Commodity Blog July 2020 - Covid-19 Blog | Deloitte Australia has been saved
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During the first six months of 2020, the global economy has undergone the biggest peacetime disruption for centuries. The IMF has revised early estimates of a -3% contraction in global GDP toward -4.9%, making it the largest recorded.
While each country has taken a hit, the magnitude of decline has correlated with how effective the public health response has been. The US economy is forecast to contract by -8% this year, Italy by -12.8% and the UK -10.2%. Commodity producing countries who have managed the outbreak effectively have enjoyed windfall gains at the expense of those who have not. Australian based iron ore producers continue to benefit from prices returning to levels above $100 a tonne caused by COVID-19 driven supply disruption in Brazil.
Among commodity consumers, data suggests quick containment in China has supported the relatively quick transition back to production. But it would be disingenuous to give China’s economy a clean bill of health.
While industrial output increased by more than 4% in May, Fixed Asset Investment, another key indicator for mining, fell by over -6.3%. Several factors continue to dampen China’s economic performance. Weak export demand has meant unemployment is rising while China’s service and consumer sectors remain soft. Perhaps the biggest challenge for China’s economic recovery is negotiating a safe passage in an external environment characterised by a very weak global economy.
Beijing’s mindset appears to be adapting. Dropping the GDP growth target arguably takes stress away from the economy, allowing policymakers to make the necessary repairs and adjustments to China’s economic model. A potential focus on quality and sustainability metrics, rather than the ruthless pursuit of a credit driven growth target. Interestingly it’s a move that the diversified miners have also adopted, focusing on the quality of growth rather than the hard volume targets of old.
Recovery in the key markets of the US and the Eurozone is likely to be slower given the ongoing virus spread. Economic policy must remain accommodative across the board until the recovery has solid foundations. At the same time, there is a significant task in cushioning the impact of a reallocation of resources – people in particular - into finding new and productive opportunities in a reshaped economy.
Central banks have taken emergency measures in an unprecedented scope and scale. Unconventional liquidity measures have backstopped funding while bond purchasing has supported fiscal policy by suppressing bond yields. Interest rates have been slashed across the globe to manage the impact on the economy and existing debt, but the resurgent investment is unlikely until a vaccine enables humanity to wrest back control. Even then, public and private debt accrued during the crisis may weigh on investment intentions and consumer spending, much as it has done since the global financial crisis.
But the early signs are there. The recent slide in the US Dollar suggests investors are regaining a degree of confidence in the global economy. Investors are buying into ‘riskier’ currencies based on a view that an economic recovery is just around the corner. Like China, several countries are emerging battered but still unbroken from coronavirus lockdowns. As restrictions ease and borders reopen, we are likely to see more a positive economic growth dialogue emerge and stronger sentiment for industrial metals.
However, the crisis also presents once in a generation opportunity. The public investment required to support recovery could be substantial enough to create step changes in carbon emissions, digitalisation and ongoing adoption of other new technologies and working practices.
The pandemic has been particularly damaging to commodity markets because it combines a supply shock – commodity supply chains have been disrupted everywhere – with the inevitable demand destruction that comes with slowing global economic growth.
The challenging economic climate and virtual collapse in global trade volumes has inevitably weighed on commodity demand and pricing. On a 12-month basis, commodities have visibly underperformed relative to broad equity markets.
However, since March, asset prices have broadly risen following an unprecedented level of monetary and fiscal support, an initial slowing of the virus and promising signs from indicators such as retail sales that the contraction had troughed. Commodities and equities are two asset classes exposed to economic growth expectations, the stronger performance from both over the past three months indicates investors’ improved sentiment about the global economic outlook.
Chart 1: 3-month and 12-month price performance of commodities and equities
Unsurprisingly given the Covid-19 impact on household incomes, industrial activity and construction, those metals leveraged to the industrial, automotive and consumer cycle have been some of the biggest casualties. Copper hit a 4-year low in mid-March with the LME price falling to US$4,760/t but has since rebounded to US$6,050.75/t. Other notable base metal casualties include aluminium (highly exposed to weak consumer markets like autos) and zinc, down -10% and -27% respectively on a year-on-year basis but having rebounded 12.7% and 8.6% respectively since late March. Demand destruction is pushing some industrial metals into surplus territory, capping price upside.
