Where Are We in the Cycle

The Current View

Growth in demand for raw materials peaked in late 2010. Initially, supply growth had outstripped demand leading to inventory rebuilding or spare production capacity. With the risk of shortages greatly reduced, prices lost their risk premia and tended toward marginal production costs to rebalance markets.

The PortfolioDirect cyclical guideposts suggest that the best possible macroeconomic circumstances for the resources sector will involve a sequence of upward revisions to global growth forecasts, the term structure of metal prices once again reflecting rising near term shortages, a weakening US dollar, strong money supply growth rates and positive Chinese growth momentum. Only one of the five guideposts is "set to green" (after the most recent adjustments in July 2017) suggesting the sector remains confined to near the bottom of the cycle.

The worst of the cyclical adjustment has passed. Although conditions have improved, the principal macroeconomic drivers do not appear to have sufficient momentum to carry the cycle to the next stage.

Has Anything Changed? - Updated View

From mid 2014, the metal market cyclical position was characterised as ‘Trough Entry’ with all but one of the PortfolioDirect cyclical guideposts - the international policy stance - flashing ‘red’ to indicate the absence of support.

Through February 2016, the first signs of cyclical improvement in nearly two years started to emerge. The metal price term structure reflected some moderate tightening in market conditions and the guidepost indicator was upgraded to ‘amber’ pending confirmation of further movement in this direction.

As of early December 2016, the Chinese growth momentum indicator was also upgraded to amber reflecting some slight improvement in the reading from the manufacturing sector purchasing managers index. Offsetting this benefit, to some extent, the policy stance indicator was been downgraded from green to amber.

The most recent change in cyclical guidepost positioning has been at the end of July 2017 when the exchange rate guidepost was upgraded to green.

Cyclical Position

Forty months after their peak, metal prices should have passed their nadir and be heading higher, as they are. Prices are not materially different from the historical average this far into a cycle.

Time, of itself, is not important but the sequence of adjustments which contribute to higher prices and changed expectations take time.

Based on the historical averages, a pullback is more likely than further rises. A pullback is not a necessary outcome but an alternative result would most likely require some combination of higher growth, further U.S. dollar weakness or a period of more supportive monetary policies.

There is no assurance presently that any of those three factors will favour the cycle progressing significantly beyond its present position.

The balance of risks suggests a more moderate appreciation in metal prices.

Global Growth - Forecast Revisions

Improved mining industry fortunes now depend on US tax cuts spurring growth, the UK and European governments negotiating a growth enhancing Brexit pact and China being able to cut back runaway lending without disrupting output growth.

US tax legislation is set to pass the Congress and be signed into law before Christmas. Estimates of the growth impact vary but the non partisan estimates prepared for legislators keep the resulting GDP growth trajectory at 2-3%.

Brexit negotiations have made progress this month with an agreement reached between the two sides over the three preconditions set by the EU negotiators but so complex are the issues that a trade deal between Britain and the remaining European countries is years away. May's slim parliamentary majority continues to limit her freedom to finalise a result without further scrutiny and uncertainty about outcomes.

The IMF announced on 10 October that it had raised its forecast for global growth in 2017 to 3.6% from 3.4% at the time of the corresponding forecast round last year and after a 3.2% expansion of the global economy in 2016.

The Fund’s upgrade of the global growth outlook ostensibly contained some of the best news for the mining industry since 2010.

The strongest increases in metal usage typically occur when global GDP growth is accelerating.

Rising growth projections are usually a prompt for strategists to raise sectoral fund allocations.

The change for 2017 - the largest upgrade since an initial forecast of 4.5% in 2013 - follows a succession of negative revisions.

The good news is that the macroeconomic risk profile has shifted significantly in favour of the mining industry.

The not so good news is that 2017 is nearly as good as it gets, in the eyes of the Fund. The positive momentum on which strengthening growth in raw material demand relies is almost nonexistent.

Among the advanced economies, growth by 2022 is expected to be 0.5 percentage points lower than in 2017 as economic slack is eliminated.

Chinese growth is expected to decline by a full percentage point.

Any global growth improvement is expected to come entirely from emerging market economies outside China in Latin America, the Middle East and sub-Saharan Africa.

