Feature Stories | Sep 17 2009
(This story was originally published on August 19, 2009. It has now been re-published to make it available to non-paying members at FNArena and readers elsewhere).
By Greg Peel
In Part I of this article [The Long And Short Term Of Commodities (Part I)], I noted a common view among analysts that the astonishing China-driven surge in commodity prices from November to July was due for a short term correction. The reasons for such a correction being inevitable are many and varied, but in simple terms could be summed up by one statement from Citi:
“The recent rally has been substantial, so we cannot rule out a short term correction in risk assets as pull-backs are common during risk rallies”.
While a correction is never a pleasant experience for commodity and resource sector investors, corrections are also considered healthy in an overly exuberant market. For the investor with a longer term horizon (or the investor still sitting nervously in cash), a correction should not be something to fear. Because just as most analysts expect short term weakness, they also expect longer term strength.
Let’s begin with the medium term, which might roughly equate to 2010. Citi provides four reasons why the “bias towards risk assets”, which include commodities, is still positive in the medium term.
Firstly, global economic data continue to improve gradually, albeit they have a long way to improve back from. Secondly, fiscal stimulus is continuing and monetary policy is remaining “loose”, and should do so for some time.
Last week the US Federal Reserve announced it would not extend its quantitative easing program beyond that previously decided, but it reiterated that a near zero cash rate would remain in place for an “extended period”. Earlier in the month the Bank of England had announced an increase to the UK’s quantitative easing program. This week the Reserve bank of Australia indicated the next cash rate move would be up, but noted it would be careful not to move too quickly and derail early economic recovery. Chinese investors fear the Chinese authorities may tighten loose monetary policy to slow the latest boom, but economists don’t see this happening until the developed world gets back on its feet and demand for Chinese exports recovers.
In other words, the global stimulus drive which has prevented financial collapse will remain to ensure the patient has indeed returned to health before a withdrawal of such stimulus is considered.
Citi’s third reason to be positive in the medium term is its analysis of investor returns, which shows key investor groups remain underweight risk assets. This is a common argument as to why any global stock market correction from here will not be severe – the simple weight of cash still sitting on the sidelines looking for an appropriate entry point.
The fourth reason is related to the “output gap”. The world’s central bankers currently see little need to raise their cash rates because inflation will remain low as a result of this output gap, which is the difference between what an economy could produce, and what it is producing. Utilisation of productive capacity remains at historically low levels across the globe as factories fell idle during the GFC. Unemployment has also risen to provide a pool of idle labour. As the global economy begins to recover, it must first close this output gap – reopen factories and re-employ labour – before there is any pressure on price and wage inflation.
Citi’s analysis of inflation and output gap cycles shows that equity markets usually rally as the output gap closes. “So the combination of recovery in activity growth and relatively low inflation,” says Citi, “should provide a sweet spot for risk assets in the medium term”.
Looking into the longer term horizon, say from 2010 through to at least 2012, the outlook is one of the rapid recovery in emerging market economies leading into a recovery in the developed world. Credit Suisse notes that massive destocking has occurred in the developed world as a result of the GFC and the multiplier effect through the value chain has been “immense”. Destocking inevitably leads to restocking, and CS believes such restocking will “see us through” 2010 before the Western consumer hopefully begins to bounce back in 2011-12.
In the US and Asia, the analysts note, we already appear to be on the cusp of a recovery. In some cases capacity utilisation rates are rising at record rates against low inventories. Europe also appears to be improving. What’s notable is that unemployment rates in the West have not risen more than in any previous recession despite the GFC supposedly being the worst recession since the Depression. Emerging markets are also now much more resilient to such shocks than they were in the 1980s and 1990s. “So far however,” notes Credit Suisse, “demand driven by major destocking has been way below that of a normal recession”.
In other words, panic had set in, leading to massive destocking and capacity shut-downs in expectation for the worst, but the worst has not come. At this stage, it looks like the worst will not come, and indeed that the bottom of the global recessionary trough has now been passed in the wider term horizon. The bounce-back from such weak expectations could thus be quite severe.
