Commodities | May 13 2010
By Chris Shaw
With China a major driver of commodity markets, any updates on economic conditions in that economy are of importance with respect to the outlook for prices in the sector.
RBS Australia notes the latest data show reported inflation measures are slightly worse than expected, while growth measures are mixed. The numbers suggest an incremental easing in China's growth outlook in RBS's view, though it suggests this won't be enough to fully offset rate hike fears.
Chinese growth will be more of a concern in the second half of 2010 predicts RBS, especially as easy comparisons with last year fade in the current quarter. This makes both interest rate hikes and renminbi appreciation less likely compared with a month ago, but this may also create some uncertainty with respect to Chinese demand for commodities.
Morgan Stanley agrees China remains the elephant in the room with respect to commodities, with a hard landing in that economy the major risk to the metals sector; in particular given China's impact on demand in recent years.
The major concern for the market according to Morgan Stanley is the potential for the Chinese government's property sector policy to spillover to underlying economic activity in general. But the broker's analysis is the timing of the current tightening cycle in China is appropriate and pre-emptive rather than being excessive or overly harsh.
With respect to China's exchange rate policy, Morgan Stanley suggests trade tensions with the US are abating at present. This, plus the broker's view domestic money supply, credit and capex growth are still too high, lead it to the view the odds of a float of the renminbi coming sooner than the market expects are still increasing.
Such a move would be good for commodity prices in the view of Morgan Stanley, as a stronger renminbi would have flow on effects on other Asian currencies. These include a moderating of excessive growth in regional foreign exchange reserves and additional downward pressure on the euro, so stimulating European exports. A stronger Chinese currency would also take some pressure off a stronger US dollar, while also reducing some inflationary pressures in China.
Turning to Europe, as noted above Morgan Stanley takes the view the weakening trend in the euro exchange rate could turn into a positive for export growth in the region generally and in particular the largest economies of Germany and France.
This would reinforce the fact the larger, less indebted economies of Europe have superior growth rates, so strengthening the trend of a two-tier growth outcome in the region in 2010. More immediately, Morgan Stanley suggests the issue for commodity markets is the risks of contagion with respect to the debt crisis, as this would impact on demand and risk appetite in commodity markets.
If there is an environment of sustained risk appetite among European financial intermediaries in commodity markets, Morgan Stanley sees it as a positive for the continuation of inventory financing deals, something it suggests is particularly important for the aluminium market.
One positive for commodity markets, says Morgan Stanley, is headwinds to a US economic recovery continue to diminish as there has been a turnaround in in leading indicators of US manufacturing and job creation is picking up.
While a stronger US dollar is a concern with respect to export performance, this is being offset a little by signs of stronger domestic demand, while continued strong external demand from Asia is also countering the impact of greenback strength.
The other positive for the US economy is investors are gaining confidence in the view interest rates will remain low for some time, especially as the European crisis is helping cap inflation expectations globally. This should offer additional support to global demand generally but especially in the US in Morgan Stanley's view.
With respect to the US economic recovery, Morgan Stanley notes one concern has been the potential for rising oil and other energy prices to result in some renewed demand destruction similar to that of early in 2008 when oil prices jumped to a peak of US$147 per barrel.
Given the issues in Europe, the broker takes the view speculative appetite in the oil market is likely to be somewhat subdued for some time. This implies oil price risk to the sustainability of the global recovery is relatively low.
A new concern for commodity market investors is increasing sovereign risk, this stemming from government proposals in Australia and elsewhere to implement new taxes on mining companies. But in the view of Morgan Stanley, the worst outcome with respect to earnings and valuations has already been priced in, meaning risk going forward should be broadly neutral.
The other possible outcome of such taxes is an elevation of the industry cost curve, a trend Morgan Stanley sees as hastening the adoption of higher long-term prices for industries such as alumina, iron ore and metallurgical coal given higher Chinese domestic cost curves.
Where the changes could have a negative impact on prices is in markets such as copper and uranium, as the taxes may deter or delay major project development such as the proposed Olympic Dam expansion.
As an overall conclusion, while the European debt crisis has been to dent risk appetite and so add to pressures on commodity prices, Morgan Stanley suggests there are clear signs of improvement in a majority of macro risk indicators.
Taken together, these justify a cautious but more positive assessment of the prospects for metals markets going forward. Morgan Stanley continues to recommend exposure to coal and iron ore among the bulk commodities and palladium and platinum among the precious metals, but only selective exposure to base metals.
Gold has been a beneficiary of the European debt crisis, this week touching an all-time high of US$1,243 per ounce. Standard Bank had expected the metal would hit a record high but not this quickly, its timing suggesting it would occur on the second half of this year.
Having hit a new record the bank sees US$1,300 per ounce as the next target, though again it doesn't expect the price to hit this level in the current half. This is partly because trading volumes in gold are currently low, something the analysts see as making it risky to add to long positions at current levels. Standard Bank suggests looking for a pullback before adding to positions.
Key drivers of the gold price in coming days in the bank's view are likely to be equity market performance in the US and Europe, given this would indicate investor risk appetite levels. If equity volatility were to decrease, buying interest in gold is likely to slow as well.
Bond yields should also offer some pointer, especially in Europe, as Standard Bank notes any decline in yields would signal a decline in sovereign credit risk. Yields are unlikely to normalise given the underlying deficit problems and the bank sees this as providing support for the gold price.
The US dollar also remains a fundamental driver of the gold price, even though that relationship is currently weak. Standard Bank expects more US dollar strength in the next six months.
The other short-term guide for the gold price according to the bank will be this Friday's CFTC data. The commitment of trader's report is expected to show a large rise in speculative long positions, but if this isn't the case Standard Bank would become more bullish on gold.
