Super stuff here from Macquarie:
What to watch for in 2017
Government policy: There’s no getting away from it – in commodities, just as with pretty much any other asset class, government policy is garnering ever more influence. In a world where governments are struggling with disenchantment among the electorate and stagnant global growth, policies are increasingly working to a new playbook. And as government policy changes, so does the lay of the land for many commodities.
Of course, this is not a new thing for metals and bulk commodity markets. Following the Chinese government has been a core part of analysis here for the past fifteen years. Take the strong liquidity push right at the start of 2016 or the 276-day policy for the domestic coal industry for example as to the impact this can have. However, as Macquarie’s global strategist Viktor Shvets recently noted, the ‘follow the government’ strategy is now going global, following China’s lead as countries edge towards promoting growth through a combination of fiscal and monetary measures rather than just pushing on the monetary string.
At present, the world is focused on fiscal-led reflation, which is certainly benefitting commodity markets from an asset allocation standpoint, and is likely to into early 2017. While fiscal stimulus itself is likely to have only minimal impact on demand, and even then with a lag, rising inflation expectations will tend to support interest in commodities. In particular, we’d highlight the potential for copper demand from the much-needed rebuilding of distribution grids in global cities as the obvious beneficiary of such state spending. However, should expectations shift from healthy reflation towards stagflation or even disinflation, industrial metals would suffer while gold prospers.
2017 is going to be particularly pertinent for policy in the world’s two largest economies. In the first part of the year we will see what a patriotic Trump government strategy will actually look like for the US. In the second half, we will see what a patriotic President Xi’s plan is for China for the coming five years. Add to that the fact that 2017 will almost certainly determine whether the Eurozone huddles together or breaks apart and policy risk remains top of the agenda.
Protectionism and two-tier commodity pricing: As with any period of political uncertainty, governments become more insular and less ‘global’ in their thinking and actions. Protectionism is no longer a ‘maybe’, it is now active and growing, with trade and commodity markets at the forefront. Trump’s protectionist campaign is a case in point, and something we discussed in this note, but other countries are also upping the ante given the heavy focus on manufacturing (i.e. high productivity) jobs. This benefits domestically-focused producers over those who rely on exports.
We expect the protectionist push to lead to further fragmentations of metals (and perhaps energy) market pricing. We foresee a situation where domestic commodity prices are in many cases artificially amplified relative to those seen internationally via trade barriers and elevated customs checks, creating a two-tier pricing system. In base metals, this might be absorbed via premiums over LME, but for others regional arbitrages will develop. Meanwhile, in coal we expect China to continue to support the domestic coal price but perhaps return to enhanced customs checks on imports (under the environmental protection banner), leading to a working capital and operational arbitrage between a higher Chinese domestic price and lower international one.
From a wider perspective, the push towards de-globalisation will only delay further the necessary capacity reset many commodity markets still need. This is most notable for steel and aluminium, as governments increasingly step in to support uneconomic domestic assets, keeping these markets in a perpetual state of overcapacity.
The path of industrial recovery: The rise in commodity markets is not all about the reflation trade, nor is it solely to do with Chinese property. That age-old demand driver of global manufacturing has also played a part. Certainly, this is hardly booming at a ~2% YoY growth rate. It is however better than the close to zero rate seen this time last year. We expect global industrial output to continue recovering, helped by improving oilfield activity and mining itself being less of a drag, and thus supporting commodities demand. Indeed, November’s global manufacturing PMI was the highest since November 2014. There is still a risk that recovery is derailed by either rampant inflation or political shocks; however, it does look reasonably robust at the current time.
Any signs that China is worried about inflation: This is something we wrote about recently regarding Chinese risks for 2017, and is like the return of an old friend (or foe) to commodity markets. Our base case remains that the government and PBoC would remain biased to keep policy reasonably supportive ahead of the 2017 mid-year leadership reshuffle at the end of President Xi’s first five year term. However, we believe there is a rising risk that the Chinese government may choose to cool the economy more aggressively if markets in general become more optimistic towards the outlook for global economic growth. All through the China boom period our view was that China acted countercyclically – if the rest of the world was strong it would put on the brakes (through tightening) and vice versa. Inflation hasn’t been a concern since 2012, but is now coming back – this was the key takeaway from our recent China trip.
Should CPI and PPI both head north of 3% in the coming months – a scenario certainly possible heading through Chinese New Year – then rather than fighting inflation on local fronts (Tier 1 property prices, coal prices) aggressive monetary tightening could become more widespread. This would be a bad thing for all industrial commodity prices, as even a minor slowing in China’s commodity demand could more than offset the improvement in demand ex-China.