Credit Suisse notes that all commodities are more or less driven by the direction of the industrial production growth cycle. The best surrogate for IP growth is steel demand, the analysts suggest, given on FY09 numbers global steel production outweighed copper by sixty times and aluminium by forty times. Steel is “relevant to almost every aspect of industrial life”, they suggest.
National Australia Bank analysts note that growth in Chinese steel production was running on an annualised basis at negative 12.5% at the end of October 2008 but it has rebounded to positive 14.4% by the end of June this year. While they expect some easing of such rapid growth in the second half of 2009 as the effects of the Chinese government stimulus policy wane somewhat, the period thereafter should see growth supported by a recovery in the West.
Another specific area of surprising strength over the past six months has been growth in auto manufacturing, NAB suggests. Short term production has been boosted by various global policies, from subsidies in China to “cash for clunkers” in Europe and most successfully in the US. While these policies may be providing only a temporary prop to the industry, NAB believes that from early 2010 and beyond rapid demand growth for vehicles in China and India will provide ongoing support.
In the wider scheme of things, Credit Suisse is long term bullish on commodity demand given a more intrinsic evolution in global demographics and infrastructure spend. Infrastructure spend is in part driven by a significant commodity-driven wealth transfer effect, the analysts suggest, from developed world consumers to commodity-rich developing nations. They note:
“The marginal propensity to spend on infrastructure is significantly higher in the developing world than in the US, Europe and Japan. Therefore, structurally higher commodity prices should lead to more intensive consumption globally, which will likely continue to drive commodity demand well above trend rates seen in the 1970s, 1980s and 1990s”.
The fact that China might currently be “frontloading” its own recovery by stockpiling commodities at cheap prices does not bother Credit Suisse, other than to forecast a shorter term price correction. The impact has been to set floors in commodity prices that “were unthinkable 5-10 years ago”. The analysts believe that global deflation stemming from the GFC could have been much worse were it not for China’s recent commodity drive, and as a result “long term price forecasts now look too conservative”.
Credit Suisse also points out that from the recessions in the 1980s, 1990s and early 2000s the average rally in steel and mining sector stock prices, from recession floor to the next peak, is 500%. So far this recovery rally has seen only about a 120% average rise.
So to summarise the view ahead:
Massive Chinese commodity buying in the last six months has put a floor under the market and assisted in turning global fears of Armageddon into hopes of a less severe downturn. The level of buying simply cannot continue in most analysts’ opinions, suggesting that in the second half of 2009 there should be some price correction. However, the apparent ongoing improvement in developed world economies in the meantime, combined with the need to restock after a massive destocking phase, should ensure 2010 is a period of comfortable demand growth. Global stimulus policies are unlikely to be withdrawn until such growth recovery is apparent.
From 2010 to 2012 and beyond, there should be strong support for commodity prices. The emerging markets will continue to play infrastructure catch-up and have the funds to do so, while developed world infrastructure will continue to be driven by government stimulus. Recovery in the developed world will also see a return of the consumer from out of the cave he’s been hiding in, inspiring a return to growth of the Chinese export market and other emerging market exports.
The general view for commodity prices is for ongoing strength. If anything, it is a resumption of the view held prior to the GFC – one which gave us the concept of an emerging market-driven super-cycle. Is this too bold or premature an opinion for analysts to have after what should have been the world’s most substantial bust of a credit bubble? Well that remains to be seen.
Now to address individual metals and minerals.
In the longer term, Standard Chartered notes that while the trend for metals prices will be strong due to an infrastructure-led recovery in China, the upside for base metals will be limited by a significant capacity overhang given the number of marginal producers and smelters that went into temporary shut-down when prices collapsed in 2008. This is particularly the case for aluminium and nickel, where supply is extremely price sensitive.
