China key to stronger base metals markets

Prospects for continued strong base metals price performance are good for 2004.

Fiscal and monetary stimulus is boosting new manufacturing orders rapidly in the Western World, prompting metal consumers to refill their low inventories. As the re-stocking phase gathers pace, the peak in the current metal price cycle should occur in 2004. The depreciation of the U.S. dollar against major currencies is reinforcing the dynamic fundamental picture for these markets for now. But certainly, weakness in the U.S. dollar reflects the country’s profound fiscal problems and we see the economic cycle turning downwards in the first half of 2005.

The outlook for the other growth engine, China, will partly depend on external demand. Foreign direct investment (FDI) has slowed, at least temporarily, while the People’s Bank of China raised reserve requirements in the second half of 2003, helping to ease the rapid growth in lending. Nonetheless, our recent trip to China confirmed that Chinese metal requirements are strong, especially for the time of year, due to consumers’ positive price outlook for the first half of 2004 amid looming deficit market conditions. Because of China’s competitive advantages, previous international trade patterns are likely to be enhanced. Most of the limited raw material that is available is flowing to China. Rising trends in refined copper and nickel imports are being reinforced and net exports of other base metals are easing. These trends should benefit London Metal Exchange (LME) prices in 2004, even though Barclays Capital’s economists foresee slowing growth in the Chinese gross domestic product through 2004 in line with China’s official target of +7%.

U.S.-dollar-denominated base metal prices have already reached the peak levels of the last commodity price cycle, in 1999/2000. On an aggregate basis, prices have risen by 30% this year and about 40% since the long-term trough in the fourth quarter of 2001. While the speed of price gains in the second half of the year was a surprise, relative price performance was less so. Nickel has been the best performer, up by 80%, while aluminum was the underperformer, gaining a more moderate 15%. The same base metal price index denominated in euros is still 40% below the previous peak level, and has gained only 15% since its long-term trough, which occurred only in May.

Despite impressive metal price performance in a year dominated by macroeconomic upside potential uncertainties, we see further upside potential for prices in 2004; and in November we upwardly revised our base metal price forecasts for 2004. To put it simply, we see the upward leg in a commodity price cycle as a 3-stage process. The speculative drive, which helped prices recover from their cyclical lows in the fourth quarter of 2001, is now over. Also, it is evident from inventory components of recent economic data that the restocking phase has started, and we expect the bulk of consumer business to occur in 2004. Investment money will continue to help direct prices, while forward selling pressure from producers has so far been generally muted.

The current commodity price cycle was unusually volatile in its first part, and only recently (the fourth quarter of 2003) has the move higher been more forceful. The volatile nature of the uptrend has given market participants a sense of comfort, for a second chance to buy has so far always occurred. The trading pattern in the fourth quarter suggests that this approach may now have to be reassessed. In fact, even though the record long-fund position in Comex copper was aggressively reduced towards the end of November (primarily by technically driven commodity trading advisor funds), long liquidation has been well-absorbed by vigorous buyers. As a result, price dips continue to be briefer and shallower, causing higher lows and keeping the upward trends intact.

This discussion can be recognized from previous commodity refiners, but it still holds. We think it is important to keep examining where prices are positioned in the cycle, especially at a time of the year when trading volumes are thinner and price moves are more volatile.

Our previous best-case scenario has now become our base-case scenario. In April, we said that if an upswing in economic activity emerges faster than anticipated, we would call for a bull run in base metal prices, especially as the exiting positive factors would provide a strong platform. In June, we stated that because of the extremely low interest rate environment and the shift in exchange rates, the current cycle could turn out to be different to previous ones. And in September, we concluded that a situation where economic growth improves and the U.S. dollar falls would have dynamic positive implications on metal prices. All these scenarios are now materializing.

We caution that the positive macroeconomic effects on base metal demand and prices could be relatively short-lived, and may not extend beyond 2004. This is partly because of the large budget financing requirements in the U.S., which will most likely receive attention only after the presidential election in November 2004. Further fiscal stimulus is due in the U.S. in 2004, and short-term interest (federal fund) rates are likely to remain low, providing a relatively rosy near-term picture. However, the U.S. federal deficit can be described as the biggest problem facing the U.S. economy, and some argue that this decade will be the most fiscally irresponsible in the country’s history. While already a large and growing hurdle, the twist is that the fiscal problem will not only affect the U.S. economy, but the global economy. Indeed, a slowdown in U.S. growth would be a key threat to the outlook for the Chinese economy, for example, and would be bound to have a negative effect on metal demand and prices.

