Business Week ran a very funny piece recently, highlighting hilarious but mathematically strong correlation-causation relationships. For example, did Facebook contribute to the destruction of the Greek economy between 2005-2008? The Facebook user-base rose exponentially through that period, perfectly matching Greek treasury yields, which also rose exponentially.
It is easy to find such unconnected but highly-correlated data series. Human beings like looking for patterns and because we look for them, we often find spurious ones. Even when correlation is clear, it isn't always easy to find causation. And, even when correlation and causation exists, relationships can change.
There are always big correlation-causation relationships playing out across the global economy. But when dealing with something as complex as that, there is a need to be careful. The links must be both mathematically and logically strong.
One of the biggest correlation-causation relationships is as follows: As China's growth rate has slowed, her exports have slowed and global industrial metal prices have dropped. Will Chinese growth continue to "taper" down and Chinese exports remain weak? If so, will metal prices also continue secular downtrends?
Mathematically, the relationship is strong. Chinese growth has fallen for two years (eight quarters) and industrial metal prices have fallen through the same period. Logically too, the relationship seems strong.
China is the world's largest consumer of primary metals and the world's largest exporter. Apart from domestic metal consumption, China also imports metals in order to export value-added metal-intensive goods. Japan and South Korea have both successfully used this strategy in the past. China's GDP growth is slowing in part because export growth has slowed leading to weak metal demand.
A rupee trader cannot bet on China but there are many possible plays on metal prices. There are commodity futures trades of metals such as iron, copper, zinc, tin, aluminium, lead, etc. There are also equity or equity derivatives positions available in miners and metal producers.
What is the utility of the Chinese GDP-metals correlation for an Indian trader? If it exists and holds, it is an additional indicator. In situations where metal price trends pause or reverse, this may be very useful.
For example, let's assume a trader shorts metals on the commodity exchanges. Now, Chinese growth continues to slow but metal prices stabilise or move up. Should the trader stay in, increase short exposures, or exit? If Chinese growth is weak, he may assume this is a temporary price correction and use it as an opportunity to increase short positions. In the obverse situation, if Chinese GDP picks up even as metal prices dip, he should seek to book profits. There are chances the metal downtrend is close to a bottom because rising Chinese demand will push up prices.
Historically, metal prices and Chinese export growth rates have been very closely tied to Chinese GDP trends. Will this relationship remain undisturbed in future? It's tricky. China hasn't seen a slowdown of this nature for many years.
China is undergoing a major economic transition and consensus suggests it could slow further. It is changing economic focus to give domestic consumption a larger share in economic activity. That may change Chinese metal consumption patterns in unpredictable ways.
At the same time, China remains the world's largest exporter. A significant uptick in Chinese growth will always have a strong export component. Hence, if global growth picks up, so will Chinese metal consumption, and Chinese GDP as well. There could be leads and lags in these relationships however.
Indian metal prices reflect global trends. We've seen the slowdown reflected by the fact that most metal producers have lost ground and many are close to their respective 52-week lows. Quite a few miners and metal producers are available in the stock futures segment -for example, Tata Steel, Hindalco, Jindal Steel, Sail, Sesa Goa, NMDC, etc. The NSE Metals Index is down 32 per cent year on year while the Nifty is up 13 per cent.
The Indian trader could short metal commodity futures directly, or short the stock futures of metals producers, or a mix of both. Choice of trades would be dictated by specifics of leverage and margins.
Ideally, the trader would want to rollover profitable positions from settlement to settlement while moving stop losses down with dropping price. The metal cycle could continue to play out over a long period. But if you dabble in metals, keep an eye on China as well as prices in the global metal markets. A bounce in Chinese GDP could precede a bounce in metals prices.