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China Is Bringing Down Metals

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Waning strength in the Chinese economy could weigh on both commodities and the metals sector over the next few quarters. China's manufacturing sector contracted for a fourth consecutive month in April, according to the most recent HSBC/Markit purchasing managers' index. The final reading of the PMI for April came in lower than forecast at 48.1 -- a reading below 50 indicates contraction.

Both output and new orders contracted in April, and new export orders also fell back into contraction after a gain the previous month. "[The numbers] indicate that the manufacturing sector, and the broader economy as a whole, continues to lose momentum," said Qu Hongbin, chief economist for China at HSBC. He added that the government may need to take bold action to make sure the economy regains its momentum.

The government's push to cut its own investment and reshape the economy by tightening monetary policy is beginning to weigh on economic output. Economic growth slowed to an 18-month low of 7.4% in the first quarter of 2014, missing the government's target of 7.5% annual growth. Despite the painful consequences of reform, Chinese Premier Li Keqiang has repeatedly said policy would not be loosened drastically to counter any short-term dips in activity.

Emerging-market consequences
As economic growth has softened for China in 2014, the country's equity market, as represented by the iShares China Large-Cap ETF (NYSEMKT: FXI  ) , has lagged behind a broader index of emerging-market equities, the iShares MSCI Emerging Markets ETF (NYSEMKT: EEM  ) . This trend, alongside geopolitical tensions between Ukraine and Russia, has pushed funds out of equity markets and into safe-haven assets such as the Japanese yen and U.S. Treasury bonds. Developed-market equities have been resilient so far, continuing to trade near record highs, but investors' fear of putting money behind higher-risk assets like emerging-market stocks has prevented many equity markets from moving to new highs over the past few months.

Copper, an industrial metal, has fallen 7% in value year to date, primarily because of weakness in China's manufacturing sector. The metal is used in factory production, so it sees falling demand as production slows. As China's manufacturing sector has declined month after month, investors have dumped the metal. And as the metal has fallen alongside other industrial metals such as silver, companies that produce or mine for metals have lagged the overall market.

What it means for the mining industry
The SPDR S&P Metals & Mining (NYSEMKT: XME  ) ETF, which is sensitive to price changes in commodities, has had a lackluster year so far. The price of the index is relatively unchanged, while its performance relative to the overall market has been declining. Demand is being dampened by China's weakening production. This is surprising, considering the low interest rates in the United States -- here's why.

Although the Federal Reserve has remained committed to winding down its stimulus program and eventually raising the benchmark rate, fearful investors are reluctant to give up the safety of U.S. Treasury bonds, which accounts for the low long-term rates. Low rates tend to weigh on the U.S. dollar versus other currencies such as the euro and yen. And as the dollar falls, commodities such as silver and copper, which are priced in dollars, should rise due to inflation.

The fact that commodities, excluding oil, have declined this year despite a weakening dollar means that higher interest rates could magnify the effects of China's weakness. When investors finally come to terms with tighter U.S. monetary policy, they are certain to flee Treasury bonds. This could set off a chain of equity market declines, which could greatly hurt the already lagging metals sector. Metals and mining companies have not been a very profitable investment in 2014, and now is surely not the time to be a contrarian and invest in the intermediate future of the sector.

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