As a result, we expect this base metal cycle’s price peak to occur in 2004, ahead of Barclays Capital’s expected peak in the Western World industrial production cycle in the first half of 2005. The lead-lag relationship is in line with speculative involvement in the metal markets. For now, Western World industrial demand indicators remain strong. Manufacturing surveys across different geographical regions are positive; they suggest soaring new orders. They also suggest that the restocking phase has just started. While quarterly U.S. GDP growth in excess of 8% will certainly not be repeated (GDP rose 8.2%, quarter over quarter, in the third quarter), we expect robust U.S. economic growth in coming quarters, coupled with mild rebounds in European and Japanese growth.

To expand a little on the consequences of the U.S. fiscal problem, U.S. spending is dependent on capital support from abroad. Recent data show that capital inflow to the U.S. fell sharply in September, to US$4.2 billion from US$50 billion in the previous month, representing the sharpest drop since 1998. This sparked fresh fears that Asian central banks are re-allocating their huge reserves away from the U.S. dollar and that the U.S. will have difficulties continuing to fund its current account deficit, which was about US$46 billion per month in the first half of this year. Consequently, the reluctance to hold U.S. dollars has increased, and ironically, heightened trade friction between the U.S. and China has added to the pressure on the U.S. currency.

It is important to appreciate the implication for base metal markets from a weak U.S.-dollar environment. Because metal prices are U.S.-dollar-denominated, there is a strong negative correlation between the trade-weighted U.S. dollar and metal prices. When the U.S. currency depreciates, producers outside the U.S. dollar region fall into a relatively weaker position (as local margins are squeezed), while the purchasing power of non-U.S.-dollar consumers improves — especially influential when order books are picking up and downstream inventories are low, as they are now.

We also believe the outlook for exchange rates will be important in regard to investor asset allocation. Metal markets have seen many new investors this year, not only in the Western World, but in China. In China, this has been supported by money being withdrawn from bearish domestic equity markets (in light of low corporate profitability and concerns over the new leadership) and transferred to futures markets, such as copper, aluminum and rubber on the Shanghai Futures Exchange. In Western countries, investment money is flowing into metals markets partly as a recovery trade, and partly as a U.S. dollar trade. Under our base case of robust Western World growth in coming quarters and a weak U.S. dollar environment, we expect greater asset allocation into metals, especially as real assets would look relatively more attractive than non-U.S. mining equities, for example, under such a scenario.

It might appear unrealistic to consider a situation where a country’s economic activity grows and its currency weakens, as is Barclays Capital’s house view for the U.S. While the U.S. dollar depreciation is certainly a reflection of the profound fiscal problems in the U.S., our foreign-exchange strategists also point to several other factors. Apart from the likelihood that Asian foreign currency reserves are diverted away from U.S. dollars, they point to the fact that economic activity is expanding in other geographical regions, and that the historically strong relationship with long-term interest rates (10-year U.S. bond yields) has broken down of late.

Although fortunate for the heavily indebted U.S. consumer (and disregarding the low short-term rate), we find it intriguing that long-term interest rates in the U.S. remain subdued despite third-quarter, 2003, GDP growth expanding at its fastest rate in almost 20 years. Historically, there is a strong positive correlation between base metal prices and 10-year bond yields, with inflation being the common theme. Even though global cyclical indicators are uniformly strong for the nearer term, this suggests that bond market participants are not yet concerned over inflationary pressures. In addition, it reflects the large foreign involvement in the U.S. Treasury market. The Federal Reserve also has few inflation fears and has strongly indicated that short-term interest rates will remain low (currently the lowest in 45 years) even if economic growth improves rapidly to ensure deflation is avoided. In contrast, falling interest rate cycles elsewhere have started to reverse, with Australia and the U.K. recently tightening monetary policies. Even if the U.S. did hike rates as early as the second quarter of 2004, we do not believe that that would trigger the reversal of rising metal prices.