Regulation of Chinese commodity markets: As a subset of the point above, recently the Chinese government has shown some irritation towards the role of domestic retail investors (i.e. speculators) in commodity futures markets. They have successfully flushed them from the coal market, but it took multiple interventions to raise margins to achieve this. Meanwhile, steel and iron ore futures have seen aggressive positioning. At present, we have only seen rhetoric that the government are not happy (with the potential closure of night trading sessions), but given what happened with A-shares last year more aggressive regulation is certainly possible. This would reduce volatility in commodity markets, but would also see an abrupt removal of retail support for commodity prices.
China’s construction activity trend: In terms of end use drivers, Chinese construction activity is still the single more important for metals and bulk commodities. A key part of the 2016 recovery in metals demand has been the relative strength in the Chinese property market contributing to a more commodity-friendly growth environment. However, we feel the cycle is at a turning point.
While we expect sales volumes to fall by 10% next year, we still expect some positive growth in starts for H1 2017 owing to cashed-up developers and a need to underpin growth, supporting sequential metals demand out of Chinese New Year. Even with this, housing inventory will still be destocked, just at a lower rate. However, the new starts tailwind is likely to be fading into mid- 2017. Chinese construction data will be of paramount importance in Q2 2017, with any sign of sequential weakness a red flag. However, should construction activity continue to surprise on the upside, the main supportive factor for global commodities demand will persist. This reinforces our view that we are in a window of opportunity for metals and bulk commodity producers. And the turn in the property cycle shows this window is starting to close.
A recovery in supply growth rates: 2016 was always going to be the year of weak or negative supply growth, owing to the lack of new projects post-capex cuts and the closure of existing operations at the low prices we saw at the start of the year. Put simply, the supply cycle has been misaligned with recovering demand this year. For 2017, however, we do expect some reaction, particularly given pretty much every metal (with the notable exception of uranium) is trading at levels where pretty much every unit of supply is making money.
To be clear, in many of these markets given our medium-term demand projections and lack of permanent supply closures, we simply don’t need major new supply projects to be incentivised. This is particularly true given the lack of visibility on Chinese demand trends beyond the latter half of 2017. Mining capex has likely passed its nadir, but is not set to rise sharply. Current pricing is correctly incentivising a response from latent capacity (i.e. a short-run response). The extent of this will be important for market balances in 2017. Meanwhile, with companies now focusing on incremental operational gains and further debottlenecking, some existing assets will see planned gains. Moreover, scrap is highly price-elastic in the short run, and we would expect to see increased availability through 2017, helped by the industrial recovery.
A return of supply disruptions: In our view, miners have been scrimping on sustaining capital for too long as the pressure to reduce costs has escalated. But you can only do this for so long without a production impact, hence the ‘sustaining’ part. This year has already seen most majors downgrade their initial iron ore guidance despite rising prices, while Q3 copper production reports consistently showed misses. We expect 2017 to show higher supply disruption given the lower buffer now held against problems, offsetting some of the growth mentioned above. And this is even before potential weather events are taken into account, or the growing potential for strikes among disillusioned mining workforces (particularly should inflation accelerate in emerging markets).
Environmental restrictions on supply: This is a very current issue for Chinese supply. We have been surprised that zinc mine output has not responded more positively to the price gains seen this year, and much of this has been down to more stringent environmental regulation (and application of this). The same has been true recently of alumina, where restarts have lagged those in aluminium, again due to environmental checks, while the seasonal crackdown on the steel industry continues. Two to three years ago, we would have considered such restrictions transient. However, post the anti-corruption push Chinese local governments are very different beasts, and environmental clampdowns are being stringently enforced. In our base case we are assuming over 400kt (8.6%) growth in Chinese 2017 mine output, and restarts in alumina. If the environmental pressure is maintained however, this may not happen. Together with zinc and alumina, nickel, tin and iron ore lump/pellet would be relative beneficiaries.
Of course, it is not just China where we are seeing environmental-related clampdowns. Should the Philippines actually become more serious with its nickel miners then this would affect supply, while permitting of Latin American operations in copper, gold, zinc and iron ore remains challenging.
Occasional raw material constraints: It is still raw material constraints that generate excitement in commodity market pricing and consistent outperformance. And, despite the price moves we have seen, these are still few and far between. For us, the most pertinent are still chrome, nickel and zinc. The strength in stainless output has rapidly depleted inventories for the former pair, to a situation where the ore prices may gain even further into Q1. For zinc, we expect a lack of concentrate to feed through to lower refined output – unless demand destruction happens quicker than we currently predict.
