Base metals: higher with caution

(The following excerpt from The Commodity Refiner, a monthly publication of Barclays Capital Research, provides an overview of current base metals markets.)

A comparison of actual base metals prices in the second quarter with our forecasts shows that our figures were not far out. Lead and tin have traded bang in line with our average cash-price expectations made at the beginning of the quarter, zinc has been the underperformer, grading 2% below expectations, while aluminum and nickel continued to perform much stronger (+6%) than forecast. Copper also performed slightly better than we had expected (by 2%) in an environment of macroeconomic malaise.

As a result, the overall upward price trend on the London Metal Exchange (LME) remains intact, even though serious threats persist. Provided that deflationary threats can be fought off, the low-interest-rate environment and evolutions in exchange rates (relative U.S. dollar weakness) could make the current commodity price cycle different from recent cycles in that it becomes longer and peaks at, or even above, the recent cycle’s peak. A number of tough years have enabled supply-side restructuring while end-use inventories are low. The move higher is likely to remain hesitant, as a definite end of the economic downturn is not obvious.

Trending higher since multi-year lows in the fourth quarter of 2001, base metal prices are close to a critical point. It has been a hesitant move higher, and not an obvious one in light of sluggish demand conditions enhanced by political unrest. LME prices are now 30% above their long-term trough and around their highest level in two and a half years. There are reasons to believe that the top-end of the range has been reached. Mining companies continue to report tough market conditions and there are no obvious signs of a pick-up in demand, while the U.S. Federal Reserve is fending off deflationary threats. Fear of a deflationary scenario is evident in a strong bond market, and there is likely to be little ammunition left with which to fight these pressures, should they persist; Fed fund rates are at 45-year lows and extensive fiscal stimulus is already in place. The labour market and consumer confidence also point to a fragile outlook, while sharp falls in order data for U.S. durable goods are likewise discouraging.

However, the macro scene has been bleak for most of the past 12 months. The key difference now is that base metal markets have had time to adjust to these circumstances, and large supply overhangs have been greatly reduced. Production cutbacks (forced and voluntary) have taken place, end-user inventories are low, and stockpiles of refined metal have started to fall. If monetary and fiscal policies in the U.S. appear too aggressive, there is even a chance economic growth will surprise on the upside, which would paint a bullish picture for metals demand and prices. We believe the base metal complex will continue its overall upward trend started in the fourth quarter of 2001, though the move is likely to be equally hesitant as a definite end of the economic downturn is not obvious.

Unlike some other commodity markets, the base metals are early-cycle commodities, and usually start a new trend ahead of a turn in the economic cycle. This lead relationship derives from the fact that metals are key materials in durable goods manufacturing and construction, which together account for 25% of U.S. gross domestic product, with the price impact often enhanced by speculative involvement on the metal exchanges. Stronger base metals prices tend to raise hopes that the economic environment will improve. That was probably true, at least for a while, in the case of strong improvements in U.S. industrial production (IP) growth last year. Since then, however, base metal prices have remained firm, but IP growth has stalled.

Monetary easing is traditionally combined with metal price weakness. However, the cut in the Fed Fund rate in November 2002 encouraged speculative buying, while the maintenance of an easing bias during the first quarter of this year and a further cut in June also did not discourage positive involvement by funds on the LME on expectations that low interest rates would stimulate growth. It is alarming that interest rates have had to fall to such an extent. Clearly, there are serious worries over the health of economic activity. This has created concern that current base metal price strength is false and that the rally will face a sharp correction, as the combination of an extended period of easing monetary policy and rising metal prices has been largely unprecedented over the past 35 years. Indeed, the shape of the bond yield curve (very flat) does not suggest that interest rate markets believe an economic recovery is imminent but rather that interest rates will remain low for a long period of time. This is in line with anecdotal evidence that metal order books are thin at a time of the year (the second quarter) when demand is traditionally strong.