Coming back to investor involvement in metal markets, we note that speculators entered metals markets earlier this cycle than in previous cycles. In fact, the net long fund copper position on Comex hit an all-time high before the U.S. industrial production cycle even turned positive. To some extent, this phenomenon may reflect investors’ discounting the importance of the U.S. in global industrial production and acting instead on the strength of refined copper demand outside the U.S. Indeed, the U.S.’s share of global copper demand has fallen to 18%, compared with 24% only five years ago. So far this year, U.S. copper demand has fallen by almost 5%, year over year, while equivalent Chinese demand has grown in excess of 20%, and China is now the world’s largest copper-consuming country.

While we believe Western World demand-related economic indicators will be crucial to follow in order to gauge the strength of overall metal demand and price direction, attention is increasingly turning to China. Chinese demand has supported the base metal markets for years, and cushioned price falls in the latest downturn. But only now is focus on the region increasing to a broader audience; at least judging by press coverage, it is.

Leading Chinese demand indicators are not as readily available as those in the Western World, and it is even more complex to measure the strength of Chinese metal requirements than elsewhere. This is partly because China is experiencing a structural change in demand. Metal consumption per capita is still low in China, less than an approximate 5 kg per capita, compared with about 20-30 kg per capita in most developed countries. China’s middle class is rising rapidly, and the current population of 1.3 billion is expected to grow to 1.7 billion by 2020, leaving substantial potential for growth in metal consumption. Auto sales, for example, are accelerating rapidly.

The other key factor driving Chinese metal demand is the transfer of Western World manufacturing towards China because of advantageous labour costs and its vast consumer market. In light of this, foreign direct investment (FDI) has risen sharply over the past few years. However, data for October show FDI in China fell 34%, year over year, to US$3.36 billion. The fall was partly attributed to market diversification in response to the outbreak of SARS, though our economists believe this was more a temporary phenomenon than the start of a new trend. In the first 10 months of the year, FDI rose by 5.8%, year over year, to US$43.6 billion, according to data from the Chinese Commerce Ministry.

Chinese economic statistics are impressive, not only for the speed of their releases, but because of the actual numbers over the past year. According to the most recent official statistics, Chinese industrial production (IP) rose by 17.2%, year over year, in October, accelerating from the 16.3% rise in the year through to September. This was the fastest monthly rate of growth since an annual 19.8% rise registered in February. Personal computer output in October was twice as great as a year earlier, while output of home appliances soared more than 50% and steel production climbed 25%. Car production rose by 52%, year over year, to 168,000 vehicles.

Growth in industrial production is closely linked with the country’s GDP, which also has a strong relation with base metal prices. GDP rose by 9.5% in the third quarter, and is 8.5% higher, year over year, so far in 2003. Our economists expect a slowdown in GDP growth in 2004 to about 7%. The lead-lag relationship between GDP growth and metal prices is interesting, as metal prices moved ahead of Chinese GDP growth in the previous cycle but seem to be lagging behind current strong economic growth.

The new Chinese leadership says it will focus more on the quality and efficiency of China’s economic expansion in 2004, rather than simply on growth targets, and has, for example, identified overcapacities in the aluminum, steel, cement and auto sectors. Still, top economic officials in China have rejected claims that the economy is in a general state of overheating, saying regulatory and monetary policies are starting to restrict credit growth and overcapacity in targeted industries.

The People’s Bank of China (BoC) reported a reduction in yuan-denominated lending in October for the first time this year. This suggests that the policy effectiveness of the series of macro-financial adjustment measures taken by the central bank has started to become evident. Given increased Chinese dominance in the metals markets in the past few years, the degree of credit availability is bound to have implications on economic activity and metals demand and prices.

In line with the rising level of lending in recent years, Chinese money supply has also soared, and the relationship with metal prices is good. As with the relationship between metal prices and GDP, metal prices are lagging in this commodity price cycle. In October, China’s broad money supply rose by 21%, year over year. In turn, this has helped spark mild inflation — with estimated consumer price index growth of 1% for the full year — after three years of deflation. The State Statistical Bureau reported that the October consumer price index was +1.8%, representing the biggest rise since October 1997. However, our Asian economists point out that the rise in inflation primarily reflects a temporary surge in food prices and that, in fact, the investment-driven nature of Chinese growth is creating fresh deflationary potential in the goods pricing sector of the economy.

