force is
the credible expectation that it will be of extended duration – no pre-emptive tightening by the Fed this
time round! The precarious household sector is exactly why money will be cheap for the forseeable
future. Indeed the development of a powerful feedback loop and hence a speculative bubble has a
significant probability. A further insight is that should some negative fundamental issues begin to cloud
the outlook for a particular sector or asset class, the pipe of liquidity will most likely quickly redirect to
less troublesome opportunities that can be inflated in an orderly fashion, rather than dry up completely.
 BRAIT CAPITAL MANAGEMENT TEAM
ELECTRONIC RESEARCH BOOK

Trouble in China

Recent announcements from Billiton and Anglo American’s management have both highlighted
concerns about commodity demand out of China for the rest of 2009 and into 2010. A massive build up
of stocks, both strategic and speculative, has boosted implied demand figures YTD. The SHASHR, an
excellent indicator of Chinese domestic liquidity conditions (there is only very limited foreign
participation), is in correction mode. While the SHASHR lead the recovery in commodity and resource
equity prices early in the year, it has decoupled once again, this time to the downside, as illustrated
below. The price of Copper and AGL, while no longer rising, are up around 40% more than that of the
SHASHR index since the lows at end Feb 2009.

Is this a temporary slowdown or something more serious? My sense is that the scale of infrastructure
investment in China is hugely overstated. That hundreds of billions could be spent on new projects
within a few months defies belief. My engineering knowledge is rudimentary, but it seems unlikely that
giant infrastructural projects can kick off without an extensive planning and approval process.

The answer, of course, is uniquely Chinese. The recording of GDP data in the US is based on actual
expenditure. In China, however, the disbursal of funds to SOE’s and regional governments by central
government is recorded as GDP growth, not the actual expenditure on projects themselves (China,
Bogus Boom? John H Makin, American Enterprise Institute for Public Policy Research, August 2009). If all
the funds disbursed are subsequently spent on projects, we are dealing merely with a timing issue,
albeit an important one given the scale of spending. However, our previous research (“Forgotten
 BRAIT CAPITAL MANAGEMENT TEAM
ELECTRONIC RESEARCH BOOK

Commies” 2007) has highlighted an endemic practice of SoE’s utilizing funds to speculate in equities,
real estate and commodities, rather than for their intended purpose. This practice reportedly has the
complicit backing of regional governments desperate for tax income unlikely to be provided by building
the likes of concrete freeways with no revenue generating model.

How long can the market continue to weather a sharp decline in Chinese commodity demand?

The chart above illustrates that the rate of change of the SHASHR has been an interesting leading
indicator for the commodity complex, here represented by AGL. My belief is that there is a substantial
long positioning in the commodity complex. Commodity ETF’s have just reached record AuM, despite
commodity prices still being substantially below the 2008 peaks (hence indicating massive value of new
fund investment). Given that, should the bad news out China continue, we expect a sharp reaction. That
said, I am not necessarily calling for broad retrenchment of risk assets, although that is possible. Rather I
expect the commodity complex to sharply under-perform other risk assets, irrespective of market
direction. The time frame for this view is short-term, some 3 – 6 months.