In reality, the uptrend on the LME has been driven primarily by systematic buying (chart-driven, rather than by speculative buying based on fundamental developments), and physical involvement has remained lacklustre, apart from the opportunities that currency moves have provided for consumers outside the U.S. This in itself suggests speculative long liquidation could bring prices back down to trend line rapidly. In addition, trading based on currency moves are likely to have a sustainable positive impact on prices only if the metal is required or if there are prospects of demand improvements, hence bringing forward the restocking cycle. If not, speculative exposure based on currency moves is also only likely to be reversed at some point.

The negative correlation of base metal prices with the U.S. dollar exchange rate has been a key factor in rising prices over the past few quarters, not least because of implications for supplies related to rising production costs. Indeed, falling production costs over the longer term have caused a decline in real metal prices, as well as prompting price peaks to occur at lower levels in each cycle. The length of the commodity price cycles appear to have become shorter as well.

Because of the extremely low interest-rate environment and the shift in exchange rates, the current cycle could turn out to be different from previous ones. Demand growth in China and high energy costs are factors that further support this view. In the current cycle, upward pressure on production costs could allow a price peak to reach at least the same level as in the previous cycle — approximately 12% above today’s price levels. But because of the extremely uncertain macro outlook, the path is likely to be drawn out and result in a lengthier cycle than before.

Other market forces that could indicate the stage at which the commodity price cycle exists have been behaving strangely of late. In particular, the diverging trends in bond yields, equities, and base metal markets during the second quarter have been unsettling. Bond market participants are signalling that an economic recovery is not imminent, while the equity market (along with base metal markets) is pricing in higher growth. The U.S. corporate sector produced first-quarter results ahead of (low) expectations, and profit forecasts for 2003 and 2004 have been revised higher for the first time in more than a year. While neither equity nor base metal markets are likely to prosper in a low-inflation environment, the combination of low interest rates, fiscal stimulus, and U.S. dollar weakness provide a robust platform. There are signs that these factors are having a positive impact on the U.S. manufacturing sector, which is likely to underpin metals prices.

Other segments of the commodity universe can also provide an indication as to where base metals are in the cycle. The Commodity Research Bureau (CRB) index is a broad-based commodity index that includes — in addition to base and precious metals — energy and soft commodities (17 commodities in total). The CRB index has been in a sharp uptrend for
a year but is about 12% below its peak, seen in 1996. This index has already surpassed the peak of the previous cycle by 7%. History suggests that base metal prices tend to follow the lead of the CRB index.

Bulk raw materials such as coal and iron ore, on the other hand, are considered late-cycle commodities and often peak at the same time as early-cycle commodities (base metals) bottom. This lag primarily relates to the inventory cycle in the steel industry. However, this year’s annual contract negotiations showed a sharp rise in iron ore prices (+9%), and like base metal prices’ relationship with bond and equity markets, the current relationship with bulk raw material prices is unusual. Unprecedented imports of iron to China partly account for this, though these imports could also be an indication that a new cycle for the base metals has only just begun.

A deflationary scenario in the U.S. is far removed from our base-case forecasts. The International Monetary Fund (IMF), too, has stated that the risk for deflation in the U.S. is minimal. Nonetheless, inflation is low and the risks cannot be ignored entirely, with the U.S. labour department reporting that a measure of core inflation has dropped to near 37-year lows. The Fed’s view is that even though the threat is minor, it is serious enough for it to be closely watched and possibly acted upon. The Fed has also said that there is no credible possibility it could run out of monetary ammunition to deal with any deflation problem but warned that it has little institutional experience in dealing with deflation.

Deflation

Deflation is certainly a greater threat in the eurozone (not least in light of the appreciation of the euro and inflexibility in regional monetary polices), and several Asian countries are already under deflationary pressures (Japan, Hong Kong, Taiwan and Singapore). A recent study by the IMF concluded that while at least a limited period of negative headline Consumer Price Index (CPI) inflation cannot be ruled out in the U.S., there is a considerable risk of mild deflation in Germany.

