Commodities: Manufacturing Hits a Sweet Spot

Includes: GSG, JJC
by: Sandeep Daga

Business survey indices released last week showed expansion in manufacturing activities – from Japan, China, UK, EU to U.S. – at a multi-year high pace in some places. Rising prices of base, ferrous and minor metals and rapidly recovering international traffic is testimony to this. A few things worth noticing here: firstly, external reasons have magnified the impact of recovery in demand into prices. Zinc, lead, aluminium and nickel stocks are at multi-year high despite recent draw-downs. However, price recovery in aluminium and nickel took support from a financing deal creating an artificial shortage at a time when demand started recovering; zinc and lead struggled.

Similarly, steel prices are being boosted more by rising Iron Ore prices than by demand. Secondly, not all idled capacities are back on-stream. Those are, however, rapidly coming on; a typical supply-demand lag. Thirdly, Chinese imports of metals is trending quieter as the rest of the world recovers; a smooth transition that most of us have craved. Fourthly, in contrast with rapid industrial recovery, the service sector struggles in the west and is cutting jobs, yet. This makes the proponents of both “V” and “L” shaped recovery proven correct – depending on where they look.

Uneven world
Theories of bubbles, forecasts of “possible double-dip” and claims of false Chinese data were questioned last week when most regions globally reported strong business confidence in widely tracked surveys. Industries are recovering at a close to record pace in some regions, as a soft stance on monetary policy remains. Except Australia, where economic data has been showing flattening growth, industrial growth in most other regions showed signs of starting to stand on its own feet as private investments complement government stimulus.

This, however, is half the story. The service sector continues to remain under pressure in most regions, especially in U.S. The U.S. job report, which showed a creation of new 162k jobs in March 2010, put the financial sector under a poor light – which continues to cut jobs. Service sector business survey indices are flirting around 50 in most regions (except the latest Chinese numbers), which means stagnation. A jobless economic recovery is explained by this.

Wave of restocking
A typical cycle of re-stocking is spreading to the west. The cycle started with government-assisted commodity imports and production in Q2 2009 in China. After record imports last year, China is now well supplied with most metals (See: Tongling’s and Jianxi’s comments on China Copper demand this year). Replication of same template is taking place in the west. Signs of industrial recovery is pushing traders to fill their warehouses and thereby resulting in rising demand for metals, scrap and strengthening premiums. Copper, Aluminium and Nickel’s LME stocks continue to see new cancellation in US as vindication of the restocking wave.

The big picture
Despite a continuous draw-down of metals from exchange warehouses, inventories are still at a comfortably high levels. Besides, rising prices is encouraging several mines and smelters to come on-stream gradually and consistently. Most analysts, including those making bullish price forecasts, expect metal inventories to rise this year (except for tin). Let’s remember that historically analysts have been slow in acknowledging the opaque supply response and hence understating metal balance during the phase of industrial recovery.

Manufacturing constitutes a small proportion of the GDP in the west. Hence, restocking by the West will not have as strong an impact on commodity prices as the Chinese made last year.

Fundamentally, most metals (especially copper) have a large speculative premium attached to their prices. In other words, at similar demand-supply balance/inventory-size, prices have been lower historically than they are now. Increasing indulgence of investment funds across the forward curve is vindicated by record high non-commercial open interest in metals and bullions as reported by CFTC. This makes us believe that commodities, especially metals, are set for a good whipsaw in the coming summer as interest rates rise push out cheap money from risky assets.

Market mood
Window-dressing in the quarter-end was followed by the news of surprisingly good manufacturing expansion around the world. This was followed by a good job report from the U.S. (the fine print is not that encouraging) on Friday when most markets were closed. Commodities have, accordingly, kept a strong bias for the upside despite a technical overheating. The market has yet to react to sharp rise in U.S. treasury yields and good job report; the U.S. works on Monday, LME returns on Tuesday.

Copper, crude, nickel are reaching their potential “technical consolidation” point. Failure to convincingly push higher this week could see them making a “flag” consolidation by giving back some gains but keeping the uptrend. Q2 being one of strongest period for industrial activities in the west, we could see stock draw-downs in U.S., Europe. However, the market would like to see ahead of these.

Looking at the medium term, with most positive news about industrial recovery already priced-in, a few could use rallies to build short positions. We expect sharp movements in metal prices in May/June as hot money is replaced by long-term passive investment money. Market will provide opportunities for change of hands from momentum funds to consumers. However, before that, prices could spike somewhat higher from here.

We see copper pausing this week. However, a push higher, later, could see resistance at 8050/8100 first. Beyond this, a capitulation by shorts could push it to 8500 too swiftly. This could be the time to build short positions. Zinc and aluminium could push gradually higher by broader positive sentiment.

Crude has a strong technical resistance around $86 and this week could see good fight between the two sides in this commodity. We don’t think the world is yet ready for higher crude prices and hence a consolidation down to low the 70s is possible in the coming weeks. We, however, expect crude to finish the year with three digit number.

Gold is inching-up to the upper band of the bullish consolidation triangle ($1135/40). Break-out may take a while, however, the commodity looks good technically and is worth dip buying.

The dollar is set to rally further; the most against yen. The JPY has technically broken out of the long trendline of appreciation. This is a big event and should help JPY push towards 105 by the end of this year. We expect 120 to be seen in 2011.

The market will fully price-in the effect of the good job report and rising yields in the USD on Monday. EUR and GBP are set to push lower in coming weeks after technical consoilidation seems to be getting over. We expect the euro to see 1.28 by end of April. The Australian Dollar is struggling above 0.9250 despite rising Copper, Ore and Coal prices; this is major technical resistence as well. In absence of strong Australian data, we exepect this to push down below 0.90 in coming two weeks.

The Chinese premier’s meeting with the U.S, President will be watched closely for “negotiating” possible currency strength against “respect” for Chinese foreign policies towards Tibet and Taiwan.

Disclosure: None