Drop in prices points to economic double dip

Aug. 5-9 at a glance

– Copper prices have failed to gain from any risks associated with fund short-covering and remain in the crucial support area of US$1,500 per tonne.

– Aluminum has found good support, thanks to short-covering and light physical interest on the price dips. The increase in London Metal Exchange (LME) stock levels, however, continues to pose a risk.

– Nickel has edged away from the US$6,600-per-tonne level as the drift lower in stock levels continues. Risks of a move toward key support at US$6,400 per tonne have eased, while cancelled warrant data also remain supportive.

– Zinc posted another poor performance, registering the second consecutive end to the trading week below US$760 per tonne. Current prices are also factoring in further weakness in industrial production.

– Gold prices benefited from renewed producer-based buying activity and climbed back to the US$315-per-oz. area. However, we continue to view underlying fundamentals as weak, and our medium-to-long-term view of the gold market remains neutral-negative.

The jury may still be out on whether or not the U.S. economy is heading for a double dip, but base metals markets participants appear to have made up their minds already. Although not all the LME metals are back at the trough levels seen in late 2001, several are now very close, notably zinc and aluminum. Meanwhile in copper, although speculative funds have amassed a large short position over a short space of time, there are few signs that this is about to prompt a nervous, short-covering rally.

The key missing ingredient to such a price rally remains consumer sentiment and consumer demand. The recent downgrading in expectations of an improvement in metals consumption during the current half of the year is not, of course, the only factor weighing down price prospects. The growth in LME inventory levels has been a key aspect of the currently bearish environment in the base metals complex. However, if the latest bouts of weakness in metals prices are acting as an indicator of future economic expectations, the risks of a double dip in economic prospects are growing. Based on past experience, the current level of some metals prices is pointing towards renewed weakness in the industrial production sectors.

The latest speculative fund data from the Commodity Futures Trading Commission clearly shows the increased presence of short-holding speculative funds in copper. The impact on prices has been equally clear. Although short-covering has turned recent moves below US$1,500 per tonne into brief dips, the weak close on Aug. 9 highlighted the fact that short-covering risks alone remain an insufficient defence against copper’s downtrend.

Current copper prices imply a sharp slowdown in global growth. The two main factors driving price levels over the medium term are inventory levels and expectations of global industrial production growth (accounting, between them, for around 80% of the quarterly variation in copper prices).

Prices are discounting a sharp contraction in quarterly industrial production, equivalent to around 5%, year over year, for the Western World. Our data series for Western World industrial production (sourced from Brook Hunt) shows that a trough occurred in the fourth quarter of 2001, when growth fell 5.6%, year over year. Since then, the contraction has slowed to minus 4% in the first quarter of 2002 and minus 0.9% in the following 3-month period. Our expectation is that industrial production will turn mildly positive again in the third quarter, though there is considerable uncertainty over the outlook for the fourth quarter.

Since 1994, copper has only twice averaged below US$1,500 per tonne during a quarter of positive growth in industrial production (the first two quarters of 1999). Of course, high inventory levels are also contributing to current low prices, but a mild recovery in demand so far this year means that the level of stock in terms of demand has fallen slightly. At the current stock-to-consumption ratio of 8.2 weeks, a cash price of US$1,470 per tonne puts copper at the bottom end of the range justified by inventory levels, suggesting that the market is anticipating a renewed uptrend in visible inventory over the coming months.

Although a test of aluminum‘s support just below US$1,300 per tonne was avoided during the report period, risks to the downside remain. Pockets of physical interest have been rare despite the latest falls in prices, and anecdotal evidence continues to suggest that, among consumers, there remains no real concern about locking up current price weakness in expectation of an upturn in consumption levels. Light short-covering has eased downside risks lately, but more fundamental factors continue to threaten renewed weakness.

Aluminum stocks continue to rise steadily, climbing 20,825 tonnes so far in August, compared with an increase of 30,000 tonnes in July. The increase is unsurprising given the dramatic rise in global production seen this year. Since the end of 2001, LME stocks have climbed by 471,000 tonnes in what is an accurate reflection of the extent of the surplus in the first half. The increase is the second-biggest in relation to consumption after zinc. For seasonal reasons, aluminum demand is usually at its strongest in the first half.

Given the current uncertainties that exist over the demand outlook for the remainder of the year, there is a big risk that demand will be even weaker than it normally is in the second half. At the same time, production is likely to continue accelerating from the annual growth rate of more than 5% we estimate for June. In the West, this is because full production will be achieved by smelters that restarted operations in early 2002. In China, a large number of new projects and expansions will continue to boost supply growth. After increasing by almost 100% to 260,000 tonnes in the first half, Chinese exports are likely to continue rising in the second half. Under these conditions, there’s a good chance the increase in LME aluminum stocks will top 1 million tonnes for the year.

