Base metals: upside despite macro gloom

The following is the second in a series devoted to metals markets and was culled from Barclays Capital’s monthly report The Commodity Refiner. This week’s instalment provides an overview of base metals.

Despite prevailing macro uncertainties, we are expecting a substantial improvement in base metal prices this year compared with last. The risk remains that Western World economic growth continues to disappoint and a second recession emerges. However, current fiscal and monetary stimulus should help avoid that scenario in the U.S. (Europe and Japan appear more vulnerable.)

Excluding China, leading indicators for base metal demand remain largely unimpressive. Our focus is on leading indicators in the U.S. market, as we expect those to lead other key Western World regions.

Speculators can be expected to drive the initial stage of a rally, and this first step of a recovery is already evident: Commodity Trading Advisor funds spurred prices 10% higher in the fourth quarter of 2002, while there are signs macro funds are becoming increasingly active on the long side — though major concerns remain over international political tensions.

The manufacturing survey of the U.S. Institute for Supply Management has caused a sharp rise in base metal prices, which suggests the market is very responsive to positive demand-related news and that constrained supply conditions in some markets help provide a firm floor for prices. However, since the release of that survey, U.S. economic data have not given much hope of economic growth on the upside in 2003. Key figures released during January on industrial production, employment and retail sales were all disappointing. As a result, we continue to assume relatively subdued growth in Western World industrial production, at 2.3% for 2003 and 3.9% for 2004.

Despite this relatively subdued economic picture, price performance on the London Metal Exchange has been strong recently. We believe the following factors have been key in driving the trend:

q Strong Asian demand (Southeast Asia and China in particular);

q Restructuring on the supply side — disciplinary as well as cost- and strike-related;

q Asset allocation into commodities;

q U.S. dollar weakness, which is encouraging non-U.S. demand and putting pressure on production costs outside the U.S.

Strong demand growth in China should continue to help offset weakness in other geographical regions. Chinese base metal consumption accounted for only around 5% of global demand in the mid-1980s, whereas now it accounts for 17-18%, and we estimate this ratio could rise above 20% by the middle of this decade. As a result, Chinese metal trade flows have generally developed in a positive fashion over the past year (bar aluminum).

Apart from demand, other key price-determining factors (new supply and inventory levels) are beginning to look increasingly constructive. Deficit conditions developing in several markets have already started to affect reported inventory levels, with widespread drawdowns evident during the previous quarter. Supply discipline introduced in response to the October 2001 price trough, which was intensified during the previous quarter, has helped reduce downside price risk.

This is particularly notable in copper, while the scarce number of planned new nickel projects makes the outlook for that market also particularly encouraging. However, while the prevailing aluminum surplus is large, we expect a reduction during 2004, and the market will likely move into deficit in 2005. This will all happen earlier than we had expected, following somewhat better demand numbers for 2002. Re-stocking has boosted demand growth, which will remain an important ingredient in 2003.

Strong performance in commodity prices has occurred at a time when other asset classes have declined in value and as the U.S. dollar has weakened further. Investment funds’ appetite for commodities is evident from data of the Commodity Futures Trading Commission that shows that speculators are currently net long of all Comex/ Nymex traded industrial and energy-related commodities. There is an inverse relationship between the U.S. dollar and base metal prices. European consumers have already been seen taking advantage of favourable exchange rates. The aluminum price denominated in euros, for example, is trading its lowest levels since 1999. European producers are meanwhile coming under increasing financial pressure, as is especially evident in the lead and zinc industries.

Against this backdrop, we expect base metals with constrained supply sides and positive exposure to China (copper and nickel) to perform best. We expect aluminum to under-perform the rest of the complex but highlight the potential for positive surprises on the supply side, which could restrict downside risk. We expect lead and zinc prices to strengthen in line with a cyclical recovery and on short-term regional availability tightness.