Chart 2: London Metals Exchange (LME) copper price and stocks
Chart 3 London Metals Exchange (LME) aluminium price and stocks
It’s been an exceptionally tough time for energy commodities too with the pandemic negatively impacting energy demand. April saw Brent Crude prices fall below US$20/bbl and WTI enter negative territory for the first time ever. Spare a thought for much-maligned thermal coal with seaborne prices down -50% on an annual basis. The combination of slowing economic growth and national decarbonisation policies has weighed heavily on coal prices and coal producer margins. Global demand for met coal has suffered with blast furnace utilisation rates falling. While gas is doing better than other fossil fuels, partly insulated by power generation and heating demand, it’s not out of the woods either. Asian LNG prices have felt the chill winds of slowing regional economic growth and a global surplus.
Interestingly a few commodities have emerged mostly unscathed from the crisis, avoiding the broad market sell-off. Iron ore has been particularly resilient with the seaborne price of Australian ore up 16% in the past three months. Ongoing supply chain bottlenecks in Brazil together with falling iron ore port stockpiles, declining steel inventories and a resurgent manufacturing sector in China have helped to push the iron ore price over US$100/t, a remarkable performance given the perilous global economic backdrop.
Chart 4: Iron ore price (62% Fe fines) USD/mt
It’s also a very good time to be a gold producer. The classic investor ‘safe haven’ asset during times of economic distress is edging towards to a 10-year price high. As with iron ore, there’s potential upside in the tank too. Continued unconventional central bank activity, ongoing civil unrest in the United States and geopolitical tensions everywhere from Libya, Hong Kong, the Himalayas to the Korean peninsula have the potential to add fuel to the current gold price rally.
Chart 5 London Bullion Market gold price (USD/ounce)
The pandemic and all the associated market noise have made the tricky business of predicting where commodities will go next an even more difficult proposition. Disruption on a global scale has triggered significant volatility in the world’s financial and commodity markets. Positions and market sentiment can change daily.
That said, there are enough encouraging indicators in the world economy and individual commodity markets suggesting that the second half of 2020 will be notably better for several commodities. Indeed, several markets are already pricing this in. A quick inspection of recent trends shows most commodities posting price gains over the past month. Copper (12%) and aluminium (5%) recorded strong monthly price gains off the back of a stronger demand environment. The LNG Asian spot price recently spiked following stronger demand from China and South Korea. Oil prices are also picking up with Brent Crude now trading in the low US$40s, a sharp reversal from April’s low.
How much of this is transitory – effectively movements off a low base – or the beginning of something more sustainable? Whisper it quietly but we are seeing foundations for a broad commodity market recovery.
Catalysts include recent economic indicators out of China. Post lockdown, industrial and manufacturing activity is springing back into action. As restrictions ease in other countries and international trade barriers are lifted, we may see an uplift in industrial activity, increased consumer spending, higher trade volumes and a modest recovery in business investment spend, all positives for commodity demand.
Supply chain disruptions are also helping to create a more bullish price outlook. This is particularly evident in the bulk commodity space. Take a commodity like iron ore, one with relatively few major producers and a buyer with serious appetite like China. There’s further upside to the iron ore price as Covid-19 related supply chain disruptions intensify in Brazil. While mining restrictions are being lifted in several countries, the supply response from mines could be limited as other industries continue to operate below capacity.
Another commodity to watch with an emerging supply tightness narrative is oil with production cutbacks and a sharp decline in rig count sparking fears of a global supply crunch sometime down the track.
What about the miners? Caution is the word here with capital austerity and cash-flow preservation likely to trump ambitious growth projects in the near-term. Capex guidance has been cut materially across the board. The demand and commodity pricing environment is expected to be challenging for some months to come. It’s a good time to be diversified, have scale economies and have a deep balance sheet.
This blog was co-authored by Nye Hill.
James is a director in the Perth Deloitte Access Economics practice where he focuses on both mining and the public sector. Prior to joining Deloitte, James worked as a management consultant for both government clients and ASX listed companies following 17 years as an economist in UK government. During his time in the UK James worked across a numerous policy areas, most recently in international roles at the Foreign and Commonwealth Office and HM Treasury.