Sagging economy an ominous sign for base metals

This article is the first of two instalments devoted to base metals and was culled from Barclays Capital’s monthly commodities report The Commodity Refiner. Part 2 will appear in our Dec. 9-15 issue.

Since the last Metals Commentary (T.N.M., Oct 21-27/02), we have made downward revisions to our demand growth projections on lower economic assumptions, while watching leading indicators deteriorate further. Paradoxically, base metal prices have traded constantly higher over the same period, which has forced us to make some adjustments to our near-term price estimates.

The state of the U.S. auto industry appears to be deteriorating, which is a worrying trend for base metal markets. Sharply rising U.S. auto inventories and possible auto production curtailments are likely to help constrain base metal demand growth.

On a positive note, our assumption of continuous double-digit economic growth rates in China for 2003-05 remains a strongly supportive factor for the base metal complex, with copper in particular positively exposed.

Over the near term, we think further attempts on the upside will be capped until leading demand indicators turn around. As a result, we have kept our previous price forecasts for the period 2003-06 unchanged, and continue to expect only a modest recovery next year. We have upwardly revised fourth-quarter prices for all base metals, bar tin, to capture recent rallies. This revision, in turn, has resulted in an aggregate rise to our fourth-quarter estimate of 6.8%.

Our relative preference in the base metal complex has not materially changed with the alterations to our assumptions. A comparison of current forward curves suggests that buying opportunities exist for nickel, zinc and tin in particular.

With historically low prices, much speculative short-selling already in place, and evidence of buying interest on dips, significant price falls appear to have been avoided. And while technically driven price rallies have occurred, underlying demand fundamentals have failed to impress. Therefore, we do not think recent rallies will be sustainable, and we will be looking for renewed attractive buying opportunities over the next quarter.

This time last year, when prices rallied from long-term lows, higher prices were the result of a combination of supply curtailments and improvements in key leading indicators. As a result of producer discipline, supply sides are relatively constrained for most base metals at present, which should provide a solid floor for the markets, preventing significant downside pressure in an already weak price environment. However, we believe the evolution of the leading indicators does not justify higher prices at present.

Instead, the likelihood that the lows of last November will be re-tested has diminished, and prices are likely to form a new base around these relatively higher levels.

Most of the key leading metal demand indicators continue to paint a poor outlook. Particularly discouraging are declines in the Organization for Economic Co-operation and Development’s (OECD’s) leading indicators for economic growth and in the leading indicators of activity in U.S. metal industries provided from the U.S. Geological Survey (USGS).

Meanwhile, sharp declines in durable goods orders and contraction in the U.S. manufacturing sector are reinforcing the gloomy outlook. While these are negative for the state of the U.S. economy, the situation is worse in lagging (heavy-metal-consuming) European markets. Key German indicators suggest that the country’s economy will move into recession, in which case base metal demand will remain sluggish.

While Chinese demand continues to grow strongly, this is also reflected in improvements in more positive Japanese indicators, though Japanese data still show little sign of a meaningful or sustainable domestic recovery.

The state of the U.S. auto industry appears to be deteriorating. According to data released from the Bureau of Economic Analysis, U.S. auto inventories rose to their highest level since February 2001 in September. The inventory/sales ratio rose by a hefty 3.6% in September 2002 from the corresponding month a year earlier (and +22.3% month-over-month). Again, this is further evidence that base metal demand will remain constrained as the auto inventory and sales data suggest auto production could be curtailed. Most base metals are heavily exposed to the transport sector: in aluminum, this market accounts for about 44% of total demand; in copper, 10%; lead, 59%; nickel, 15%; and zinc, 18%.

In line with deteriorating economic indications, we have lowered our economic growth assumptions. This has negative implications for our base metal demand projections. The latest update from Consensus Economics (which compiles the predictions of 240 economic forecasters) reveals continuous downward revisions by the market too. The consensus now is that U.S. industrial production will likely rate at +3% next year, revised down from +3.8%.

Japan saw larger downward revisions, from +3.7% to +2.6% in 2003.

Another key region for base metal demand, Germany, has seen its 2003 industrial production forecast slashed from previous expectations of +1.7% to +1.2%. However, consensus assumptions are still higher than our own, and we fear risk still remains on the downside. The risks are partly related to the lack of capital investment and the automotive sector in light of falling sales and rising stockpiles.

However, the one geographical area that remains strong, and is likely to continue to do so, is China. In our forecast models, we assume that the Chinese economy will continue to register double-digit growth in the period 2003-05. In an otherwise weak global economy, China has been a key supportive factor for the base metal markets.

External markets

Simultaneous with downward revisions to economic growth assumptions, a shift in investor strategy away from bond markets and into equity markets has aided sentiment in base metal markets.

Better-than-expected corporate earnings and hopes that another interest rate cut in the U.S. would improve the corporate outlook have partly driven this development. However, while the low interest rate environment should eventually be positive for base metals demand, mining companies repeatedly warn about prevailing weak market conditions and the poor near-term outlook.

