The Current View
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.
Two of the five guideposts are "set to green" suggesting the most arduous part of the cyclical adjustment has passed. Although conditions have improved, the principal macroeconomic drivers do not yet appear to have sufficient momentum to carry the cycle into the upswing phase.
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.
At the end of July 2017, the exchange rate guidepost was upgraded to green.
As 2017 ended, there were emerging signs of economic forecasters beginning a sequence of growth forecast upgrades prompting a revision of the global growth guidepost to "green".
Cyclical Position
The level of metal prices is consistent with the historical average this far into a cycle. A more detailed analysis of metal price cyclical duration is available here.
Time, of itself, is not important but the sequence of adjustments which are typical of a commodity price cycle and contribute to higher prices and changed expectations does take time.
The question now is whether there is enough momentum to carry the industry further into the upswing phase of the cycle. More often than not, progress stalls around this point.
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.
Global Growth - Forecast Revisions
International Monetary Fund (IMF) forecasts have flashed warning signs that global economic growth might have already peaked.
In releasing the regular half yearly World Economic Outlook on 17 April, the IMF research director described the world economy as showing broad based momentum but kept the Fund’s global growth projections at 3.9% for both 2018 and 2019.
Generally upbeat assessments of the world economy rely
heavily on what happened in late 2017 rather than on what lies ahead. Global
growth accelerated in 2017 from 3.2% to 3.8%, the strongest increase since
the recovery from the financial crisis during 2010. Improving growth
outcomes in the second half of the year underpinned rising metal usage
following an otherwise lacklustre first half.
In January, the World Bank announced that it had raised its global GDP growth forecast for 2018 from 2.9% to 3.1%. The forecast for 2019 was raised from 2.9% to 3.0%.
The upgrades to the global growth outlook by the two international organisations 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 not so good news is that 2017 is nearly as good as it gets, in the eyes of the Fund and the World Bank.
The
IMF analysis points to no difference in average growth rates in the next six
years than in the last six years. Key regions of the world – the USA,
Europe, emerging Asia – face a downward trending growth outlook.
The Fund view is similar to that of the World Bank published in January 2018.
Unusually low productivity growth in most advanced economies, reflecting low business investment spending and governments with little enthusiasm for reform agendas, are constraining how quickly global output can expand.
Legislation to cut taxes in the USA will add a fiscal stimulus in the near term but whether it supports productivity enhancing capital spending in the next several years to sustain a stronger growth base is less certain.
Expanding world trade has contributed to higher global output. A departure from the trade liberalisation forces of the past several decades precipitated by the US administration seeking to capture a larger share of world trade would have a detrimental effect on global growth prospects and, ultimately, on the prosperity of the mining industry.
Whether such risks are realised will play out over the next several months.
US pursuit of its own self interest could help break down many existing barriers to goods and services entering Europe, China and Japan. There is an outside chance of that happening, with beneficial spillover effects for others.
Since bilateral trade imbalances reflect relative savings rates, even unexpectedly strong penetration of new US export markets could coincide with a widening US trade deficit due to the savings reduction caused by that country’s recently implemented fiscal policies.
Before conclusions can be drawn about these outcomes, a greater danger looms. Left to fester, uncertainties about trade policies will retard business investment plans. Signs of this are already evident. The most important missing piece in the progress of the metal price cycle – a stronger private sector investment commitment – is at risk immediately whatever the eventual impact on trade flows.
US Dollar Exchange Rate - Chart 2
Along with reduced risks to growth, a weaker U.S. dollar has contributed to the upward trajectory in metal prices.
Over the past 45 years, a 1% fall in the US dollar trade weighted index has come with an average rise of 3% in nonferrous metal prices. Since the end of 2016, the US dollar has fallen against a basket of currencies by 10% while daily traded non ferrous metal prices have risen over this period by as much as 20%.
The currency adjustment has 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.
After that initial adjustment to changes in interest rate expectations, markets also responded to further improvements in the outlook for growth in Europe and the diminished risks to growth attaching to instability in its financial system
Another negative influence on the US dollar has been the reduced need in a less risky macro environment for use of the US dollar as a safe haven.
All these factors remain relevant but, as markets have taken them into account, a period of relative stability has ensued pending another reason for reappraising an equilibrium level for the currency.
While stronger US growth from a tax and spending driven fiscal stimulus may precipitate a reappraisal of relative growth and interest rates in favour of the US dollar, rising US debt will push the currency in the opposite direction and toward its longer term downward trajectory.
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, they remain expansionary.
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 willingness of governments to foster stronger productivity outcomes to raise global growth potential.
Stronger productivity growth will facilitate increases in wages and consumer spending with fewer worries about rising inflation pressures.
The greatest danger to a metal price cycle comes when monetary policy settings begin to tighten in response to higher inflation with an adverse effect on output growth and investment spending.
This far into the cycle, monetary policy settings would usually be tightening, sometimes quite aggressively. Policy settings are changing far more gradually than in the past because of competitive forces within labour markets holding back inflation pressures.
While this beneficial effect on inflation may persist for longer than currently anticipated, policy is set to become progressively less supportive.
Metal Price Term Structure - Chart 1
Some 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 2017 rose by 0.7%, the smallest annual increase in demand since 2009.
Despite the unusually slow growth in usage, market balances were kept in
check by a decline in mine output.
The International Lead Zinc Study group statistics show zinc usage increasing at a 1.7% annual rate between 2010 and 2017 compared with a metal output growth rate of 0.9% leading to a multi-year rundown in inventories on a scale which has occurred only twice before in the past 50 years.
Constraints on the supply side have driven tighter market conditions but these can be reversed. If the zinc mine production rate in the last quarter of 2017 was maintained through 2018, for example, output will have grown by nearly 9% in the current year.
With only moderately increasing rates of usage across the major daily traded metals, relatively narrow metal price spreads may indicate market conditions are insufficiently strong (and possibly subject to reversal if producers choose to do so) to carry the cycle significantly further.
Chinese Growth Momentum - Chart 4
Chinese manufacturing 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).
The most recent official purchasing managers statistics for manufacturers suggest a recovery from an apparent slowing in activity in the early weeks of 2018.
Current Chinese growth rates remain highly dependent on bank lending despite widespread agreement that the flow of funds is unsustainable and creating longer term distortions which will need addressing.
More accommodating policy settings than have been in place for the past several years are highly unlikely, biasing any cyclical risks for raw material markets to the downside.
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 was higher than in 2016 but little different from four years earlier.
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.
World Steel Association statistics for March show
Chinese crude steel production 5.4% higher in the first three months of 2018
than in the corresponding period of 2017. While this is consistent with
other reports of a bounce in activity in the early weeks of the year, the
industry also reports a build up in inventories as concerns
rise that US tariffs will block markets, either directly or indirectly, for
some Chinese steel products.
China's official statistical agency reported that GDP had grown by 1.4%, or at an annualised rate of 5.7%, in the March quarter of 2018. The relatively slow pace of growth if maintained would fall significantly short of the growth targeted by Chinese leaders.
Chinese growth is destined to head lower in coming years but China has consistently met annual statistical goals in recent years through periodic growth surges. The same will likely occur in 2018 but the effort becomes progressively harder.