The steady climb in nickel prices was halted in trading on Aug. 9, indicating that conditions for sustainable price recoveries are far from set. Although prices have so far been able to avoid a test of the key US$6,400-per-tonne area, only limited encouragement can be taken from this. The halt in the rest of the LME slide eased much of the downside momentum in nickel, while the thinness of current trading conditions also deters funds from building increased short positions. Furthermore, the absence, during the report period, of U.S. data capable of igniting moves in the LME complex also provided an opportunity for breathing space. Second-half demand expectations have nonetheless been downgraded, a fact that should also feed through to the nickel market and its price prospects over the remainder of the year.

In the shorter term, supply constraints, reflected in the low and falling LME inventory levels, suggest that concerted fund pressure on the downside may be reluctant to emerge. Significant losses in the rest of the complex could tip the price risks further toward a test of key support at US$6,400 per tonne. Even if weakness in the rest of the complex does add pressure on nickel prices, the low stock environment is expected to build a degree of immunity into price moves, and although our nickel price expectations for the third quarter were downgraded during the period under review, we nonetheless expect prices to average US$6,800 per tonne for the quarter, rising to US$7,400 per tonne in the final three months of the year.

Zinc prices continued to reflect the weakness of both supply-side and demand-side fundamentals, struggling to move toward a test of the 10-day moving average line and failing to retain any gains made on the way. For the second consecutive week, zinc prices ended below US$760 per tonne, and with prospects in the rest of the complex still finely balanced, short-term expectations of a recovery above this key level hinge on the chances of
a short-covering rally being triggered, which could at least return prices back above the 10-day line, currently lying at US$766 per tonne.

Notwithstanding risks of a speculatively short fund market running prices higher in a short-covering rally, the stock burden that increasing LME inventories have placed on prices continues to limit prospects of sustainable price gains. Stocks have risen by almost 25,000 tonnes in August alone, and although this is seasonally a quiet period for the physical market, the fact that it has taken place within a context of an established uptrend in stock levels suggests that the stock-related pressures faced by prices will continue to face lower, even when the holiday season draws to a close.

The stock buildup in zinc partly explains a significant aspect of the weakness in the current zinc price. However, the current price is also factoring in a significant fall in the performance of the Western World’s manufacturing base to the tune of minus 6%, year over year, in the third quarter. The R-squared of 0.60 that exists between the zinc price and western industrial production suggests that the remainder of the pressure on zinc prices has emerged from the increase in stock levels.

The impact of producer hedge restructuring on gold prices continued to be in evidence over the past week. The climb towards the US$315-per-oz. area was triggered and maintained by large volumes of producer-based buying rather than a response to the broader macroeconomic environment. The price response to hedge restructuring has been the central theme of our view of the gold price developments since the fourth quarter of 2001. Although such developments move the gold price risks to the upside, we continue to question whether the broader trading environment is lending significant support to prices.

The problem we associate with the current level of producer activity is that these buying levels are replacing, rather than augmenting, levels of consumer or investment demand in the market. The relative movements in leading equity indices, such as the Dow and gold prices, also make us skeptical of claims that prices are benefiting from equity weakness. The Dow, for example, is still 400 points below the level it was at back at the start of the third quarter of 2002, while gold prices, even with the presence of producer buying, were unchanged on Aug. 9. The comparative size of the two markets also raises questions about their relationships. It should be remembered that the volume of funds required to lift gold prices back to the US$315-per-oz. level is diminutive compared to the size of capital movements required to lower the Dow by 400 points.

In terms of the physical state of the gold market, there would appear to be emerging a hole in gold’s consumption outlook. Recent company reports have revealed the degree to which producers have continued to be active on the buy side of the market during the first half of 2002. The next quantitative gold demand figures are not due to be released until next month. When the World Gold Demand figures are released for the second quarter, they will probably show that consumer interest in gold has suffered from the producer activity of recent months.

But consumer interest aside, the key failure of gold prices recently has been their ability to attract levels of investor interest in the face of the weakening investor sentiment in other mainstream instruments. While producers remain active on the buy side of the gold market, price risks will remain on the upside. However, as the second half progresses, we expect producer hedge restructuring to exert a far less invasive influence in the price determination process, and, rather than altering our fundamental view of the medium-to-long-term outlook for the gold market, we continue to expect a drift away from current levels over the course of the second half.

— 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 kevin.norris@barcap.com