Outlook for base metals

Base metal prices saw their first peak in April, and have retraced 15% since then. Before the second leg of our expected twin-price peak starts to form, we expect further price falls.

We also believe that clear evidence of a cooling Chinese economy will cause a period of de-stocking, while the perception of a move forward in the interest-rate cycle and consequent U.S. dollar strength are also taking the shine off metal prices.

Signs of strong leading-demand indicators topping out, together with deteriorating technical chart patterns, are likely to discourage fresh long exposure to the industrial metals at current prices by investment funds.

However, a global economy experiencing its strongest 2-year pace of growth in almost 30 years against low metal inventories and deficit base metal markets is expected to drive metal prices higher again, to their ultimate cyclical peak in the period between the fourth quarter of 2004 and the first quarter of 2005.

During periods of extreme supply tightness in the past, base metal prices have shown strong resilience to adverse currency movements and slowing growth, which supports our view of a second peak.

Medium- to long-term trends in Chinese metal demand remain positive, partly because of investment in the power sector and partly because of ongoing consumer demand growth.

Previously, we raised our long-term base metal price forecast on the basis of a structural shift higher in metals consumption (driven by emerging markets, primarily China) and low investment into new output capacity. For the nearer term, we maintain our vision of a twin price peak, as evident in past commodity cycles, but have modified our quarterly price profile. We have lowered our near-term price forecasts because the profit-taking we expected through the third quarter happened earlier. But we have also lifted our 2005-2006 price projections.

The first of the twin price peaks occurred at the beginning of April. Price volatility increased through May — a feature we expect will continue over the next few months and take base metal prices lower over this period on seasonally weaker demand, Chinese de-stocking, and more diverse trading strategies by funds. Macro-oriented funds highlight the move forward in the interest-rate cycle, a stronger U.S. dollar, moderation in some leading indicators and steep falls in freight rates as justification for liquidation of long positions in the base metals. In addition, technical chart trends have deteriorated, encouraging technical funds to take profits and possibly take on short positions.

Against the backdrop of synchronized global growth and the strongest phase of growth the global economy has seen in almost 30 years, we believe the Northern Hemisphere summer period will be followed by another leg higher in metal prices — the second of the twin peaks. We believe this rally will be driven by real physical tightness, as primary metal inventory levels are running extremely low.

Because of seasonal and typical cyclical patterns, we expect the timing of the next upward move to vary across the base metals. For example, we expect lead to peak ahead of most others (in the fourth quarter this year), based on expectations of a pick-up in winter battery demand, and we also forecast that the lead market will be in a modest surplus next year, in contrast to all other base metal markets. We believe zinc will be the laggard in this move higher, which would be in line with previous commodity cycles. Zinc prices, unlike those of most other base metals, are still held back by large stockpiles of refined metal, but as these are being gradually depleted, we expect a more sustained rally through the first half of next year. We believe nickel will continue to lead the base metal complex. Nickel prices are now consolidating their losses since their peak at the beginning of the year, and we see this as an encouraging sign for overall metal price prospects further out this year.

We continue to favour the base metals with particularly tight supplies, and expect copper and tin to perform particularly well as the second of the twin peaks starts to form. We also believe zinc and aluminum now have the potential to see strong price gains. These two metals have been underperformers in this particular commodity bull market, and their supply-side fundamentals will likely improve further to justify fresh price peaks.

We forecast that the second peak (in the first quarter of 2005) will be higher than the first one, on an aggregate basis — partly because the first peak was lower than we had expected, and also because we believe fund-driven profit-taking on several “big picture” macroeconomic concerns is overdone in relation to market specific fundamentals. These concerns relate primarily to the demand outlook in China and the U.S. on tighter monetary policies and the impact on base metal prices of a stronger U.S. dollar and high oil prices.

China

Unsurprisingly given its dominance in metal consumption growth in recent years, China remains the major talking point in the world of commodities. Will it have a hard or soft landing, or will it even land at all? In line with the Chinese government’s desire to slow gross domestic product growth from 9% to 7%, our Asian economists expect growth of 7-7.5% in the second half of 2004, with both investment and import demand set to slow. Indeed, sharp falls in freight rates, as well as declines in Chinese physical metal premiums, suggest a slowdown is now reality.

However, recent macro data give comfort to the view that the Chinese economy is slowing gradually rather than abruptly. There are now signs of bank lending slowing, which should feed through to softer metal order books, particularly after further credit tightening in April. In May, year-over-year growth in renminbi bank loans eased to 18.6%, compared with 19.8% in April. Chinese industrial production growth rose by less than expected in the first five months this year, at 17.5%, compared with 19.1% growth in the first four months of this year. And crucially, growth in China’s fixed-asset investment fell to 18.3% in May, which is nearly half the 34.7% growth seen in the previous month. As a result, and mirroring nickel through the first half of this year, we believe other base metals are also vulnerable to a period of de-stocking over the next few months.

However, our recent trip to Shanghai for the Shanghai Futures Exchange’s First Derivatives Conference provided some comfort for our positive view on medium-to long-term metal demand and prices, for several reasons:

— Chinese officials have identified key macroeconomic problems (primarily related to overheated investment, projects that are too large, and an excess of new construction projects) and are taking measures to rectify them, which should prevent a sharper slowdown later.

