Copper...better than gold.
Don Coxe
February 20, 2004
Conference call from Chicago
jonesheward.com
Chart: Copper
Comment: Better Than Gold
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I want to address this situation in light of the overall commodity view and also in the light of all sorts of experiences I’ve been having since I last talked to you. I had the privilege of being one of the speakers at the Alcan offsite, the first they’ve had since their takeover of Pechiney and there were some terrific speakers there. Had lots of institutional investors meetings with lots of questions and so what I want to do is take you through this story, but I’m going to preface it with the interesting reaction that we’re getting in the currency markets today to the US CPI numbers, and of course what it’s done to gold and to commodities generally.
What’s fascinating here is that the surprise high CPI number has had the effect actually of strengthening the dollar, not knocking it down. So what it’s done, it’s broken support levels on the dollar/Euro relationship and it’s knocked gold back down towards that $400 range again.
Now, one of the reasons I was going to do this copper being better than gold, is precisely because of my view that gold really only has value as an investment as a hedge against the American dollar. And that the story on copper, nickel, lead, zinc, aluminum, cobalt, the metals generally is a different story, but it has an inflation aspect to it and an anti-dollar aspect in that I believe all of these commodities, including oil, will outperform the dollar. So that, gold is a pure play hedge but the others go up more than the dollar goes down. But not withstanding that, it does have an impact on how they earn money – the companies that produce.
So I want to talk about these complexities in the light of the move up in copper, which went nearly parabolic and that shouldn’t happen. You know, copper is the best known and the most transparently traded of the industrial metals, with huge trading in London plus it’s on the Comex. Whereas nickel, lead, zinc and aluminum trade in London and there are other markets, but what you do not have is the kind of high visibility North American futures market for them.
So, this sensational run-up lately in copper is something that you can be somewhat skeptical about, but I believe it’s actually part of the much bigger story which is a positive one.
Now, first of all, you’ve got to start with the fact that a lot of the statistics that you’ve been seeing from China and hearing from China are out of date. Specifically, when you’re looking at copper and you’re looking at oil, what you’ve got to realize is that China was an exporter of these until very recently. Three years ago they were exporters of oil and very recently they were exporters of copper. Now they’re importers. And it’s the swing from them being an exporter to an importer at a time of burgeoning growth that produces the squeeze on the metals.
If I could have found how to pull up the chart, I actually would have used Cleveland hot melt which is one of Greenspan’s long-time favorite indicators he used to, when he was in the private sector, be a consultant to the steel industry. And hot melt is the most widely cited contract for steel scrap. And in my old days, when I was on Wall Street, that was a chart that I used a lot and it was a very good indicator, where the economy was back then, when steel was still part of the American economy.
Well, what’s happened with steel scrap here is, it has outperformed all other commodities lately. Gone straight up and so much so that the mini-mills in the US steel industry, which includes the mini-mill operations of Ipsco in the US and companies such as Nucor, they are trying to get support for asking the White House to put an embargo on steel scrap exports. Because steel scrap is now selling for far more than hot rolled coil did as recently as nine months ago.
Now this is an incredible inversion. So, the copper story then, then nickel, the aluminum, the lead and zinc stories are part of the bigger story that China was able to meet its own commodity needs until quite recently. They were importers, but my friend and colleague Ray Brackstone pointed out that as of 2002, they were only importing $35 billion worth of commodities. Now that’s still a lot, but it’s not enough to drive the world markets.
But, since then what we’ve had is last year when they did more than 9% growth and now that we’re at 19% industrial production growth in China in January, the kinds of numbers that I was hearing at the Alcan conference for growth in consumption of industrial metals is on the order of 24 to 28%, depending on which time period you use.
Now remember, China was an exporter of aluminum, too. And what’s going here – you come back to the basic rule on commodities – commodity prices are set at the margin. And so that there were two major reasons above the ordinary problems of the G7 economies in the 1990s that produced the end of the triple waterfall crash in the metals. The first was, of course, the end of the Cold War. And I personally went negative on the base metals and stayed negative after the fall of the Berlin Wall. Because it meant that there going to be no military purchases and as we were to find out in the Soviet Union, 36% of GDP was the military.
So what you had then was the factories in the Soviet Union were geared up to produce metals for the Red Army – they didn’t have a buyer anymore. So what you had was massive dumping out on global markets. Well that was a special factor that made things bad for the metals in the 90’s. And the other one was that it still had taken time to work through the commitment that was made for a lot of mines by the industry back when they were doing things badly and stupidly in building new mines.
