Commodities: Fundamentally constructive despite moderating returns

Copper: Supply to be the main driver amid some China-fueled volatility. Target 12M: USD 7500 /mt (vs spot USD 7085/mt)

Base metals shined in H2 2017, outperforming global equities and bringing copper and aluminium prices to levels not seen since the 2014 commodity sell-off. As we believe that global economic growth is likely to remain strong in 2018, we expect base metals to continue to ride the cycle and perform well this year. Since the start of the year, markets have been consolidating, giving way to idiosyncratic, metal-by-metal specific stories. Chinese economic activity, regulation and supply dynamics should move back to the fore.  

In China, as policymakers shift focus to financial stability, some slowdown in the pace of economic growth is to be expected. Indeed, monetary conditions are becoming gradually tighter as exhibited in recent credit data. Given the dominance of Chinese demand in the metals space, it is difficult to avoid the issue.

The aggressive targeting of financial excesses has dampened domestic activity recently, but robust foreign demand, along with surprisingly resilient infrastructure and housing construction, has lead us to believe there is enough momentum in the economy to sustain low 6% growth in the next few quarters.

Looking forward, we see limited downside risk to our baseline scenario as any material deceleration in headline growth to the 5% range would trigger a significant policy response.

All in all, with the headline figure near to its recent peak, we will keep a close eye on future PMI releases given the sensitivity of investors’ positioning to this data (Chart VI). Short term, this newsflow could trigger some volatility episodes in the base metals complex. We would, however,  see these as transitory and a tactical opportunity, given the dynamism of ex-China economic activity and our supply outlook.

On the supply side, China is also a key player for most base metals such that short-term physical balances are being affected by Chinese regulation (state-mandated factory closures and policies to protect the environment during the winter season). Inventories are already down from recent highs (Chart VII). Medium term, supply might face physical constraints in some segments.  Years of low investment in the non-ferrous metal sector are likely to translate into a market deficit and, in turn, price acceleration, especially in long-cycle commodities such as copper (Chart VIII). Compared to history, the duration of disinvestment has been particularly long this time, leading to high levels of caution on the part of companies’ management, despite current prices exceeding median cash costs.

In our baseline scenario, global trade should remain supportive, while the USD will stay under pressure, suggesting another two-digit performance for copper in 2018. Against this backdrop, we revise our target up, expecting copper prices to be at USD 7500/mt by end 2018.

Gold: Weaker US dollar is supportive, but real rates to remain an anchor. Target 12M: USD 1300/ounce (vs spot USD 1345/ounce)

Gold is experiencing a strong rally, posting more than 10% gains since July last year. Initially triggered by receding geopolitical concerns, the upward trend has been reinforced more recently by the USD weakness across the board. Strikingly, this impressive move took place at a time when the US bond market was experiencing a sharp sell-off, pushing real rates up by 15 basis points.

We have long supported the view that gold prices should remain in a range, dictated by relatively low and stable US real rates (Chart IX). This outlook on rates is structural, influenced mainly by potential growth being below that of past decades (due to negative demographics and weak productivity). On a shorter-time horizon, we expect the US Federal Reserve (Fed) to pursue its monetary policy tightening – another factor that should prevent a surge in gold prices, especially if the long-awaited bottoming out of inflation and wage growth data leads to further repricing of Fed action.

Interestingly, real rates, which had been the main driver over the past 18 months, are now less correlated with gold than the US dollar. A weakening USD environment, particularly against emerging markets currencies, is likely to fuel additional demand for gold (Chart X). The latest datapoints confirm this: after several years in negative territory, jewellery consumption is accelerating in Brazil, China, Russia and Taiwan, certainly helped by a domestic and global cyclical pick-up.

Cross-asset relationships show that current levels of US real rates and USD suggest that gold might be slightly overvalued – or seems to price in some geopolitical risk. We keep our neutral positioning unchanged, while raising our target to USD 1300/ounce to take into account the effect of a weaker US dollar going forward and, in turn, potential strengthening of emerging markets demand. Yet, in the absence of systemic risk (likely to further fuel financial demand), the medium-term anchor to real rates limits the upside. 

Investment implications

On top of the fundamental analysis developed above, investment flows certainly offered strong support to the broad-based rally experienced in December and early January. Indeed, the rise in intra-commodities correlation suggests that allocation flows were at play, seemingly driven by inflation fears. After years of gloom, market sentiment seems to have changed for the better.

As such, we think it is worth maintaining an exposure to the asset class – despite expected returns having been reduced by the impressive price action witnessed last quarter. With more risk on the upside (given rising inflation or geopolitical risk) than on the downside, the asset class looks interesting. Yet, for those who do not already have  an exposure, stretched speculative positioning calls for caution in the short term as better entry points might arise over the course of the year.

¹Bottom-up estimates for marginal costs point to a USD 52-59/bbl range, depending of the company and the wells location

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