Notably, mining shares have not been performing as well as the rest of the market. So far this quarter, basic material shares have gained approximately 3%, against a general equity market improvement of about 5%. In the third quarter, basic material share prices fell by 22%, compared with a general market decline of 18%. This suggests investors are reluctant to buy into cyclical stocks, owing to concerns about the economic recovery.

The other important change in external market conditions over the past month is a further depreciation of the U.S. dollar against key metal-consuming/producing currencies. The strength of the euro, which has put European base metal consumers in a relatively favourable position, has supported base metal prices. However, in the near term, we think currency benefits are likely to be offset by deteriorating underlying demand, at least in Europe. In addition, our economists forecast that the U.S. dollar will strengthen against key currencies, with the euro falling back to US85 in one year’s time (from US$1.01 currently), and the yen to US$140 (from US$121 at present).

The implications for base metal prices under such circumstances is that any upturn in prices would be muted or downturn-inflated as a strong U.S. dollar would benefit producers and harm consumers outside the U.S.

Apart from modest downward revisions to demand numbers for all base metals (primarily for 2003) since the last Metals Commentary, adjustments to our supply assumptions have also helped to alter market balances.

We have made no significant changes to the aluminum supply and demand model since our previous review. We expect the aluminum market to remain in oversupply for the foreseeable future, and prices to remain sufficiently high to prevent cost-related cutbacks. In addition, we do not see the potential for a response from Western World producers, as they are focusing on market share in light of rising production in the rest of the world.

China remains the wildcard, and changes to production plans could have an important impact on exports to the West. We continue to expect 2003-04 to represent peak years for former east bloc net exports to the West.

For copper, we expect balanced market conditions this year, while we think the market could enter a string of tight years in 2003, with Western World production likely to remain constrained as a result of weak demand conditions.

Lead and zinc metal production should remain constrained by the tight raw material markets, which will likely enable reductions of large surpluses in both markets from next year. However, as smelting operating rates are low, production can be ramped up rapidly, depending on the availability of concentrates.

In the nickel market, we are wary of the demand outlook for next year in light of recent restocking in the stainless steel sector and the lack of improving underlying demand. As a result, we think demand growth could slow next year. We have excluded Noril’sk Nickel’s collateral loan from this year’s Russian shipments, and have instead assumed that this material will be released during 2004-05. We expect a small deficit next year.

We have initiated coverage of the tin market. We regard its fundamentals as attractive and look for the market to move into deficit next year.

Our relative preference in the base metals complex has not materially changed even though our assumptions have altered, as discussed above. We continue to regard copper and nickel market fundamentals as superior, and their recent price performances reflect this.

From a speculative point of view, our price projections suggest that the largest upside potential is for tin, zinc and nickel in 2003. We also regard copper especially likely to benefit from any economic recovery. Even if a Western World recovery is slow, copper has positive exposure to China, with imports having risen sharply so far this year. Even though zinc is still a significant net exporter, at least exports are slowing. This slowdown is attributable both to a tight raw material market and favourable domestic premiums.

In the aluminum market, we recommend producers take advantage of prevailing attractive forward prices. Despite recent tightening, prevailing forward prices are still higher than our forecast prices. We would also encourage consumers to await a retrace toward US$1,300 per tonne before making purchases. However, current euro strength is worth considering for European consumers.

With better fundamentals and the market likely to move into deficit next year, we regard copper prices below US$1,550 per tonne as attractive for consumers, though producers should stay patient in a rising price environment. However, over the longer term, prices are unlikely to reach previous cyclical peak levels, and we suggest producers may need to lower expectations of forward-price levels and take advantage of price rallies.

We think there is a risk that nickel prices will retrace to below US$7,000 per tonne over the next quarter, and we regard those lower levels as a good buying opportunity for consumers. Nonetheless, this market is fundamentally sound and should benefit from a rising price trend when the economic picture improves.

Zinc prices are still close to long-term lows, and we think current prices of around US$750 per tonne represent good value for money.

Leading indicators

o U.S. industrial production for October was worse than expected at -0.8% month over month (compared with an expected 0.4% decline) and represented the third consecutive fall (after declines of 0.2% in both September and August).

The Federal Reserve says U.S. demand for manufactured goods remains exceptionally weak and is getting worse, and it’s conceivable this weakness will spread to other areas of the economy.

In contrast to the recent trend, industrial production slowed also, year over year, though it remained in positive territory at +1.2% (compared with +1.4% year over year, in September). This is a worrying trend for base metal demand, in our view.

o Japanese industrial production was revised upward to -0.1%, month over month, from a preliminary -0.3% for September, resulting in an adjustment to +2.2%, quarter over quarter, from +2.1%, quarter over quarter, for July to September. The change was partly attributable to an upward revision of 1.7 points in the transport machinery industry.

Meanwhile, gross domestic product data for July to September were stronger than expected, at +0.7%, quarter over quarter, or +3.0% annualized, compared with expectations of +0.5% and +0.6%, respectively.