— These measures will lead to a reduction in overcapacity in some primary metal production, notably in aluminum.

— The Chinese government is encouraging investment in some sectors, such as power, which is the largest end-use sector for copper in the country. Power constraints, which have had restrictive implications on both primary aluminum and zinc production in particular, are getting worse, and structural energy shortfalls are not likely to ease until 2006.

In addition, China re-exports a substantial share of its metal consumption as manufactured goods. This share of consumption is largely immune to any domestic slowdown in activity, and we do not expect that to slow until U.S. interest rates have risen sufficiently to reverse growth in U.S. spending. And investment in China by international companies is showing no sign of abating. Foreign direct investment was up 11% in January-May at US$25.91 billion, while contracted investment (an indicator of future trends) was 50% higher, year over year, at US$57.2 billion. In light of this, the big three U.S. auto companies (General Motors, Ford, and Daimler Chrysler) recently announced aggressive expansion plans for production in China.

The overall slowdown in Chinese growth that we expect
this year will likely be offset by strong growth in other regions, particularly in the U.S. and Japan. U.S. industrial production continues to expand sharply (up an impressive 6.3%, year over year, in May), which, together with a strong manufacturing survey results from the Institute for Supply Management (ISM), suggests a continued positive environment for metal demand. European metal demand is now also showing initial signs of picking up.

While medium- to long-term metal demand prospects remain upbeat in China and other Asian countries, some of the recent profit-taking in the base metal markets occurred over fears about the effects on U.S. demand from higher interest rates. Signs of a pick-up in inflation, an improving labour market, and comments from the Federal Reserve mean the futures market is now pricing in a 125-basis-point rise in the Fed Fund (short-term) rate this year. We forecast a 50 basis point rise at the Fed meeting in September, and another 50-bp tightening after that to take the Fed Fund rate to 2.25% by the end of the year.

While we always believed tightening monetary policy would spark a wave of investor liquidation, we also think the traditional link of higher short- and long-term interest rates and rising metal prices will reassert itself.

Higher interest rates tend to reflect economic expansion, but the unusually low interest environment in the U.S. has stimulated metal demand to grow strongly. In combination with strong Chinese demand, this has led to extreme tightness in the physical U.S. metal markets — evident from surging physical premiums.

Against expectations of rising interest rates, a reversal of the U.S. dollar’s declining trend against key currencies also suggests a reversal of the rising base-metal price trend. And dollar strength helped spark the first wave of fund profit-taking in recent months. However, there are a number of important aspects to consider for future metal price performance in relation to the U.S. dollar:

— We believe metal supply shortfalls will be sufficiently severe in coming quarters to sustain the negative impact of an appreciation of the trade-weighted U.S. dollar that our foreign-exchange strategists expect. Nickel in the late 1980s is a good example, where the second price peak occurred despite a firmer U.S. dollar and slowing growth because inventory levels were critically low.

— While we expect the U.S. dollar to appreciate against the euro through the remainder of the year, with a euro/dollar target of 1.08 in one year, we expect the greenback to continue to depreciate against the yen, with a dollar/Japanese yen target of 100 over the same period. For example, Japanese smelting output should remain constrained as a result, especially as treatment charges remain around all-time lows (despite showing signs of bottoming out).

— The level of the trade-weighted U.S. dollar compared with the peak in 2002 (roughly minus 20%) is relatively low, and this will likely continue to exert pressure on production costs outside the U.S. despite an appreciation.

— The U.S. budget deficit continues to grow (to a record US$48.3 billion in April), which means higher interest rates might not be sufficient to attract money into the U.S.

So although a stronger U.S. dollar is clearly denting the upside in metal prices, while some funds take profits on the traditional inverse relationship between the two, we do not believe a stronger U.S. currency will necessarily prevent metal prices from reaching fresh highs. The combination of low inventories, continued tight raw material markets, and strong demand are far too compelling. Stock-to-consumption ratios have fallen to critically low levels, with refined inventory levels especially low in lead, tin, nickel and copper. Aluminum and zinc stocks remain relatively high but have started to fall.

We expect all base metal markets to show deficits this year. The copper and tin markets are particularly tight, meaning that if demand were to disappoint, those would resist price pressure relatively better, in our view. In 2005, we expect tightness to increase in aluminum and nickel, while the supply/demand imbalance will also remain for copper, zinc and tin, albeit at a reduced rate. Lead is moving into a modest surplus after three years of supply shortfalls, according to our forecasts.

Even though the base metal markets remain in deficit, we believe a period of price softness and high price volatility lies ahead over the quieter Northern Hemisphere summer months, with the Chinese economy finally showing signs of cooling. However, the cyclical price peak for industrial metals probably has not yet been reached, and we are still looking for the last leg higher in this metal-price cycle, driven by genuine physical tightness, before the economic cycle turns. Beyond the cyclical peak, we expect a higher underlying price floor across commodity markets because of structural demand and supply trends.

What does this mean for the various metal market participants?