Although deflation might be caused by either demand- or supply-side factors, the principle impact is lodged firmly in the former. Deflation redistributes wealth from debtors to creditors, and the marginal propensity to consume among the latter tends to be lower. Given the Keynesian concept that wages are sticky downwards, real wage costs will rise, leading to declining profits and unemployment. In general, deflation is associated with rising debt burdens and bankruptcies, social and political unrest, financial crises and significant output volatility. More generally, the deflation in Japan has been associated with sub-par performance over several years.

In short, deflation is a bad thing; it spells lower aggregate output, job losses and difficulties for companies as the debt burden increases. While it can be beaten by economic policy, the use of such policy has implications for the future of the economy. Moreover, there is the impact of budget deficits on currencies, which tend to be devalued, raising the future cost of borrowing. The use of monetary policy has the problem of lags; it is not stimulative in the short term and may therefore exacerbate and destabilize an economic situation rather than get one moving. For example, the lags associated with monetary policy might mean that its impact will only be felt once an economy has turned the corner from deflation and is moving into recovery, creating the very problem of inflation that monetary policy is intended to prevent.

Deflation is not just a reduction of the general price level, it is a reduction of the general level of output. This means that as far as they are part of the general economy, base metal markets will see demand fall. But what happens on the producer side? If we make the fairly safe assumption that producers are debtors, then the burden of their debt will increase, and this will be particularly acute since even the nominal value of their income will be reduced — which is the very apotheosis of deflation. For producers, the problem is exacerbated by wage rigidities in the face of falling revenue, meaning that their profitability will be eroded.

Western Europe is a major consumer of all base metals (consuming 26% of aluminum, 24% of copper, 27% of lead, 40% of nickel, 24% of tin, and 24% of zinc), and exposure of this magnitude will obviously present a danger if Europe’s largest economy falls into deflation — and as the IMF points out, Germany is sliding toward deflation with no measure to act as an effective brake.

Key economic indicators

Industrial production in the U.S. rose by 0.1%, month over month, in May, compared with a 0.5% month-over-month decline in the previous month. Although this figure might look encouraging, the longer-term trend looks somewhat worrying. May saw a year-over-year decline of 0.8%, representing the second consecutive reading in negative territory after nine consecutive months of improvement.

The IP cycle is the prime driving force for metals demand and prices, and unless further easing of monetary policy has a positive impact on economic growth, base metal prices will remain pressured in the near term.

The latest data on Japanese industrial production fell 1.2%, month over month, for April. Our economists expect industrial production to come out roughly flat in April-June on slowing growth in exports and a weakening recovery in domestic demand but to resume its moderate upward trend from July to September onward with an accelerated economic recovery in the U.S. and a continuing trend of recovery in domestic capital investment.

Japanese manufacturing activity also contracted in May, suggesting that a pickup in April was a blip and that the overall trend remains down. The main index slipped to 49.0, from 51.0 in April, which was the first time that the measure had moved above 50 (expansion) in eight months.

There have been a few positive economic data releases from the German region of late, though this is something our economists refer to as “noise” rather than signs of a new and positive trend. Instead, there is a moderate threat of deflation in Germany (according to the IMF), which, if realized, would be a far from supportive environment for metal demand growth. German IP for May contracted a larger-than-expected 1.0% month over month, but registered a small positive figure year over year.

The Purchasing Managers’ Index Manufacturing Surveys in the eurozone also came in weaker than expected for May, indicating that the manufacturing sector is contracting in the euro area, and another interest rate cut by the European Central Bank is widely expected.

As in late 2002, the Organization for Economic Co-operation and Development’s leading indicators of economic growth improved a little, according to the latest data for April. The composite leading indicator (CLI), designed to provide early signals of turning points in economic activity, rose modestly (6-month rate at +0.1%) for the whole OECD region. The 6-monthly rate of change in the U.S. CLI improved from -1.5% in March to -0.3% in April. The equivalent number for Japan showed further deterioration, while, perhaps surprisingly, European changes were generally positive, with German CLI at +0.6% in April. The Conference Board’s leading indicators rose 1.0% in May, well ahead of expectations and their largest rise since December 2001. Eight of the 10 indicators that make up the index showed improvement, including money supply measures, consumer confidence and stock prices. This provides encouraging signs that economic conditions are starting to improve in the U.S.