These phenomenal growth rates cannot continue forever, especially if external growth slows, as we expect in 2005. However, the large divergence in growth rates between China and other big economies is likely to continue for now. Chinese commodity market participants themselves are generally optimistic on metals demand and bullish on prices for 2004.

The reason China is attracting so much attention in the metals markets is not only because it is becoming the largest metal-consuming country in the world, but because it possesses insufficient mineral reserves to feed rising refined production capacities. Consequently, international trade of raw materials is substantial, and as refined capacities, in many cases, have been added too rapidly, the country is also a refined net exporter of all base metals bar copper and nickel.

However, significant changes to Chinese commodity trading patterns are starting to emerge, which we believe will be metal-price-supportive in 2004. On the raw material side (the first stage of production), the global markets are tight for all base metals, and the available concentrates are costly. Because of China’s production cost advantages, a large part of available material is flowing into China, leaving other geographical regions starved of raw material feed. Not only are China’s producers, in many cases, lower down the cost curve because of cheap labour, but also because of current currency advantages. European, Japanese and Canadian customs smelters, for example, are all suffering from strong local currencies against the U.S. dollar.

In the copper smelting industry, we estimate that more than half of global smelters would be loss-making under a worst-case scenario where contract treatment charges fall to US$40 per tonne for 2004 (compared with mid-year terms of US$47 per tonne) accompanied by a further 10% depreciation of the U.S. dollar against major producer currencies. Even if LME prices are trading at multi-year highs, we would therefore not be surprised to see further smelting or refined output cuts, but most likely outside China and the U.S. While supply cuts at copper smelters might not necessarily lead to material changes to the refined market balance and prices, lower smelting production in the aluminum industry, for example, would most likely result in an improved market balance, especially at present, due to alumina shortages.

While copper is in a relatively better position on the cost curve in copper smelting, for example, this is not necessarily the case in other metal smelting businesses. In aluminum, smelters are generally operating under thin profit margins in light of sharply higher spot alumina and scrap prices over the past year. And in zinc smelting, where only about 80% of capacity is operational at current prices, many of the operations (often state-owned and inefficient) will require higher prices in order to remain profitable. The zinc concentrates market has been tight for some time, and trade statistics show that even after refined closures in Europe during 2003, China has not managed to attract enough raw material, partly because of extremely low global inventories of zinc concentrates.

As a result, on the refined side, Chinese trade patterns with the Western World show that net imports are getting stronger for copper and nickel, while previously rising net export volumes of lead, zinc, tin and aluminum are showing signs of reversing. This is a price-supportive development and is a reflection of the dual positive effects of strong domestic consumption and tight raw material supplies. These trends are likely to be enhanced in 2004, following reductions in export tax rebates Jan. 1, as recently announced.

As producers can receive a higher price in the domestic market, Chinese producers are likely to favour selling internally whenever possible, as profits are already squeezed from high raw material and power costs in some cases.

Because of the significant metal trading flows between China and the Western World and their influence on metal prices, a change to the renminbi/U.S. dollar currency peg could be important. In general, we believe a renminbi appreciation would help enhance trends already emerging (that is, supporting imports but discouraging exports), though we also believe any appreciation is unlikely to be large enough (or soon enough) to have a substantial influence on trade in this commodity price cycle. The other factor worth considering is the hefty rise in freight rates this year. Because of China’s competitive advantages, this has also contributed to the divergence of material to China and away from other geographical regions.

We see a strong year ahead for the base metal markets, with 2004 representing the peak year in the current commodity price cycle. Our recommendation to investors seeking leverage to a rebound in economic activity is that current base metal price levels still represent opportunities, while metals also represent an attractive hedge against a depreciating U.S. dollar. Consumers should be aware that price performance may not be as volatile as it was earlier in this cycle. With many market participants looking for positive exposure, they must seek opportunities to restock given that economic indicators suggest order books may pick up quickly. As the third and final leg higher of the upward trend is approaching, producers should seek opportunities to hedge at least part of their production, since forward prices are attractive compared with previous cycles.

— 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 or ingrid.sternby.com