So, it took a while to reach the bottom, but when it did what we got was this turnaround. And of course it also coincided with the entering of the US dollar into a bear market because as you’ve heard from me any number of times, when the US dollar’s in a bear market, you tend to have a commodities bull market.
The fact that we get a setback such as today in response to the first uptick in inflation with the US is to me an example of markets behaving irrationally. We have 950 years of price history, starting in Europe and through to North America. There’s two things that come out from this: first of all, is we’ve never had sustained inflation without a war. Secondly, in 100% of cases in which there has been a sustained change of direction in the course of inflation, either up or down, it’s been lead by the prices of food and fuels.
Now, I was preparing myself for the fact that something was going to unfold on this front because last week both Ed Hyman and Ned Davis, people I very much respect, threw in the towel on the relationship between commodity prices and inflation. They said, it worked historically, it isn’t working now. And I believe that those 950 years are going to become 951, 952, 953 because there’s no question that much higher energy prices have an impact on inflation. And what you see in this country is, the chemical industry, particularly the plastics industry, is just staring to shut down. We’ve had such huge price increases for some of the commodity chemicals, such as ethylene and styrene, and that eventually translates into higher prices for consumers. It takes a while but the last PPI number that I saw was up 4% year over year and PPI changes tend to lead CPI changes. Because what they are of course is entirely goods as opposed to services.
So, the uptick in inflation above what the economists expected should not be a reason to buy the dollar, it should be a reason to sell the dollar. Because it may mean that the Fed has waited too long to try to prop up the US economy and that by having 1% interest rates we have an extremely weak currency that they are inviting disaster.
So, what you’ve go to do is you’ve got to raise interest rates before the currency markets decide you’re in serious trouble, because when you raise interest rates out of fear as opposed to fighting inflation, then there is the law of the pheromone fear factor in currency trading which you’ve probably heard me refer to before which is that if you’ve got a dog with a tendency to bite sitting in the front yard, not a pit bull, and lots of people go by, if a man walks by who has an inordinate fear of being bitten by dogs, he emits pheromones that the dog picks up and the dog bites him.
Well, what we saw in 1987 and then what we saw in 1992 or 1993, I forget which year it was, with the British Pound, is when the central bank is raising rates to defend the currency against inflation, that is raising the rates out of fear instead of out of strength and that invites the currency speculators to really go to work.
So, I look on this reaction today as being the wrong way to view things. I am of the view that we’re going to have the surprises on inflation being on the high side, because when you start going – I mean, what’s going to happen on steel prices, is they’re going to go up substantially. And it’s true in the case of the automobile industry and a few others, there are long term contracts. But you’re going to have a new class of steel company going bust if they’re forced to deliver on their long-term contracts, which is those that were okay up to before, which is the mini-mills. The others, the integrated ones went bust because they had their legacy costs for healthcare and pensions. The mini-mills, who don’t have those kinds of costs and who don’t use iron ore now are in the position that if scrap sells for more than long-term contracts for coil, as an example, they’re going to go bust.
So, I have to believe that notwithstanding the long-term contracts that you’re going to see steel prices working their way into the economy. Yes, I know it isn’t as important as back in 1962, when you had the celebrated confrontation between President Kennedy with the steel industry, when he came out with that famous quote that my dad told me “All business men were sons of bitches” and produced a stock market sell-off, but what we’ve got here is that it may be the sign of the turning of the tide.
Up until now we’ve had high energy prices, rising prices for grain and soaring prices for metals and yet we’ve had inflation year over year, the CPI, or what they call core CPI, which is the old story of the economist that doesn’t eat or heat, at 1.1% year over year. Well, what I believe is that that cannot last. And given the fact that the US dollar has already fallen so far, despite unbelievable levels of intervention by foreign central banks. You know, 56 billion buying by the Japanese in January alone something like 43% of the buying of Treasuries at the auction last week was Asian central banks, all to prop up the dollar.
So, one of the things that the Germans learned and have never forgotten is a weak currency means rising inflation. Now you Canadians on the phone can say “Oh that doesn’t work, because look, we had an extremely weak currency during the 90’s and our inflation rates were at or below US rates.” Well, the reason why that worked that way was because Canada was a small economy relative to the US and global firms were prepared to maintain their place in the Canadian market by pricing goods at US levels. And I was always amused when I’d be shopping in Toronto and I used to see pineapples, for example, used to sell for exactly the same price in Canadian dollars at the St. Lawrence market that I was paying for them in Chicago. And the cars, to take a bigger item, cars were selling in Ontario at roughly the same price in Canadian dollars that they were selling in US dollars in Chicago. Now this was just a long-term strategy from suppliers and because Canada was a small market they could do this. When you have a big economy like the US then what you’re going to have eventually is that the pass-throughs will increase in price for lots of things.
