Bubble trouble

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Mitchell Fraser-Jones 27 April 2016 Est. reading: 3 min read

Over the past few weeks, the Red Dragon has been breathing fire over its financial markets’ stability again: commodities from aluminium to zinc have been the subject of increasing levels of speculation from Chinese investors.

We know from recent history that China’s desire to embrace capitalism and free trade is resulting in some unintended consequences. There are now more than 100 million registered trading accounts in China – more than there are members of the Communist party in China (88 million).

Last summer, increasing participation from Chinese private investors drove the local stock exchange to bubble-like valuations. The episode ended badly with a crash from its peak in June 2015, that saw almost 50% of the stock market’s value being wiped off.

Although the excitement on China’s stock exchange appears to have cooled significantly recently, it seems that the party may simply have moved elsewhere. We are seeing increasing signs of speculative behaviour from private investors on China’s Dalian Commodities Exchange. Some commentators have gone as far as to blame Chinese ‘cabbies’ for fuelling the price of iron ore.

The chart below provides some context to the extent of China’s recent appetite for trading in commodity futures and the numbers are simply staggering. On some days recently, for instance, futures volumes in iron ore have exceeded the total amount of iron ore that China imported in the whole of 2015 (950 million tons).

There are reasons for caution on this latest bout of speculation in China.

First, we know from history that when bubbles burst, they do so in a damaging and unpredictable way. It is impossible to predict when and what will trigger their bursting, but it is inevitable that fundamentals will reassert themselves eventually.

Second, futures exchanges allow investors to use leverage which could exacerbate the extent of the turmoil when this activity starts to unwind. Already, the Dalian Exchange has started to increase margin requirements and transaction costs, in order to try to dampen enthusiasm, which suggests its end may already be close.

And third, perhaps most relevant to UK investors, is the impact that this activity may be having on the underlying price of the commodities that are being traded. We have struggled to understand what has caused the recent rally in commodity prices, which in our view does not appear justified by fundamentals. The emerging evidence of this commodity speculation provides, at least in part, an explanation for recent price activity. In turn, this has influenced the share prices of commodity-related businesses such as the miners, driving their valuations well-above historic norms.

Ultimately, this episode should serve as a vivid reminder of the difference between investment and speculation. As long-term investors, we invest on the basis of fundamentals, both macroeconomic and stock specific.

In the long run, fundamentals are the only thing that matter but that doesn’t deter speculation. At the other end of the investment spectrum, speculators engage in more frequent trading and focus on much shorter time horizons, often investing on the basis of momentum and sentiment rather than fundamentals.

One of the greatest investors of the 20th century, Benjamin Graham, expressed this point very simply: “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

Woodford Investment Management Ltd is authorised and regulated by the Financial Conduct Authority (firm reference number 745433). Incorporated in England and Wales, company number 10118169. Registered address: 27 Old Gloucester Street, London, WC1N 3AX.

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