To match this outlook, we have recently revised our estimate for annual average cash copper prices by plus 5% to US$1,694 per tonne (US76.8 per lb.) for 2003; for nickel, we have revised our estimate by plus 8% to US$8,100 per tonne (US$3.67 per lb.). The other main change is a downward revision to our estimated rise in zinc prices for the period 2003-04, as we believe the supply side will take longer to restructure than in our previously more optimistic forecast. On an aggregate basis, we expect a price rise of 10% this year, following a 0.3% drop in 2002.

Key Indicators

q Base metal prices reacted negatively to the latest data on U.S. industrial production, which was much weaker than expected at minus 0.2%, month over month, in December 2002. The surprise was a big drop in car and light truck assemblies to 11.7 million (annualized rate), down from 12.7 million in November, after strong sales in December. Production plans call for around 12.3 million (annualized) in the first quarter.

Manufacturing output excluding autos rose by 0.2% in December, with output in the mining sector rising 1.6%. Select high-tech industries rose 0.5%, and most other categories registered declines. These numbers corroborate other evidence that the economy slowed in the fourth quarter, and our economists estimate that gross domestic product is likely to have grown by only 1% in the fourth quarter, down from 4% in the third (and below the previous forecast of plus 2%). We still forecast GDP growth of 3.5% for the current quarter.

The Economy Watcher Survey (released in mid-January) confirmed that the Japanese economy is deteriorating, albeit not at an accelerated rate. In fact, the current assessment and outlook for the manufacturing sector improved, raising hopes that industrial production has further room to expand. Our economists believe the economy will stay largely flat from January to March, and the diffusion index is likely to remain weak for some time.

The quarterly Tankan business sentiment survey came in at minus 9 in the fourth quarter from minus 14 in the third. The survey was mixed but with an overall tone of smaller-than-expected improvements in business sentiment and a flat trend in the economy. November industrial production was revised upward to minus 1.6%, month over month, from a preliminary minus 2.2%.

q The decline in the German IFO (Institute for Economic Research) to 87.1 in December (from 87.3 in November) was in line with expectations and is consistent with a contraction in German GDP growth. The Eurozone manufacturing survey (PMI) fell to 48.4 in December from 49.5 in November, which is also discouraging and the steepest deterioration since January 2002. The new-orders component dropped below the 50-mark, pointing to weak manufacturing growth in the first quarter. Meanwhile, firms continue to deplete their inventories in the face of weak demand conditions.

The German PMI fell for the fifth consecutive month to 46.9 in December, from 49 in November.

While European economic data remain soft, there are signs that European metal demand is reviving from the low levels of last year.

q The Organization for Economic Co-operation
and Development’s composite leading indicators (CLI) of economic growth registered poor readings for most regions, according to the latest data. The CLIs for the OECD as a whole and for Germany fell for six consecutive months. The U.S. CLI registered its fifth decline in a row, while the Japanese CLI rose for the second consecutive month. This would also suggest that economic growth is unlikely to surprise on the upside in the near future.

While the OECD has made revisions to the methodology, it is designed to provide early signals of turning points in economic activity. In practice, peaks have been found about nine months after their signals were detected in the 6-month rate of change.

q December’s 0.1% rise in the Conference Board’s index of leading economic indicators followed gains of 0.5% in November and 0.2% in October. The string of increases was the longest since the four months that ended in March.

However, year-over-year growth has slowed sharply, to the same level as February 2002.

q The December figures from the Institute for Supply Management were strong, which, coming in the wake of other, poor economic data, was something of a surprise. The composite index jumped to 54.7, compared with 49.2 in November, suggesting the U.S. manufacturing sector is expanding. This was the largest rise since June 1991 and the highest level since June 2002.

Sub-components of the index were also strong. New orders (which tend to drive the total index) rose to 63.3 in December from 49.9 previously, representing the highest level since March 2002 and the largest rise since August 1980. Inventories also rose, to 46.2 from 42.1 in the previous month.

In mid-January, the Philly Fed manufacturing survey was also stronger than expected, at 11.2, compared with a revised 11.3 in December (revised from 7.2).

q U.S. durable goods orders were weaker than expected for November, falling by 1.4%, month over month. The year-over-year growth rate also slowed.

