Metals Update: Time To Play A Reversal

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About: Invesco DB Base Metals ETF (DBB)
by: Orchid Research
Summary

Base metals remains under pressure since the start of June, as US-China trade tensions weight on sentiment.

Fundamental indicators suggest an overall improvement in the fundamental picture across the industrial metals in Q2, thanks to a seasonal improvement in demand.

As positioning across the complex is too negative, we believe that industrial metals are ripe for a solid rebound in the course of June.

We reiterate our buy view on DBB – our target price of $16.8/share by Q2 end represents a 10% gain from current levels.

Introduction

In this regular note, we provide a discussion on the degree of fundamental tightness/looseness across the industrial metals, with a special focus on copper, zinc, and aluminium, in order to formulate a clear view on the Invesco DB Base Metals Fund (DBB).

Although DDB remains undermined by ongoing US-China trade tensions, resulting in a weaker risk appetite across the base metals complex, we note that positioning is too short and therefore, incorporate a lot of bearish expectations.

If a short-covering rally emerges in industrial metals – and we think it will, DBB could rebound sharply.

We therefore continue to see a solid rally in DBB in the course of the month, expecting DBB to reach a high of $16.8/share, a 11% gain from its current level

Source: Trading View

Market price

Source: Bloomberg

The LMEX shows a year-to-date negative performance since May 29.

All the LME base metals excluding nickel and zinc post a loss on the year.

LME nickel remains the top-performer, up 9% YTD. But DBB does not include LME nickel, which is why DBB has underperformed LMEX.

The cross-correlation between daily metals returns is high, suggesting that the weakness is not driven by idiosyncratic factors; rather, the challenging macro picture results in broad-based de-risking across the complex, pushing prices lower.

Open interest

Source: Bloomberg

Open interest across most LME base metals has increased since the start of June. This means that the broad-based decline in the complex has been more driven by fresh shorting.

An increase in gross short exposure tends to portend an increased bearish sentiment.

We think that it is mainly momentum-driven. As the technical picture across most LME base metals deteriorate, momentum-based selling accelerates.

But we caution that positioning across most base metals is already very negative judging by historical standards, suggesting that a broad-based short-covering rally is likely to occur in the next three months.

Copper, exhibiting the most sensitivity to the macro forces, is the base metals for which speculators are the most short. As such, a short-covering rally is very likely for the red metal.

Since DBB includes copper, DBB could surprise to the upside.

Exchange inventories

Source: Bloomberg

Exchange inventories declined significantly in copper last month, were little changed in aluminium, and increased in zinc.

This offers a rather mixed picture. But on net, we view the recent fluctuations as indicative of tighter fundamentals. Indeed, the substantial increase in copper exchange inventories in Q1 (+80%) was an ominous sign, which could have highlighted a very negative fundamental picture.

But the fact that stocks are now moving lower suggests that demand has improved again.

The strengthening of the fundamental picture across the base metals should underpin a recovery in prices. This bodes well for DBB’s performance.

Nearby spreads

Source: Bloomberg

The most bullish aspect of this chart is the extreme backwardation at the front end of the LME zinc curve. The c/3s spread reached a backwardation (in annualized term) as high as 40% earlier last month. This was the highest level in 13 years.

As DBB is composed of zinc, DBB’s investors get a positive rolling yield by being indirectly long zinc.

The fact that zinc metal has not been attracted to LME inventories despite the extreme backwardation points to underlying tight fundamentals.

Zinc prices could move much higher accordingly.

In such a case, DBB would benefit greatly from 1)the appreciation in LME zinc prices and 2)the positive roll generated by being long zinc.

Physical premiums

Source: Bloomberg

On net, physical premiums have improved in recent weeks, which is not surprising as Q2 tends to coincide with strong seasonal demand.

However, market participants indicate that increased US-China trade tensions deter physical buying sentiment as manufacturers are reluctant to restock.

the restocking cycle, which could result in soft premiums in the coming weeks.

The current state of the physical market does not point to meaningful tight refined market conditions, which is therefore not conducive to a firmer DBB.

LMEX discount/premium to global manufacturing PMI

Source: Bloomberg, JPMorgan, Orchid Research

In the chart above, we show whether base metals (LMEX) trade at a discount or a premium to the global JPMorgan manufacturing PMI.

We find that the LMEX was trading at a premium as high as 11% in Q1 2019, but this premium has subsequently vanished in Q2.

As of today, the LMEX trades at a marginal premium of 2% to the global manufacturing PMI.

From this perspective, this means that base metals do not price strong global growth expectations. This is consistent with the fact that positioning across LME base metals is negative.

If sentiment deteriorates further, the LMEX could trade a discount, which we would view as a buying opportunity.

Conclusion

All in all, we believe that DBB has performed poorly in the past two months due to increased US-China trade tensions. Our ex-price indicators do not signal any material loosening of the fundamental picture across the base metals, including copper, aluminium, and zinc, the three components of DBB.

As positioning becomes stretched to the downside, we feel that a short-covering rally could emerge in Q2, or Q3 at the latest.

We therefore reiterate our buy view for DBB. Our price target is at $16.89/share by Q2-end.

About Invesco DB Base Metals Fund (DBB)

Invesco DB Base Metals Fund allows investors to assert exposure to some of the LME base metals.

The composition of the Fund is as follows:

DBB's assets under management total $150 million, with an average daily volume of $1.18 million and average spread (over the past 60 days) of 0.10%.

Its expense ratio is 0.80%, which makes it a relatively cheap ETF to get an exposure to the industrial metals complex.


Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Our research has not been prepared in accordance with the legal requirements designed to promote the independence of investment research. Therefore, this material cannot be considered as investment research, a research recommendation, nor a personal recommendation or advice, for regulatory purposes.