It takes a good deal of time from the point of making a price-based decision to re-fire up production to the point where actual production is resumed. Analysts are only now noting the effects of a supply-side response to the recent price surges, which is one reason why a short-term price correction is expected. However, extensive capacity in aluminium and nickel means there will be an ongoing overhang even as we move through 2010.
Also significant is the extent of existing LME inventories of aluminium and nickel, with NAB noting the former has the highest level of excess stock and the latter the second highest. But such inventories have been breaking new records over the past several months and yet prices have kept on rising. A reason for this is because aluminium, in particular, is seeing a high proportion of metal being tied up in financing deals. This should ensure prices will continue to rally, says Standard Chartered, but beyond the September quarter the effect of freshly ramped up production will begin to assert.
The capacity overhang argument for copper and lead has become “less persuasive”, argues Standard Chartered. Supply cutbacks to date have been more about unexpected outages and underlying structural problems rather than being driven by price-related production cuts. And both metals have much lower comparative LME inventory levels than aluminium and nickel. In the medium term, Standard Chartered expects copper and lead to outperform.
Credit Suisse agrees with this thesis and thus suggests copper remains the “stand-out” commodity both structurally and cyclically. However, the analysts do warn that China’s apparent “overbuying” has been greater in copper than in other metals. CS also agrees that aluminium and nickel prices are subject to a return of production capacity, but between the two the analysts still like the outlook for nickel.
Nickel is facing the consequences of relatively high inventories of stainless steel at present, the analysts note, but stainless steel production looks set to rebound sharply after significant production cuts, which will drive demand. This should support nickel prices in the rebound phase but ultimately a return of Chinese nickel pig iron supply due to higher prices will put a cap on price upside. And there is no lack of mined nickel capacity.
Credit Suisse believes the outlook is less rosy for aluminium however, suggesting poor production discipline in the last eight months or so has allowed substantial inventory build. The analysts believe the industry needs to make structural changes, and that the outlook for aluminium will remain “benign” over the next twelve months or so.
It’s much better news for zinc. Credit Suisse notes zinc is far more geared to a recovery in the developed world on a cyclical basis, but is ultimately geared to China on a structural basis. The GFC has brought about deep cuts in zinc production and cuts to carbon steel production in the developed world. The carbon steel cycle looks set to recover, the analysts suggest, meaning zinc should see “a potentially significant rebound through 2010-12”.
Credit Suisse is most excited about steel. Significant global production cuts have led to very low inventory levels, which provides cyclical upside, but the real upside comes from the structural argument. Infrastructure spending is the main demand driver for steel, and to that end the analysts can’t see anything other than a V-shaped recovery beyond 2010. Steel should see above-trend demand for the next few years.
The NAB analysts note another factor underlying the outlook for all metal production. While some metals face the drag of idle capacity coming back on line, NAB notes there is currently significant effort being devoted in China to modernising facilities. This means the cost of production is unlikely to reduce greatly in the short term, and implies the official sector will continue to support prices at levels that allow for economically feasible domestic production, thus “effectively providing a floor to metal prices”.
Moving on to bulk minerals, the first assumption one might make is that the upbeat view for steel should carry across the iron ore and coal. However, this is not necessarily the case.
Credit Suisse notes iron ore is currently suffering from substantial excess capacity which is only being eliminated as the iron ore price falls down the cost curve. Now that contract prices have been settled there will clearly be a price-drag through to 2010 and probably for the following twelve months as well, the analysts suggest. The spot market may be thriving but only a small proportion of iron ore is traded at spot. So cyclically, iron ore should remain subdued at least into 2011.
Structurally however, the same story that applies to steel must ultimately apply to iron ore.
For metallurgical (coking) coal used in steel production, the story is highly dependent on a recovery in the developed world given China is its own major producer. Credit Suisse can’t see a very tight met coal market over the next two years unless China is forced to become a structural net importer.
In the case of thermal coal used in power production, Credit Suisse notes a similar lack of cyclical momentum in the next twelve months or so given contract pricing.