— For consumers, we would recommend taking advantage of near-term price weakness to rebuild inventories ahead of expected strong demand through to next year. Higher long-term metal prices also mean consumers will have to budget for purchasing prices higher than what we have seen in recent years.

— Producers will face new opportunities to sell forward at attractive prices. In addition, we expect far-forward price levels to trade at higher levels in coming years, which also offers opportunities to finance increased production.

— We believe investors will be able to enjoy another ride higher in base metal prices later this year and into next year. Those investors who fear that the cyclical peak has been reached and are expecting a full reversal of the upward price trend should appreciate the consequences of selling short in backwardated markets. The backwardations will ensure attractive returns for long-term investors looking at commodities as an alternative asset class, as discussed in Section 1. We believe specialized commodity hedge fund investors will find value in markets that are especially short of supply, and so relatively more immune to any disappointments on the demand side (such as tin and copper). We also see good potential for the aluminum and zinc market to perform well; their respective supply sides are expected to improve sufficiently to take prices to fresh highs, after relative underperformance so far in this metals price cycle.

U.S. industrial production increased by an impressive 1.1%, month over month, in May, with some modest upward revisions to the data for prior months. Leading the way was a 3.5% increase in output at high-tech industries. The surge in manufacturing output in recent months was likely partly reflected in rapid inventory accumulation during the second quarter, data for which are not yet available. With production growth accelerating, capacity utilization is quickly moving to normal levels. The capacity utilization rate has moved up over two points in the past three months and now stands at 77.8. By year-end, it is likely to exceed 80, putting it a level close to the average seen in recent cycles. Coming on top of strong ISM readings, the data suggest a continued positive environment for base metals.

Japanese industrial production grew 3.3%, month over month, and 7.7%, year over year, in April, the former marking a second consecutive rise. Together with Ministry of Economy Trade and Industry forecasts for May (3.5%, month over month) and June (-1.5%, month over month), this development suggests that output expanded 4.2%, quarter over quarter, for the second quarter as a whole. Our Japan economics colleagues expect industrial production to remain in an upward trend through the next fiscal year on continuing support from exports and capital investment, with an additional boost from consumption. While an intentional inventory build-up is visible in electronic components and devices, most other industries remain cautious about stocking, suggesting production will not face any downward pressure on this front in the near future.

The IFO (I
nstitute for Economic Research) business climate index was 96.1 in May, down from the previous month’s 96.3. The key expectations index was 97.8, compared with the previous month’s 97.7. The IFO said manufacturing conditions had improved slightly, that companies expected profits to improve, and that the slight decline was a result of a worsening situation in eastern Germany. Higher oil prices ought to have been a negative factor, so the fact that expectations held steady is an encouraging sign for thinking that the euro-area economy will continue to show moderate growth in the second quarter. The softening of the euro since the start of the year, coupled with a still-buoyant global economy, explains why expectations are holding up.

Fixed-asset investment in China remained strong through the first quarter of this year, with growth of 43%, year over year, in the first quarter. However, Beijing has been making concerted efforts to control the rate of growth in the economy and thereby avoid the risk of overheating. The most recent data show that Beijing is beginning to have some success in this endeavour, and while the economy continues to grow rapidly, the pace of growth has been somewhat reduced. In May, the rate of fixed-asset investment growth was 18.3%, year over year, compared with a rise of 34.7% in April. Further evidence of a slightly cooling economy has been provided by reduced rates of growth in both money supply and renminbi bank loans in May.

The Organization for Economic Co-operation and Development’s composite leading indicators (CLIs) show continued expansion lies ahead, but other data signal slightly weakening performance in the U.S. and euro area. The 6-month rate of change (providing an earlier and clearer signal for future turning points than the CLI itself) for the whole OECD area was down for the third consecutive month in April, following an upward trend that began in April 2003. The equivalent number for the U.S. represented its fourth retracement, while in the euro area, a fifth consecutive decline was reported. In Japan, on the other hand, the 6-month rate of change improved slightly and has been stable in recent months. The indicators tend to lead GDP by about nine months and base metals prices by about seven months.

The May ISM manufacturing survey indicated continued robust growth in the manufacturing sector, with the index rising to 62.8 in May from 62.4. This marked the seventh consecutive month above 60, a level generally consistent with GDP growth of at least 6%. The employment component rose more than 4 points to 61.9, the highest reading for that index since 1973. The prices paid index edged down to 86.0 from 88.0. Although the new orders index continued the slow downward trend that has been in place since the start of the year, it remains strong at 62.8. As the chart shows, the continued strength and confidence in the manufacturing sector is positive for metals consumption moving forward.

Recent data show that durable goods orders fell by 2.9%, month over month, in April, somewhat more than the market had been expecting. However, our U.S. economics colleagues argue that this should not be seen as a significant slowdown in activity. The previous two months had seen strong gains of 5.7% and 3.9%, so some reversal was likely in April.

Data from the U.S. Geological Survey show that the 6-month growth rate of metal product inventories has picked up sharply through the first quarter of this year, suggesting that the consumer restocking phase has gained momentum.

— The opinions presented are the author’s 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 author at ingrid.sternby@barcap.com