These forecasts broadly reflect our Fair Value model after making some adjustments for our own judgements particularly around capital flows that may not be fully explained by commodity prices and interest rates. The key drivers behind our views are a fall in Australia’s commodity export prices and an unprecedented sharp negative widening in the AUD/USD interest rate differential as US rates rise sharply. Furthermore, we anticipate a reversal of the current trend for the USD to weaken against the other majors.
The key to commodity prices lies with China. China’s Chairman Xi recently identified pollution; poverty and excessive leverage as China’s key policy challenges. Our commodity price views have been based around the expected slowdown in China’s credit growth (particularly in the unregulated so-called shadow banking sector) firstly squeezing commodity speculators who currently hold substantial stocks of iron ore and secondly slowing investment particularly in major transport projects. These projects are typically associated and funded by local governments, usually outside the regulated banking sector. They place considerable reliance on funding from the shadow banking system. In addition, housing activity, which also partly relies on the shadow banking sector, looks set to remain quite flat over the next few years.
While these are clear factors which are likely to weigh on commodity prices, China’s anti-pollution policies have been supporting iron ore and coking coal prices. Small high polluting mines/furnaces have been closed down with some production moving to larger more efficient operations. These larger producers have been using a higher share of quality imported iron ore, effectively holding up import prices despite lower production. The dominant iron ore exporters – Australia and Brazil – have not been significantly lifting production to take advantage of higher prices and widening margins.