Volatility in margins as well as prices: The strong moves in raw material prices we have recently seen create a dilemma for downstream processers such as steel mills, aluminium smelters and ferroalloy plants. This is because they still have not yet fully aligned raw materials pricing cycles with finished goods cycles or adopt active hedging strategies, as the better conversion industries do. Structurally, these sectors remains challenged owing to rampant overcapacity, however the lack of value chain alignment means margins will be highly volatile. Look for a pattern of one strong quarter for margins followed by an extremely weak one, as seen over 2010-11.
Only when raw material constraints are so severe than refined output is curtailed does this break. We don’t see any potential for this in carbon steel, and limited in aluminium (save for severe Chinese alumina constraints), however, stainless steel producers may well find themselves in a position where they have pricing power in H1 2017 owing to the lack of nickel and/or chrome.
The trajectory of oil pricing: Oil remains extremely important for all commodity markets, both in driving allocation to the wider asset class through inflation expectations and for cost structures. With the recent OPEC announcement of cuts, there is expectation of a higher price into next year. This is likely to be supportive to all commodity prices, but will also serve to steepen cost curves particularly in the bulk commodities (notably iron ore) where oil plays a major role in the cost structure. This does also mean that producer costs, after a multi-year downtrend, are likely to start slowly moving upward again.
Cost curves matter again: We struggle to think of a period over the past few years where we have had least questions on cost curves than the past two months. And that is because, at the moment, cost curves don’t matter. However, with costs set to rise as noted above and demand growth merely decent rather than aggressive, this doesn’t feel like a sustainable situation. We expect a return to cost curve-based normality over the coming year given most markets should be adequately supplied. To be clear, we are not expecting to see prices trading aggressively into these curves a la January 2016, but to a level where marginal producers are again under some pressure. Meanwhile, the game for the majors will be to move asset portfolios down these curves to be best positioned for the longer cycle, where operational gains really matter.
The dollar, and the RMB: Lastly, FX moves will continue to play an important role in commodity markets, though as we noted in “US dollar stronger but less scary for (most) metal prices” it is not the only game in town, especially for base and bulk commodities.
The narrative as the year ends is all about the strong dollar as the Fed is poised to hike interest rates. Readers will note that was the narrative last year too and look how that played out. But this time around the dollar’s strength has gained added impetus by expectations post the US election that the US economy will be boosted by US fiscal stimulus, which (especially if it allows the Fed to raise rates repeatedly) typically pushes up the exchange rate. Nevertheless there is still room for caution. On many measures the dollar is already richly valued, and the Fed is sensitive to the tightening impact a stronger currency imparts. US inflation is also likely to rise, which helps to work the other way.
Of particular interest to metals prices is the yuan exchange rate. In November it depreciated against the dollar over 6.9 for the first time since 2008. Of course as noted above most currencies fell against the dollar – and the yuan has by no means been the worst, meaning measured by the CFETS FX basket – now seen as a key metric of its relative strength – it has been broadly stable in 2H. But that we talk about it relative to the basket not the dollar is a big change, and in any case over 2016 as a whole it fallen a similar 6% against both. Market expectations are that it will fall further next year, with capital outflows continuing to pressure it (especially as in early 2017 a new US$50k quota is available for most citizens). Our China economist Larry Hu believes the PBOC has three options for the yuan – letting it fall to find its own level, maintain the status quo whereby it weakens against the USD but is stable against the basket, or to peg it against the dollar. He believes none are pleasant but expects either the second or third, meaning continued intervention and upside risk.
On the face of it any weakening of the yuan against the dollar should be bearish dollar metal prices – it increases the local price of metals, which in time means less demand and more supply. But so far this has been mitigated by the relatively low price elasticity of supply and demand in base metals (although we note copper scrap supply has been rising lately, and that Chinese battery makers have recently been said to be refusing to buy lead at recent high prices, according to Chinese consultancy SMM). Furthermore, the investment angle has worked the other way – it seems the fear of continuing devaluation is helping the investment case for base metals demand as a hedge against further devaluation. This is not to downplay the risks from a weaker yuan, especially if, as in mid-2015 it becomes intertwined over fears about the health of the Chinese economy, but simply to note at present it is not seen a big risk. Should fears about a weaker Chinese economy emerge, the theoretical ‘cost curve floor’ would be lower.
Is there anything really leftfield to think about? Plenty, as there is every year! But, at the trend rate of decline, base metal inventories at LME warehouses might get close to zero, certainly on a regional basis, at some point during 2017. That is not to say above ground stocks are zero, just that they are held outside the LME system. This could be the low-probability, high-impact event to distort metals markets over the coming 12 months.
Excellent analysis. Risk definitely outweighing reward for bulks in 2017.