Metal prices suffered another hefty price correction in late April, driven by fears of a slowdown in Chinese demand and tightening U.S. monetary policy. But owing to strong market-specific fundamentals, we still believe metals prices will strengthen again.
However, more fund liquidation is likely in the interim, and even better buying opportunities may arise before the second leg of our expected twin peak in metals prices commences.
In this report, we restate our fundamentally positive view for base metals prices, outline where major support levels should be found if investor liquidation continues, and show how nickel could be a leading indicator for our expected recovery in base metals prices.
We discussed our outlook for the metals complex in a recent metals commentary (T.N.M., April 16-22 and 23-29), and given the extent of the latest heavy retracement in metal prices, it is worth restating our views, together with an assessment of the potential downside risk to metal prices:
— Further downside is likely, with potential falls of 10-20% from current price levels — This long liquidation is being driven by market perceptions of a move forward in the interest rate cycle, a stronger U.S. dollar, moderation in some leading growth indicators and in freight rates; and finally, signs that China will slow in the coming months with its government determined to prevent overheating. The extent of the price declines have broken the previous upward trend and triggered mass selling from systems-based traders. We expect technically based trading, plus some weaker metals-related data, to push metal prices lower.
— Industrial metal inventories are low and will fall towards or, in some cases, below “critical” levels during 2004-05 — In the Western World, inventory levels throughout the manufacturing chain are still at extremely low levels, despite some improvement in recent months. Indeed, in the U.S. the growth in primary metal sales has so far exceeded growth in inventory levels that the U.S. inventory/shipments ratio has fallen to a level seen only once before, in mid-1974. However, the low ratio level in 1974 was alleviated by the recession of 1974-75. However, in stark contrast, for 2004 and 2005, we forecast the strongest 2-year period for global economic growth since 1977.
— We expect the traditional pro-cyclical relationship between commodity prices and interest rates to resume, while a firmer U.S. dollar can be associated with higher commodity prices — The end of the “reflation” trade, wherein the combination of low interest rates and a weak U.S. dollar encouraged broad-based buying of commodities as an asset class, means an end to the rare divergence between interest rates and commodity prices. We would expect upward pressure on interest rates to come from strong economic growth. Similarly, of course, strong economic growth is generally associated with rising commodity prices.
— We expect some slowdown in fixed capital investment in China — This is likely to result in some slowdown in commodities demand in the short term. Furthermore, we expect a swing in trade flows in the coming quarters for some metals after “excessive” apparent consumption in the first quarter. However, we would emphasize that the underlying drivers for China’s commodities demand growth — urbanization and consumerism — continue to hold despite the lending restrictions that have been imposed.
For now, we remain confident that a soft landing can be generated where growth of gross domestic product in the second half decelerates to under 8%. If so, demand for commodities will clearly slow, given the decline in the investment intensity of growth, but the slide in demand would not be dramatic given that the excess industrial capacity created as a result of the investment bubble will still be operated and will produce output, creating incremental demand for raw materials.
For all these reasons, and despite the likelihood of further selling pressure in the short term, we expect a classic fundamentals-justified rally to take prices to a second price peak later this year. However, market participants may well need to see nickel once more lead the next stage higher of this cycle — from investor-driven to consumer-driven — before their faith in the commodity cycle can be restored.
Nickel leads cycle
Nickel is often seen as leading the metals complex at key turning points, and it has fulfilled that role during this cycle. Nickel led the complex during the rally from 2001, and prices peaked back in the first week of this year. Since then, nickel prices have declined by more than 40%. Given the heavy retracement in metal prices in the second half of April, the earlier decline in nickel can again be seen to have led the metals complex.
The precious metals have also followed a pattern largely similar to that of nickel. Gold has actually moved pro-cyclically with nickel, though its moves have not been as large. All the white precious metals have lagged the nickel price pattern in a similar manner but have retraced with far more speed during April.