Weakness in the numbers was evident across the board, with orders for civilian aircraft falling by 7.7%. Non-defence capital goods orders excluding civilian aircraft (a proxy for capital spending), were down by 2.2% after rising by 5.6% in October.

Orders for motor vehicles and parts fell by 4.5%, reversing the 3.7% rise in the previous month. Overall, this report is at odds with the underlying tone of improvement seen in the October report.

q U.S. business inventories rose 0.2%, month over month, in November, representing the seventh consecutive monthly increase.

Business sales rose 0.3% in the same month, and it would take 1.4 months to exhaust businesses’ stockpiles if sales kept up at that pace, according to the Commerce Department.

Retail inventories rose by 0.8%, automobile inventories increased 1.7%, and wholesale inventories expanded by 0.2%. Manufacturing inventories eased 0.3%.

q The U.S. Geological Survey’s leading index of metal prices was unchanged in October. Although the index has been somewhat weak in recent months, it still does not seem to be signaling a near-term decline in metal prices. The 6-month smoothed growth rate was reduced to plus 0.5% from a revised plus 1.3% in September.

Meanwhile, the USGS primary metals leading index rose in November, pointing to the possibility of modest growth in domestic industry activity in the immediate future. The 6-month smoothed growth rate rose to plus 3.1% from a revised plus 1.4% in October. The 6-month smoothed growth rate is a compound annual rate that measures the near-term trend. Usually, a growth rate above plus 1% signals an increase in metals activity, while a growth rate below minus 1% indicates a downturn in activity.

q Consumer confidence remains sluggish, having dropped to 80.3 in December — the lowest level since 1994.

Retail sales rose by 1.2% in December, which was less than expected. Non-auto sales were unchanged, also a touch weaker than expected. November non-auto sales were revised down to show a 0.3% increase (from 0.5%). December numbers were held down by declines in sales at building materials and hardware outlets (minus 1.1%) and food stores (minus 1%).

The preliminary Michigan consumer sentiment survey was also weaker than expected in January, at 83.7, compared with 86.7 in December.

q According to the latest data from the Bureau of Economic Analysis, U.S. auto inventories were somewhat reduced during November, helped by strong sales volumes. Production levels remained at relatively low levels.

General Motors estimates that January’s Seasonally Adjusted Annualized Rate is running at about 16.5 million, down from December’s 18.3 million.

Despite a decline, this news is a positive; most industry participants had been anticipating a sharp decrease in January U.S. auto unit sales as a “payback” for December’s incentive-induced sales increase.

q Housing starts jumped by 5% in December to an annualized rate of 1.8 million, representing the highest level since June 1986. In 2002, housing starts averaged 1.71 million, 6.6% higher than in 2001. Low mortgage rates in a low-interest-rate environment have buoyed the housing market in the past year. Building permits posted a bigger rise to 1.9 million annualized. The high level of building permits indicates that the starts should stay robust in the coming months as well.

q FTSE mining equities continued to strengthen during December, having gained 16% since the recent trough at the end of September. Despite recent broad-based losses in U.S. equities, metals and mining equities were relatively resilient for most of January, signalling that equity investors perhaps favour exposure towards an early cycle sector.

However, renewed aggressive selling pressure emerged in aluminum equities, which coincided both with quarterly results from Alcan and broad-based losses in global equity markets. Mining equities tend to lead base metal prices.

q U.S. 10-year bond yields have remained volatile at low levels; below 4% at mid-January.

We believe an investment strategy geared towards selling bond markets (pushing yields higher) and buying equity markets would involve overall positive sentiment for the base metal markets, given the historical positive correlation between base metal prices and U.S. bond yields.

q Dollar weakness has been a dominant theme over recent months and a key supportive factor for the base metal markets. In the longer term, dollar weakness in a rising base metal price environment is likely to attract further European consumer business.

On the producer side, a weak dollar would mean local currency strength and a rise in production costs, and this could eventually result in a curtailment of high-cost production outside the U.S.

Next week: Copper, lead and aluminum.

— 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 Kevin Norrish, head of commodities research and energy, at kevin.norrish@barcap.com