Now the action of copper does suggest that we’re due to some consolidation here in the base metals just as we’ve had consolidation in gold and it’s occurring at the time when the US dollar is rallying strongly. So, I’m inclined to believe that what we are going through here is the second part of the sonata and that this is the andante or largo movement where we have some consolidation going on within the metals and getting ready for the next leg down of the dollar.
We’re coming up to the period of time when the Yen which is traditionally strong because of the tying up of the books of the Japanese multinationals, so that being offset by the massive buying by the central bank, the BOJ. But once we get that sort of factor out of the way, then I think we’re going to see a new kind of attack on the dollar which I suspect will partly come from hedgers this time.
I was really fascinated to read the report of the earnings of BHP Billiton. Now you’ve heard me talk about that company many times, it’s the biggest mining company and extremely well-managed. But what was fascinating was, because they are based in Melbourne, the company, although commodity prices, copper prices and they have the biggest copper mine in the world there, Escondida, but they said that they lost $455 million bucks because of the rise in currencies against the American dollar, particularly the Australian dollar. Yet, despite that, their profits were up 40%.
So if they had done any hedging, their profits would have been up at least, with a modest amount of hedging, 60%, 70%. So, I have a feeling that although this is a new kind of experience for the mining industry, you’ve got the gold mines in South Africa that are actually making no money in some cases because of the rising Rand. If it starts to sink in on mining companies and manufacturing companies that they’ve really got to hedge, the German auto companies hedge part of their exposure to North America or otherwise they would have really been in disasterous shape, then what that will do is produce a new set of sellers in the dollar, which hasn’t happened before.
So, my view remains that this massive central bank buying…it it weren’t for that we’d already be at the situation where the dollar would already be through a buck sixty on the Euro and in the high 80s on the Canadian dollar. So you can argue that we don’t know when that will stop, but I’m going to be working on this leading up to the next issue of Basic Points, in an analysis of how I think that China is going to address the value of the Renminbi and why Japan will also change its policy somewhat on the valuation of the Yen and both of these will be negative for the dollar.
So, wrapping it up before we get to the questions, I think the behavior of the markets today - particularly the commodity markets and the currency markets - is irrational in response to the US data. Yes, it signals that the Fed may have to tighten sooner, but what it tells you is that inflation is perhaps starting to work into the system and that isn’t good for the American dollar and ultimately it’s good for gold.
So, yeah, gold may pull back to 375, who knows what the level is on this, but if the reason that it’s getting knocked down now is because of a rally in the dollar driven by the perception that the inflation numbers will force the Fed will move soon, that is a knee-jerk reaction and in its own way is stupid as the reaction where some Wall Street strategists in November who had not been recommending the metals came out with a recommendation to buy them because the US had that spectacular GDP number, 8% in the third quarter. And that was really dumb! Because that did not produce an increase in metals demand. It was, as you know, the new middle class in Asia that was producing the increase in metals demand.
So, the markets can, on a short term basis, do stupid things, where they’re not responding rationally to news. But that doesn’t mean that the long-term story has changed. The long-term story still is that we are in the early stages of a commodity bull market that has not been experienced, anything like it, since the 1950’s.
And so we’ll have setbacks along the way, particularly because people still in these industries remain cautious. If you read the statements of Chip Goodyear of Billiton about what should be the policies here, he said that he does not believe, he said that the small companies that are financing stock to go out and drill new ore bodies, he cautioned that they should not do this because what you need is ore bodies which are economic right through the cycle as he put it. In other words, that prices of metals are going to fall back. That remains the view of the big mining companies and it’s of that kind of caution that sustained bull markets are made. That’s the story, any questions?
Q&A Session
John Noble: Hi, I just like to find out what you thought about Ivanhoe Mines as a copper play.
Answer:
As a matter of policy, I try to avoid making recommendations on Canadian stocks that are covered by Nesbitt Burns’ experts. I’m not an expert on individual stocks. I have to, when I make a sector call, know what the big cap stocks are globally in that field and have views on them. So when I talk about the major companies, such as BHP Billiton, Alcan, Alcoa and Inco – these are global companies which respond to global trends. So I would leave that up to people who are real experts on this.
