China is the world's largest consumer of copper, and the country's most recent manufacturing data showed contraction for the first time in seven months. This, in conjunction with the possibility of tighter monetary policy in the U.S., creates a greater likelihood we will see declining demand for raw materials into the beginning of next year.
Chinese DataPreliminary readings in the HSBC Purchasing Managers' Index showed that manufacturing activity in China contracted for the month, falling below the survey's 50 line, which signals expansion. The report for May showed a result of 49.6, down slightly from the already weak April reading of 50.4. This follows the U.S. manufacturing purchasing managers' index, which dropped to a seven-month low of 51.9 for May, following a 52.1 reading for April. Globally, the broad trajectory toward weakness here is clear, and commodities markets are set to head lower in response. In addition to its substantial metals imports, China is also the world's second biggest consumer of oil.
This month's contraction in manufacturing activity signals that a major trend change might be in place, and this limits the prospects for construction building in Asia's developing city centers. The sector acts as the main driver of economic activity, so it is not surprising to see that declining manufacturing figures have contributed negatively to GDP growth in China. Chinese GDP dropped to 7.7% for the first quarter, slowing slightly from the 7.8% rate that was seen for all of 2012 (the weakest yearly pace in 13 years).
Federal Reserve StanceAs a compounding factor, this week's Federal Reserve commentaries showed that a growing majority of the voting membership sees a need to begin phasing out its third round of quantitative easing. Most of the Fed's attention has centered on the state of the labor market, which has shown steady improvement after bottoming out in 2009. The Fed has set an initial target unemployment rate of 6.5%, and is expected to begin raising interest rates once this threshold is reached. As we begin to approach these levels, investors should keep in mind that an end to quantitative easing would be bullish for the dollar, and negative for stocks and commodities priced in dollars.
Negative Outlook for CommoditiesThese considerations from the Fed have the dual effect of limiting commodities demand (by tightening policy), and in putting pressure on prices through inversely correlated assets. Specific comments from Bernanke suggested that the Fed is looking to slow the rate purchases in its bond-buying programs (currently equal to $85 billion in mortgage-backed securities each month). These actions will likely be taken in one of the Fed's next few meetings, as long as policymakers are confident that the nation's economy is recovering in a sustainable fashion.
After Bernanke's testimony, the dollar rose and the benchmark stock indices dropped. These trends are likely to continue as long as the Fed maintains this bias toward policy tightening, as increased monetary restrictions will weigh on demand prospects for energy and metals. Oil prices have seen rallies since April, but given the broader picture this looks to be a suitable area to start selling the commodity and shares in oil-producing companies. The dollar-positive trends created by higher interest rates (and removed stimulus) will create upside barriers in commodities prices, which have the added negatives of slowing demand in its largest consumer markets. Given the broad scope of each of these factors, it is unlikely we will see much of a recovery in oil and metals prices before the end of this year. At the time of publication the author had no position in any of the stocks mentioned. This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.