The ISM index jumped to 49.4 in May from 45.4 in the previous month. This bounce-back is stronger than that seen in the last Gulf War, when the index rose more gradually (about two points per month for five months). The two forward-looking components — new orders and vendor delivery — both rose above 51.0. Out of a survey of 20 industries, 11 reported growth in May.

The data released for the first two months of the second quarter are consistent wit
h modest GDP growth in the 1.5-2.5% range. An ISM index reading of 55 by the next quarter would be consistent with real GDP growth of about 4.0% in the third quarter.

Data for U.S. durable goods orders for May were again not pretty for metals, with the metals component of the index falling both from the previous month and over the year.

While the headline figure declined 0.3% month over month and 2.7% year over year, the metals component fell 0.5% and 8.0%, respectively. This was even worse than April’s hefty 6.9% year-over-year decline.

The overall relationship with metal prices is strong and would suggest a near-term correction in metal prices before the overall upward trend that we expect resumes.

The USGS primary metals price leading index’s 6-month smooth growth rate (which measures the near-term trend) rose sharply to +1.7% in May from a revised -2.5% in the previous month. As a growth rate above +1.0% signals an upward trend for future growth in metals prices and activity, according to the U.S. Geological Survey, we would regard the latest data as encouraging for base metal prices.

The aluminum mill products leading index increased 0.7%, with more than half of the increase attributable to increases in construction contracts for commercial and industrial buildings and new housing permits issued at the beginning of the second quarter. Also, the growth rate of the USGS’s inflation-adjusted value of inventories of U.S. non-ferrous metal products rose in May, improving to -11.2% from -14.1% in the previous month. While these data provide evidence of some re-stocking, the level of end-use inventories still remains low by historical standards. As a result, if economic activity was to pick up faster than expected, metals demand would likely be boosted by a degree of restocking.

Retail sales rose by 0.1% in May, fairly close to expectations. Excluding autos, sales were also up, by 0.1%. These numbers are consistent with real consumption growth of about 2.0% in the second quarter. However, the preliminary University of Michigan consumer sentiment index for June was much weaker than expected, falling from 92.1 in May to 87.2 in June. Nonetheless, consumer confidence remains a key hurdle to the outlook, especially taking into account the high level of private debt.

Mining equities

As with the base metals, mining equities have traded generally higher since the fourth quarter of last year, albeit hesitantly. With equity markets in general performing well since March (the Dow Jones industrial Average having produced its best 3-month performance since the final quarter of 1998), investors seem especially keen on positive exposure to the metals and mining sector in an attempt to benefit from an eventual rebound in economic activity.

Mining equities tend to lead LME prices; hence further equity gains are likely to fare positively on LME sentiment.

Fear of deflation and comments from the Fed that it would consider buying bonds and equities should it run out of ammunition to deal with deflation threats have helped push U.S. 10-year bond yields to historical lows. The diverging trends in bond yields and metals and equity markets evident during the second quarter are unusual. While equity and metals market participants are hopeful of macro improvements, the bond market signals that economic growth will be slow and that interest rates are likely to remain low for an extended period of time.

The determination to fend off deflationary threats, however, leaves the potential for economic growth to surprise on the upside, which would likely help restore historical market relationships to normal (benefiting base metal prices).

U.S. dollar weakness has been a key positive for commodity prices over the past couple of quarters. In light of this, there have been a number of corporate announcements of late, highlighting negative implications on corporate profitability and production from unfavourable currency moves.

However, key to the base metals will be economic growth, and even if the dollar regains strength, this would likely reflect macro improvements, which we would regard as a key positive development for the base metals.

— Kevin Norrish is head of commodities research/energy and Ingrid Sternby is the base metals analyst for Barclays Capital Research. The opinions presented are the authors’ and do not necessarily represent those of the Barclays group. For access to all of Barclays’ economic, foreign-exchange and fixed-income research, go to the web site at barclayscapital.com. Queries may be submitted to the authors at kevin.norrish@barcap.com and ingrid.sternby@barcap.com