However, market response was muted, for the data show little sign of a meaningful or sustainable recovery, according to our economists.

o Economic conditions continue to deteriorate in Germany. The latest Institute for Economic Research (IFO) business climate survey fell for the fifth consecutive month, to 87.7 in October from 88.2 in September. In line with this, new manufacturing factory orders in Germany fell by 2.5%, month over month, in September.

German industrial production for September fell twice as much as expected, by 1.2%, month over month. After a 0.2% quarter-over-quarter fall in the second quarter, industrial production rose 0.5%, quarter over quarter, in the third quarter. Our economists forecast a partial rebound in October, though recent surveys suggest renewed contraction in the fourth quarter.

Uniformly poor economic data from Europe’s largest region highlights the persisting poor demand environment for base metals.

o The composite leading indicator (CLI) for the OECD area fell by another 0.3 point, month over month, in September.

The 6-month smooth growth rate (designed to provide an early pointer to possible economic turning points) has fallen for four consecutive months. In the U.S., the 6-month rate of change has fallen for three months in a row, while the European CLI also registered its fourth consecutive monthly decline. In Japan, the equivalent CLI also fell.

These leading indicators point to a deteriorating economic outlook in all major geographical regions, which is discouraging for the outlook for base metal demand and prices.

o The Conference Board Index of leading economic indicators was unchanged in October, following four consecutive monthly declines (its longest losing streak since November 1990).

The Conference Board (a New York business research group) states that while the September reading raised fear of a double-dip recession, it is more likely that growth will just stall.

o The Institute for Supply Management manufacturing survey for October was slightly worse than expected, at 48.5 compared with a consensus forecast of 49. However, other recent manufacturing indices (Philly Fed and Chicago PMI) have been much worse than expected, so a reading fairly close to 50 is not bad in our view.

It is encouraging that the new orders index (which tends to lead the total index) rose from 50.2 to 50.9 in October. Inventories showed renewed de-stocking, with the inventory index falling from 43.6 to 42.5 in October.

o Durable goods orders fell by 5.9%, month over month, in September. Weak demand for cars and aircraft equipment was partly behind the larger-than-expected fall. The primary metals component fell 1.7%, month over month.

o Meanwhile, U.S. businesses increased their stockpiles at the fastest pace in almost two years in September as business sales slumped, according to the Commerce Department. Inventories at retailers, manufacturers and wholesalers grew by an unexpectedly large 0.5% in September, month over month, partly driven by increased stockpiles at car dealers.

Together with sharply rising U.S. auto stockpiles, we regard this development as further evidence of a deteriorating demand outlook for base metals.

o The growth rate of the value of U.S. inventories of nonferrous metal products increased in August, but remains at a low level, according to the latest available data from the USGS.

We believe re-stocking has occurred for most base metals, at least for parts of this year. However, in light of slowing demand growth into the fourth quarter, we believe this will diminish as demand conditions appear to be deteriorating.

Meanwhile, the USGS metal price-leading index has fallen by 1.3% in August (latest available month) to 113.1, while its 6-month smoothed growth rate was reduced to -8% from -6.9%. The price-leading index tends to signal major changes in the growth rate of nonferrous metal prices by an average of eight months in advance, according to the USGS.

The USGS primary metals leading index fell 2.2% in September, to 126.7. The 6-month smoothed growth rate, which measures the near-term trend, dropped to -2.7% from a revised +1.6% in August. Usually, a growth rate above +1 indicates an increase in metals activity, while a growth rate below 1% signals a downturn in activity, according to the USGS.

While the current reading is pointing to a downturn, it is still too early to say if the recent growth in primary metals activity is coming to an end (following 10 consecutive readings above -1%). All four other leading USGS metal industry indices (copper, primary aluminum, aluminum mill products, and steel) decreased in August (the latest month for which data are available), albeit remaining in positive territory.

o As has been evident in forward-looking economic indicators, the 50-basis-point cut in interest rates by the Federal Reserve reflects the severe state of the U.S. economy and the poor near-term outlook for demand.

Although the move to a neutral bias possibly signals a bottom of the interest rate cycle, we believe the current environment of depressed economic growth will provide a difficult trading environment for base metals.

At best, base metal prices would form a new and higher base, supported by constrained refined supply sides in some of the markets (copper and nickel) and speculative support with prospects of demand eventually picking up. However, continuation of the recent uptrend will depend on improving demand.

o U.S. bond yields have risen along with equity markets, and this change in investment sentiment has benefited base metal prices.

U.S. 10-year bond yields fell again in early November, from 4.2% to 3.8%, which may indicate renewed pressure on base metal markets as yields tend to lead the way.

o Falls in equity markets for most of this year were arrested during October, giving declining metal prices a respite. However, Rio Tinto, warned in mid-November that market conditions are likely to remain tough for next year. Major aluminum companies Alcoa and Alcan have also expressed concern over the outlook. When discussing third-quarter earnings in mid-October, Alcoa said U.S. demand remains weak and that it cannot see conditions improving during the fourth quarter.

Next week: The outlook for base metals in detail.

— 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.norrish@barcap.com