Chinese shares continued their downward trend last night with
the Shanghai Composite falling almost 6%. The CSI 300, the largest listed firms
on both the Shanghai and Shenzhen exchanges fell almost 7%. We wrote yesterday
on the enormous efforts of the Chinese authorities to stem the losses but it
appears panic selling has taken hold in a “dot.com-like” bursting of their
market. Now it appears the panic selling is starting to bleed over into other
regional markets. Hong Kong’s Hang Seng closed 23,516.56 down 5.8% and Australia’s
ASX200 closed 5,469.53 down 2%. Japan’s Nikkei closed $19,737.64 off 3.1%.
Other regional markets that suffered a bout of selling include Malaysia, Philippines,
Singapore, South Korea, Taiwan, Thailand…you get the picture. Every index
suffered rather large losses for the day. The fear of panic selling contagion
is real and as we stated yesterday, if the financial, economic and social
well-being of the world’s second largest economy becomes unglued, we can see
that selling pressure come to our shores and impact our stock market.
Precious Metals
I have written several times in the past about the virtues
of owning precious metals and platinum and palladium in particular.
My musings on PGM:
Since I started writing about these industrious precious
metals, both Platinum and Palladium are down approximately 16% and 13%,
respectively. Admittedly not the greatest of calls. That said, we are still
believers in the fundamental reasons for ownership in these metals and more
importantly, despite the declines in the metals and the overall commodity
space, we are still able to show gains for our investors in our metals trading
division.
So what’s happening to these metals?
Much of the decline is rooted in the decline in the Chinese
stock markets. We have written about the global supply and demand issues in the
past and will reiterate our thesis.
Demand Dynamics
On the demand side, prices for these precious metals are
largely tied to auto sales given their high concentration of usage in catalytic
converters. The global outlook for vehicle sales has been fairly robust of late
in spite of the global economic slowdown that we are witnessing. Global auto
sales in 2014 have been just under 80 million vehicles sold of which sales
in Asia have been leading the way. North America represents
approximately 27% of the worldwide auto market. Western Europe is 17% of the
global auto market and South America consumes 6%. Eastern Europe makes up 5% of
the global auto market.
Clearly the highest area of growth in auto sales has been in
Asia. Approximately 32 million vehicles sold in Asia is over 40% of global auto
production and China has been the driver of Asian auto sales at just over 18
million units sold.
Analysts had been expecting the global auto market to growth
at a 2% clip over the next several years as additional monetary stimulus in
Europe and Asia are implemented to assist their economies gain traction. The
recent events in China may be changing that. I read an article last night from BloombergBusiness
entitled, “China’s Stock-Market Rout Puts
Car Sales in ‘Meat Grinder’” In the article they make several good points
about the link between Chinese market participants and the auto industry. This
of course connects a direct line between the Chinese markets and the price of
PGM. The chart below shows NYSE Arca China Index (red and white candlesticks)
with a palladium overlay (black line). I haven’t checked the official “fit”
between the two but if you eye-ball it, one can see a rough correlation.
Due to the declining markets in China, “An increasing number of car buyers in China are canceling their
purchases and risking forfeiture of their down payments after a stock-market
rout that has erased about $3.2 trillion in value, according to Cui Dongshu,
secretary-general of China’s Passenger Car Association. “The plunging stock
market is essentially a meat grinder, shredding money meant for buying cars,”
Cui said in a phone interview. Auto sales fell last month for the first time in
more than two years, according to figures released by the group Wednesday.”
They go on to say, “Dealers
who reported softening demand as prospective buyers postponed their purchases
during the rally to punt on equities now face the prospect of lost sales in the
ensuing plunge. “The stock market is going down too fast, this is wealth
destruction,” said Song Yang, a Hong Kong-based analyst at Barclays Plc. “If
you’re losing so much money in the stock market, that dampens your desire to
buy a car.””
Auto makers are cutting prices in China to retain market
share but that seems like a futile effort if folks are just postponing auto
purchases until the market rout ends. Regarding pricing cuts and product-mix
revamping, “That’s done little to spur
demand, with a survey by MNI Indicators showing the proportion of consumers who
planned to buy a car shrinking last month. Inventory was at levels that
indicate low market demand for nine consecutive months, with June’s reading at
the second highest mark for this year, data from the China Automobile Dealers
Association show. Weak car demand is not expected to recover before September,
according to Cui, who also said it is unlikely for the government to roll out
any policy incentives to help spur vehicle demand in the near future. An
estimated $2.6 trillion of shares, or about 40 percent of the market’s
capitalization is now locked through trading suspensions by companies on the
two Chinese exchanges, according to data compiled by Bloomberg.”
Trading PGM
The way we trade the PGM space is a bit unique and has for
the most part sheltered us from precipitous declines in our portfolio. Even
with the financial pandemonium taking place in China, demand for the metals
exists and primary (mining) supplies are not able to meet that demand.
Much of the shortfall in supply is found in the secondary
recycling market. As automobiles are scrapped, the catalytic converter is
removed and the precious metals contained within (platinum, palladium and
rhodium) are extracted and recycled. By running a disciplined trading approach,
there are exceptional ROIC characteristics at play.
The fall in the commodity arena has also claimed the prices
of base metals. This is the key pricing variable for individuals that own auto
scrap yards. Given the lean margins and lower price points, the fall in these
metals is currently hurting those in the scrap metal space. Even with the
recent declines in precious metals pricing, the recovered auto catalyst holds
the greatest value per pound in all the material in the yard. So as
commodities and base and scrap metal in particular has been declining, we have seen a greater
willingness for these yards to sell the auto catalysts to help mitigate the
scrap metal downturn. For the precious metal recyclers that we run the hedge
book for, business has been accelerating.
Using a ratio of CTFC NYMEX open commercial long to short
contracts is useful in trading for the purposes of the hedge book. Taking this
ratio and seeing where it lies on the bell curve using a z-score gives us the
directional bias. When the one month commitment of traders’ algorithm rises
above 1.0, then the directional bias of the metal is higher. When it falls
below -1.0, then the bias is lower.
When buying recycled precious metals from the secondary
market, one can take advantage of buying the metals for a few percentage points
below the published bid for an instantaneous arbitrage sale. To keep the
trading margins intact, one much protect those margins against commodity risk.
When the metals bias is higher the trade is as follows. Keep
a naked position for physical delivery and protect your downside using put
options on the futures of the underlying metals. When the metals bias is lower,
take a forward sale locking in your physical delivery sale price and protect
yourself from an upward movement in the underlying using a call back spread
option strategy with a credit spread in place.
Being able to trade around your positions mitigates the risk
of just buying and holding the underlying metal (something we are still willing
to do) by providing a stream of income to offset the correction we are seeing
in platinum and palladium.
Bottom Line: We are
still believers in the underlying fundamentals of PGM ownership but understand
that market sentiment is unfavorable. That said we are still able to produce
returns on invested capital to offset any near-term market turbulence.
Joseph S. Kalinowski, CFA
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