Macquarie’s economists are turning more pessimistic.
In their latest Global Macro Outlook note, the Australian bank warns that the global economy’s recent “coordinated” growth has peaked, which will have implications for all asset classes. In this note we look at their forecast for the commodity sector, where Macquarie is especially gloomy, warning that “the supporting factors for wider commodity markets are now being steadily eroded” and adds that “hopes for accelerating global growth and accompanying healthy reflation are fading. The industrial recovery cycle has matured, and is providing less global impetus.”
A key culprit behind the upcoming slowdown is predictably China:
After the regular liquidity pushes of 2016, the Chinese government has now shifted to a tightening bias, propagating a destock cycle through the manufacturing chain. Chinese construction activity has been extremely strong, but we also expect sequential weakness in this area. To be clear, underlying demand conditions are and still will be good over the coming months even if the global industrial growth cycle has peaked, but sentiment shifts are clearly now on a downward trend given previously high expectations.
Furthermore, the bank warns that “things were too good to be sustainable earlier in the year, with many commodities trading out of cost curves. Cyclically, that means commodity positioning should be generally defensive, with even those commodities having raw material constraints under pressure. But as the reflation tide goes out, it gives an opportunity to discern which commodities genuinely have strong fundamentals. Structurally, it is a time to start picking longer-term winners.“
And so, once again we go to the credit impulse and the (re)flation cycle, which has in recent years originated almost exclusively in China.
So what does that mean from a commodity cycle standpoint: as Macquarie notes, demand leads and supply reacts, with a lag. And the factor which facilitates this process is price.
2017 looks to be providing another classic example of this simple commodity rule, one we have seen played out again and again. Those which traded out the cost curve in 2016 are seeing the strongest positive supply reaction (before disruptions), and those which have consistently traded into the cost curve a supply decline in the main. Coming months will find out the extent to which supply-side flexibility exists across various commodities.
Below we present some further observations from the Macquarie commodities team:
- Looking further out, core exposure should still be to those where the supply side has structural pressures. These can be ongoing raw material constraints or areas where the projects needed to provide balance are expensive and dilutive to the existing asset base. Alternatively, it can be those where current pricing is simply too low to be sustainable, where insufficient capex is being spent, or where there is overreliance on a single country for supply.
- For metals and bulk commodities, the key thing to watch over the coming couple of months is Chinese construction activity. Currently, while steel hot rolled coil margins in China are negative as downstream sectors struggle to accommodate excess supply, rebar margins are strong while long product inventory held by the traders is drawing down fast. This points to still-robust construction activity. However, with MoM sales prices now limited, and only Tier-3 cities (most of whom have high inventory) seeing strong sales, we expect signs of weakness to come through in new starts and fixed asset investment in real estate.
- Given this view, we expect a further leg lower in the ferrous value chain. After the excitement earlier this year, iron ore will head back to displacement mode, with $ 50/t pricing required. We also see downside into year-end in met coal and manganese. Steel margins should be structurally improving as we head past peak global overcapacity amid Chinese reform; however there is no expectation of a bottleneck anytime soon. Longer-term, met coal remains the best in the ferrous chain given the propensity for supply problems which arguably justify a risk premium over long-run equilibrium prices.
- The external environment for gold has given mixed messages so far in 2017. The US economy has been disappointing, but Fed rate expectations have remained solid. The dollar is down, but mainly because the euro is up. US political risk has risen, but in Europe it has fallen. This has meant investor interest has been relatively light, and what gains the price has made seem largely down to an improving physical balance. But investors don’t stay on the sidelines for long in the gold market and while short-term we remain cautious – the Fed is going to raise rates – long-term we think the US economy is near full capacity, potential growth rates are low and long-term yields will peak far lower than the market expects. This is setting up a positive gold price performance in 2H.
- For many energy markets, we currently have a supply side which is offering strong fundamental support. From OPEC’s cuts to lithium’s delayed projects, to the fact that US natural gas supply growth has decelerated, supply to markets is below levels we would have 12 months ago. This allows us to be constructive in the near term with regard to potential price performance. Moreover, demand conditions are reasonable on the back of decent industrial production growth.
- However, in our view we are too reliant on government policy in many areas of the energy markets to be comfortable. Certainly, this has often been the case with demand, but also in terms of supply. Slippage in OPEC compliance remains a risk in oil, without evidence of the announced production cuts from Kazakhstan any uranium rebalancing is off the table, and while the Chinese government ‘put’ under the global thermal coal market can hold for now, we don’t believe this will happen in perpetuity.
- Moreover, the supply response is coming. In oil, if the US realises our expected path in 2017 of 1.5 MBD exit/exit growth, we could be looking at global market oversupply nearing 2MBPD into mid-2018. US natural gas output growth is also set to reaccelerate into H2, while Australian lithium output is set to double this year. This makes us generally more cautious on energy pricing into 2018 after some near-term gains.
Over the coming months, commodities as a whole look set to face slightly more headwinds than tailwinds. We would avoid those most exposed to Chinese construction, given it is currently so strong that the next move is likely to be lower. This means further pressure on iron ore, metallurgical coal and manganese. In contrast, we expect upside to gold and silver over the coming months as the market refocuses from healthy reflation to deflation potential. We also believe the wider market has become too sanguine to weather risks in agricultural markets, where we feel risk/reward is skewed to the upside.
We would also consider optionality around those commodities where the Chinese government is set to curtail capacity. Aluminium has been widely discussed in this regard, but we would also look at stainless steel, nitrogen and alumina as those with potential to be next on the supply side reform agenda.
On a longer-term view, we like exposure to copper, silver, gold, chrome and, eventually, oil. We also believe that uranium and potash are at the start of a long crawl off the canvas after a tough couple of years.