Nickel tends to lead the other metals in the cycle, owing to its modest liquidity; dominant single end-use application (stainless steel, which, in turn, is used in factory construction, and so is heavily cyclical, and in appliances and, thus, is linked to consumer spending and income growth); limited suppliers; and a marked inventory stocking cycle.
Freight rates are often also seen as either a leading or at least real-time indicator of economic growth and metals demand. Nickel appeared to lead the main Baltic Dry Freight index by around 70 days during this cycle, though the relationship with capsize freight rates (that generally transport iron ore, coal and grains) is more concurrent. This highlights the importance that trade with China has had both for nickel as well as bulk commodities. It also suggests that there has been overstocking in several commodities late last year and early this year, which drove freight rates to their earlier peaks and exaggerated the apparent consumption figures for many commodities. These trade flows are now slowing.
Why nickel prices fell
Not only has nickel led the rest of the complex lower in terms of prices but also in many of the broader themes. First, there are concerns about the outlook for demand, with signs of a slowdown in stainless steel production and the threat of substitution. Next, Chinese import demand for nickel slowed dramatically in the first quarter of the year, spurred by high prices and increased production of lower nickel contained stainless steel. Third, a number of producers reported increases in supply. And finally, reported inventories stopped declining.
We expect most of the base metals to face similar concerns in the coming months.
We believe the overall environment remains a positive one for the industrial commodities, and the risks in the short term are now lower, not higher.
We expect nickel prices to rise again. Nickel is likely to provide a crucial test of our belief that the current price correction is the valley between twin price peaks and will provide excellent buying opportunities across the industrial metals complex.
We would highlight the performance of nickel in the late 1980s as an example of the price profile that we expect during this rally. Critically, despite a firmer U.S. dollar, rising interest rates and slowing economic growth in the U.S. during 1988-89, nickel enjoyed a second rally that took prices to new highs driven by a sheer inventory shortage.
The 1987-89 rally occurred because of the combination of a lack of supply growth (following a protracted period of low prices plus strikes at the Sudbury, Ont., operations of Inco and Falconbridge) and a strong economic recovery driving inventories to critical levels. Importantly, the second price peak occurred despite a slowdown in U.S. economic growth in reaction to higher interest rates and a firmer U.S. dollar.
During the 2001-04 rally, there has again been a combination of modest supply growth (as the failure of the nickel laterite projects removed the expected low-cost supply) and strong demand (with a structural increase in demand from China plus, now, the strongest synchronized global growth outlook since the 1970s). This has drawn inventories down to their lowest levels in at least 30 years. Interestingly, the outlook for the U.S. dollar, interest rates and economic growth is more supportive for higher nickel prices in 2004 than it was back in 1988-89.
Nickel is likely to provide a crucial test of our belief that the current price correction is again the valley between twin price peaks. Indeed, it is our strong belief that the correction in industrial metal prices, which we warn is likely to continue lower in the short-to-medium term, will provide a huge buying opportunity.
We expect some slowdown in fixed capital investment in China, and this is likely to result in some slowdown in commodities demand in the short term. Furthermore, we expect a swing in trade flows in the coming quarters for some metals after “excessive” apparent consumption in the first quarter. However, we would emphasize that the underlying drivers for China’s commodities demand growth — urbanization and consumerism — continue to hold despite the lending restrictions that have been imposed.
Our economists specializing in emerging markets state the following: “For now, we remain confident that a soft landing can be generated where GDP growth in the second half decelerates to under 8%. If so, demand for commodities will clearly slow, given the decline in the investment intensity of growth, but the slide in demand would not be dramatic, given that the excess industrial capacity created as a result of the investment bubble will still be operated and will produce output, creating incremental demand for raw materials.”
— The opinions presented are the authors’ 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 authors at kevin.norrish@barcap.com, kamal.naqvi@barcap.com and ingrid.sternby@barcap.com
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