London, 3 October 2011: Commodities Now

As recovery falters and trading restrictions loom large, will investors keep faith with commodities? And what of industrial metal prospects in the months ahead. The global recovery – what there is of it in many parts of the developed world – is in a dangerous new phase. This deteriorating economic outlook was born of rising concerns about the health of sovereigns and banks.

LME Week Supplement: Global activity has slowed, downside risks have increased, and the rebalancing of demand needed for sustainable global growth has stalled. As new IMF chief Christine Lagarde recently reminded us: “In key advanced economies, the necessary hand-off from public to private demand is not taking place. The fundamental problem is that weak growth and weak balance sheets – of governments, financial institutions, and households – are feeding negatively on each other. If growth continues to lose momentum, balance sheet problems will worsen, fiscal sustainability will be threatened, and the scope for policies to salvage the recovery will disappear.” *

Everyone has been downgrading their forecasts for economic activity in the next two years. And it is not just equities that have borne the brunt of the consequent market sell-off. Oil and copper – key commodities for economic growth – did just as badly. The volatility in August and September reflected the uncertainty of the global economic outlook, and price declines showed that investors were writing off growth in the developed world for this year and fretting about renewed recession.

But what has been marked about commodities is that, in contrast to their equity counterparts, commodity analysts still remain relatively optimistic. However, the case for commodity gains still rests on ongoing demand from the developing world and no recession in the United States and Europe. And, despite all the negative news out there, the global economy will continue to grow – at around 4% this year.

So does recent price volatility in commodities represent a fundamental turning point? Well, as long as China manages a soft landing, the demand outlook still appears robust. According to Barclays Capital, “Inventory levels and spare capacity are wearing very thin indeed in some key markets such as oil, as well as in several agricultural commodities markets, so there are still very significant supply risks posed by geopolitics and weather events,” says commodities head Kevin Norrish. Moreover, degrees of supply constraint will be the main differentiators of price performance in commodities going forward. “So far this year, commodity demand has again surprised to the upside. Reflecting a more uncertain economic outlook, markets have recently moved to price in a sharp slowdown in growth. However, we doubt that the strength of early 2011 trends has yet been recognized or understood fully, and we believe that market participants have become too pessimistic about the outlook for commodity demand,” Norrish adds.

The probability of a recession in the US and much of Europe over the next six months has risen sharply. Analysts at Standard Bank recently constructed a scenario for commodity price performance based on the price performance during previous recessions; the region where commodities are consumed; the cost-of-production of a specific commodity; as well as their current views on the underlying commodities.

“It is clear that industrial production drops off sharply during a US-led recession. China is the exception; here, industrial production acts as stabilizer for demand for certain commodities. This is especially the case for metals where China dominates world consumption,” according to commodity strategist Walter de Wet. “This raises the question: can China emerge as a saviour of commodity demand in the event of a US/Eurozone recession? We believe this could partly be the case because the Chinese economy will continue to grow. But we do not believe that China can operate as an economic island. Global macroeconomic weakness will inevitably erode and undermine organic economic activity in the world’s largest exporter of economic health.”

During the recent recession, China’s government took matters into its own hands. This time around, the will of the State to intervene as aggressively is far less apparent. “Therefore, we are seeing (and will continue to see) a more subtle response in China than during the last recession,” says de Wet.

All commodity prices – except gold (normally) – decline during a recession, with prices declining irrespective of a market surplus or deficit. Even if a commodity market is in a fundamental deficit, inventories can be drawn down. However, a market surplus or deficit at the start of a recession can impact the extent to which a commodity experiences a price decline.

Should we enter a recession, amongst the commodities Standard Bank analysed, only gold rises (by 20%). All other commodities are expected to fall, with copper and thermal coal declining the least, followed by iron ore (-25%), platinum (-25%), aluminium (-30%) and Brent crude (-40%).

Deutsche Bank also recently investigated industrial metals performance during “mild” economic downturns (which is perhaps the best we can hope for at present). Their analysis points to relatively mild reductions in prices, with the current sell-off in industrial metal prices on a par with historical averages. If, and as risk aversion levels subside, further downside may be limited. “However, if deflationary concerns take hold, we could see copper prices declining to 100% premium over marginal cost ... we believe aluminium is likely to outperform in a risk aversion environment,” according to Deutsche.

At the same time, many analysts view falling prices as a kick-starter to a restocking cycle, encouraging Chinese metals imports. If, in the Western world, monetary policy remains accommodative, we could also expect industrial metals demand to remain firm. This raises the question of how output may respond if we have QE3? “Arguably the QE policy is now more conventional, so if we see any short-term impact on output as a result of QE3 at all, the impact would be small and short-lived,” according to de Wet.

Although the past few weeks have been difficult for all growth-sensitive assets, commodities are holding up better than most. But the jury is still out as to whether recent commodity price falls are merely a repeat of a familiar pattern of the upward path in commodity prices being interrupted by macroeconomic and financial uncertainties.

Aside from valuation factors, Deutsche Bank emphasise the physical factors that may limit additional downside in certain industrial metal prices. However, “the significance of current supportive commodity fundamentals could diminish fast if the market’s worst fears about growth and debt are realised.”

So, volatility will prevail, but as Barclays Capital recently reminded us, “Right now, market sentiment seems at odds with the robustness of commodity fundamentals, and any brightening of the gloom could boost prices quite quickly.”

Ends --

By Guy Isherwood, Commodities Now.

* Remarks at the Royal Institute for International Affairs - Chatham House by By Christine Lagarde, Managing Director, International Monetary Fund (September 2011).