Why, This Time, It Really Is Different!
April 25 2005 - Australasian Investment Review – (AIR)
Whether you adopt the more common ‘stronger for longer’ theme or Deutsche Bank’s ‘fat tailed pricing environment’, the message remains the same – conditions are right for commodity prices to remain strong.
Deutsche certainly thinks so, having lifted its weighted average USD metal price forecasts by 15% in 2005 and 2006, and by 16% in 2007.
The broker suggests there are numerous reasons for its adoption of more bullish forecasts, but the driving factor is the compounding effect of a further period of above-average aggregate growth on low raw material inventories combined with supply constraints.
While the market’s recent correction may have shaken out some bulls, the broker notes its new forecasts allow for a fall in growth momentum led by Europe and Japan, as well as incorporating possible future monetary policy movements in the US to account for higher oil prices and rising inflationary pressures.
The key in the broker’s view is a better understanding of the strength of demand in the current cycle, which the market has persistently underestimated.
Gaining this better understanding requires a closer look at Industrial Production (IP), and, no surprise here, economic, social and political changes in China are at the heart of the far-reaching changes in the nature of global IP.
The broker has discovered that by changing measures of global IP to account for the rising significance of emerging market demand, especially in relation to China but also India, Russia and Brazil, the key demand variable in calculating IP is increased by an annual average of 1.24% out to 2009, which in turn requires an upward re-rating of forecasts for industrial metals over the period.
Of course, not all metals are the same, so the broker suggests a weighting towards aluminium, zinc and the bulk commodities of metallurgical and thermal coal and iron ore, as an overweighting in these metals will provide protection against enhanced volatility in other metals given likely higher US interest rates and the changing long-term global IP cycle.
In addition, the broker suggests a return to positive real interest rates and the structural problems within the US economy will also be beneficial for gold and silver prices moving forward.
In 2003 David Humphreys, former chief economist at Rio Tinto (RIO), published a conference paper that illustrated how changes in developing markets impact on global IP.
He contended the factors included the development of material-intensive infrastructure and higher spending on consumption in the early stages of industrialisation, growth in discretionary spending as per capita disposable income rises, a low or falling population dependency ratio and the continuing liberalisation of markets for capital, labour and traded goods.
These factors almost perfectly sum up the position in China today and highlight its growing importance for the global economy.
But where the China experience is different to what has gone before is China has been able to run a current account surplus for much of its development period, thanks in large part to a combination of low labour costs and rising productivity.
The fact China has been able to run a surplus, meaning it has built up a large holding of foreign securities, provides it with real power when it comes to its trade relationship with the US.
The other factor is China’s expansion is expected to last far longer than other Asian countries experienced, as despite nearly 25 years of strong GDP growth China’s per capital GDP remains well-below the level of its Asian neighbours.
This will flow through into a continued high domestic savings rate and high foreign investment, which will in turn flow through into a continued need for structural reform, which obviously flows through into continued demand for metals.
You can see where the story is going – China has little choice but to continue spending on infrastructure and construction as it needs to meet the demands of its ever-growing workforce, so with it forced to import most of its commodity requirements, strong demand is likely to last for another decade at least, all without adding in the impact of other growing nations such as Russia, India and Brazil.
With the demand picture looking rosy, can supply increases spoil the picture? Not in the broker’s view, as it expects most industrial raw material and energy markets to record deficits over the next three years despite some evidence of increased supply.
Simply put, under-investment in new capacity means while market deficits are likely to narrow, new supply can’t come on stream fast enough to push markets back into surplus in the next few years.
As mentioned earlier, late-cycle metals such as aluminium and zinc are the broker’s preferred picks, along with the bulks, where constraints in port and rail infrastructure prevent any quick fix to the problem of insufficient supply.
The broker’s conclusion is this – the stronger for longer argument remains intact, because this time the situation really is different, as the development of a number of new economies, but in particular China, have changed the fundamentals of commodity markets and participants have been caught short in reacting and need time to adjust and bring markets back into balance.
In the meantime, let the good times roll.
Copyright Australasian Investment Review.
AIR publishes a weekly magazine. Subscriptions are free at www.aireview.com
aireview.com |