What’s clear is that Ivanhoe has an ore body which can be put in the same league and may even be bigger than the Grasberg ore body of Freeport McMoran – a company that you’ve heard me speak about in glowing terms many times. So that if in fact this is an ore body of those dimensions and if it can be brought on in a reasonably short space of time, what you’re looking as is this company would become one of the great mining companies of the world. But there are a certain number of ifs on that and I won’t attempt to appraise them.
George Ireland: As always, you’re projecting price and I wanted to try to nail you in terms of projecting price out in time. How soon do you think the Fed’s going to raise rates and what impact do you think that’s going to have on the relationship against the Euro, against the Canadian dollar, against the Australian dollar against the Yen?
Answer:
Well if the Fed were really to surprise everybody by raising rates within the next couple of months, that would shock stock markets and commodity markets. We would have a lot of turmoil. But as I read the consensus, is is that they’re not going to raise rates before the election. Because the US isn’t adding to jobs. And I’ve seen various things which point out that the Fed has never gone from a period of ease to a period of tightening unless jobs were being added in the economy.
So, what I’m putting out here is a contrarian view which says that I believe they may be forced into it by two events, one of which is that inflation could surprise on the high side driven by commodities and number two is that if the Asian central banks moderate or even end their dollar support functions then you’d be looking at a situation where you’d have to attract new investors to the dollar.
To have a currency that’s in trouble and to have only a 1% interest rate on it, which is the rate you paid during the depression when the dollar was very strong, you know that’s the distinction I’m drawing here. So it’s a question of if and when. If the US economy doesn’t add jobs, Greenspan would have problems convincing people that he needed to raise rates and if he did enter a tightening period, I’m quite sure that we’d lose at least a thousand points on the Dow pretty quickly.
I happen to think that’s still the right thing to do because I’m much more worried – and that’s what I’m going to be writing about in the next Basic Points – I’m worried that if the Fed puts it off until inflation has started to move back in because of commodities and the feedback of a weak currency and then starts to tighten fast to defend the currency, that we would have a reprise of 1987. So that’s, from my standpoint, I would be thrilled if the Fed started to tightening at the next meeting, but the odds on that, I have to assume the experts, such as Sherry, say there’s not a chance of that and so what I will do is simply say that I’m now getting concerned that they're going to have to wait too long, which could produce something ugly later on.
Adam Gordon: I’m wondering, is there any risk that production in China suddenly collapses or gets scaled back because there’s a monetary blow-up in China?
Answer:
Well, that’s one of the reasons I’m inclined to believe that China is going to change its policy on the Renminbi. Because they are planning to do IPO’s on two of the four state-owned banks and that means that they have to bail out those banks. They are going to try to mimic what happened to the Shinsai(?) Bank, which is the old Long Term Credit bank in Japan – a sensationally successful IPO this week. The only place they can do that from is from tapping their foreign exchange reserves, which means putting dollars out into the system which automatically means upward pressure on the Renminbi.
So, I believe that plus soaring commodity prices where Japan is now a huge importer of them may feed into the cost structure – that those things are going to force China to reassess its policy of simply holding down the currency and the export markets and not looking about the inputs, but I expect to develop that fully in the coming week.
Michael Ecker – While I liked your comment on the call for copper at 1.25, with where it is now, do you see it staying at this level, or is it averaging at 1.25? And secondly, I wanted to have your comments on China importing their aluminum because they’re conserving their electricity instead of producing aluminum themselves, they’d rather consume the electricity.
Answer:
I’ll deal with that one first because I talked about that to the Alcan people and I got no arguments from anyone I presented this in the Plenary Session and I got no arguments from anybody that there was going to be a likely change in Chinese policy because of the gigantic strains on their electrical system. It made no sense for them to be subsidizing the production of aluminum anymore and they should import that and free up that electricity and one of the arguments I raised on this is frankly, the story in the Journal about this great new chip plant they’re putting in in China. In other words, the leaders want to see the economy diversifying out of just these basic industries, basic manufacturing into some leading edge industries.
Now these are massive users of electrical power and they need the electrical power to be reliable. So, what I believe is that the strategy will be to move away from subsidizing domestic aluminum production in favor of importing it and letting somebody else worry about paying for the oil and the coal and absorbing the pollution and leaving that electricity for consumers who are now getting electrified homes and they are not happy if they suddenly have the lights go out when for the first time in their lives they’ve been enjoying the idea of an electrified lifestyle.
So I believe that is the trend. So thanks for the question. It’s the kind of thing that once it builds, you’ve got a constituency and the internal dynamics of the decision making structure changes. |