Financial markets are also discounting the likelihood of any significant improvement in growth or higher inflation outcomes.

The pattern of US bond yield movements during the year has been consistent with yields nearing a cyclical turning point but, just as evident, is the persistence of a multi-decade downtrend.

US Dollar Exchange Rate- Chart 2

Much of the upward trajectory in metal prices through 2017 has been contributed by a weaker U.S. dollar.

The currency adjustment reflected some reappraisal of relative growth rates and the direction and pace of interest rate changes.

In particular, a rethink occurred about the length of the lag between the U.S. Federal Reserve beginning to tighten its monetary policies and the European Central Bank going down the same path.

Expectations having been reset, a need for further changes in the exchange rate have probably receded. That would leave metal prices with one less leg of support.

With the prospect of a fiscal filip to the U.S. economy in 2018 and 2019 from tax cuts, a move higher in the U.S. dollar becomes a stronger possibility.

Since the impact of the tax cuts remains uncertain, greater currency volatility might ensue as speculation occurs about how the dollar will be affected.

International Policy Stance - Chart 3

Global monetary policies had been set to support higher asset prices as a step toward raising demand and creating stronger employment markets.

While the emphasis on these policies is being reduced as growth becomes more self sustaining, monetary accommodation remains historically strong.

Metal prices are affected by monetary conditions with a lag of several quarters so that there is no imminent threat from future winding back in monetary support but the prospective trajectory of monetary policy will be a source of eventual downward pressure on metal prices.

As some of the most favourable monetary conditions in modern history are wound back, the mining industry will be relying more heavily on output growth and, for that, on the policy dexterity of Messrs Trump, Xi and May.

Metal Price Term Structure - Chart 1

Some modest tightening in nonferrous metal price spreads has been occurring over the past several months driven by emerging backwardations in London Metal Exchange lead and zinc prices.

The tightening in spreads is modest by the standards of what might be possible but overall physical market balances do not appear to be changing enough for the shift in premiums to move more dramatically.

The International Copper Study Group (ICSG) has reported that demand for the metal in the nine months to September 2017 had risen by 0.6% from the corresponding period of 2016.

The ICSG has estimated that there was a slight increase in global metal inventories between the end of September 2016 and the end of Seeptember 2017.

The International Lead Zinc Study group has reported that zinc usage in the first 10 months of 2017 increased by only 1.2%, also below the 3%-plus historical rates of nonferrous metal consumption growth.

The unusually weak expansion in zinc usage has coincided with lowered metal production after mine output fell in 2016. The changing production profile has helped constrain the inventory build that might have otherwise occurred.

With only moderately increasing or falling rates of usage across the major daily traded metals, relatively narrow metal price spreads may indicate market conditions are insufficiently strong to carry the cycle significantly further.

Chinese Growth Momentum - Chart 4

Chinese manufacturing has enjoyed a prolonged expansion during 2017 which has helped build positive sentiment for investments in the mining sector (as illustrated in the fourth chart in the right hand panel).

Current Chinese growth rates remain highly dependent on the accommodative lending policies of the central government.

The dependence on financial leverage comes despite widespread agreement that the flow of funds is unsustainable and creating longer term distortions which will need addressing.

There is no prospect of more accommodating policy settings than have been in place for the past several years biasing any cyclical risks for raw material markets to the downside.

The latest official trade data from China for the period to the end of November has shown an improvement in the value of goods exported and imported. Exports in November 2017 were 12% higher than a year earlier. Imports were 19% higher.

While the net position has implications for exchange rates and monetary settings, the direction of the change is also important for the mining sector insofar as it suggests an improvement in both domestic Chinese demand and global market conditions for Chinese manufactured products.

The improvement remains only a partial recovery after the prior domestic and global slump in demand leaving the raw material demand profile lagging behind where it had been.

The restructuring of the Chinese economy with the resulting contraction in the contribution to Chinese GDP of investment spending will have a generally detrimental effect on raw material demand.

Chinese steel production in 2017 is set to remain at around the same levels as in the past three years.

Other signs of subdued momentum have been evident in statistics released by the International Copper Study Group and the International Lead Zinc Study group which show global per capita metal usage rates remaining little changed for four consecutive years.