COVID-19 and metals markets – profound and unexpected consequences

Initially, “a lot of people were comparing this to a conventional recession, however it’s been anything but,” say the Macquarie team. “During a conventional recession, all industrial commodities – and even gold – tend to collapse synchronously, but that’s not what we’ve seen here.”

Earlier this year, prices in base metals and energy markets did collapse, with corrections in the order of 20 to 100+ per cent, as WTI crude oil turned negative in dramatic fashion.  However, prices of ferrous commodities, such as iron ore and steel, held up remarkably well. An extremely abnormal bifurcation but one that reflected the extraordinary pace with which China’s economy began to recover post-lockdown.

Inevitably, China, as one of the world’s largest consumers and suppliers of metals, has had a major influence on the price path for commodities this year. China depends heavily on fixed investment to maintain high rates of growth, something that has increased this year, with the government deploying fiscal stimulus to support the economy. This delivered a “very strong demand-pull for iron ore, steel, and coal”, note the strategy team.

China also depends on the imports of many other commodities such as copper, nickel, zinc, and bauxite. These imports account for 60 to 80 per cent of China’s total supply of these metals, so the country’s economic recovery has provided a huge offset to the wider negative impact of the pandemic, and associated lockdowns, on metals demand. According to Macquarie’s strategists, “aluminium is arguably the most extreme example of this dynamic”, with China swinging from net-exporter to net-importer in recent months, on account of the country’s demand recovery gaining strength while other major consuming countries remained under lockdown conditions. 

Moreover, there have been signs that low prices incentivised stock building, both commercial and strategic, in several metals. For copper in particular, this provided an additional demand prop when global industrial activity was heavily curtailed during the first half of the year.   

The scale and pace of China’s aggressive recovery program was unexpected.  “Many people took the view that China’s economy would recover from the second quarter of this year and return to pre-virus levels sometime in 2021” but, the team highlight, “it largely bounced back within three months.”

Of course, China has delivered large scale economic stimulus twice before - in 2009, to stabilise its domestic economy after the global financial crisis and in 2016, after China’s self-imposed ‘credit crunch’, it drove another strong recovery. In that sense, the current commodity demand bounce back has clear echoes of history but, in addition to a dramatic loosening of global monetary policy, the response to coronavirus has included fiscal easing from developed markets, on a scale unprecedented in peace time. “This has driven a startlingly fast recovery in global goods demand”, say Macquarie’s strategists, in turn supporting a rapid return to pre-coronavirus levels of global industrial production.

Gold has also confounded some market watchers, with many questioning: when inflation is so low why are people buying gold?  As the team explain, “the key thing for gold is real interest rates – so it’s the interplay between inflation and interest rates that drives gold investors’ behaviour.” Even with inflation still low, the recovery in growth since the second quarter has begun to lift inflation – and inflation expectations – but Federal Reserve policy is anchoring interest rates, resulting in real interest rates falling further into negative territory. This makes gold’s zero yield look comparatively attractive.  

Looking across markets, the relative performance of major commodities has been consistent with the nature of the global recovery to date. Compared to iron ore – with a greater gearing to China’s demand and large Brazilian supply disruptions, and crude oil – greater sensitivity to services demand and supply overhang, copper is rightly in the middle of the pack.  

As we enter the fourth quarter of 2020, markets are therefore “finely poised”, in the eyes of Macquarie’s strategy team. A glass half-full outlook would stress the fact that developed market inventories of manufactured goods are low – having been run down by coronavirus related disruptions to production and the strong subsequent demand recovery, creating the potential for a restocking cycle to lift commodities demand further into the first half of 2021.

Moreover, next year should bring the start of disbursements from Europe’s €750 billion common reconstruction fund and, even if no 5^th US fiscal package is agreed before the election, any new administration is likely to deliver further policy easing. Indeed, if this is primarily focussed on infrastructure spending and direct income support rather than tax cuts, it could present an “upside risk to aggregate demand”, note the strategists.

If we dig a little deeper into the individual metals, however, the team highlight that “some notes of caution have begun to emerge”. To continue with the example of copper, since summer the market has shifted from a period where visible inventories were falling, physical premiums were rising, and Chinese domestic prices were above their LME equivalent – incentivising imports; to a backdrop of rising visible inventories, sliding physical premiums and Chinese domestic prices below their LME equivalent.

This is not to suggest that fundamentals have suddenly deteriorated but it raises two key questions: first, have prices – spurred on by investor exuberance – overshot fundamentals? And second, has the pace of the China led demand recovery already peaked?

Macquarie’s strategists think the first answer “is yes, but not dramatically so”. The price recovery has extended beyond what fundamentals alone could justify, which is why the physical market is now lagging, but that does not diminish how impressive the real demand rebound has been to date. Nevertheless, the bigger issue is clearly whether or not that rebound has peaked. If not, improving fundamentals could still justify the heights that prices have already achieved.

Here, the team believe, “it is crucial to distinguish between the level of demand and the pace with which it is changing”. As global growth normalises after its rapid recovery phase, industrial commodities’ demand growth should slow, a shift which is likely to be exacerbated by the Chinese authorities dialling down stimulus measures, having achieved their desired effect. This combination leaves prices vulnerable to a short-term correction but, beyond this, the level of demand – supported by restocking – should lift further into 2021, keeping prices relatively buoyant.

This year we are delighted to be able to host our annual LME base metals summit virtually for the first time on 19 October 2020, where the Macquarie team of expert commodity and macro strategists explore the market themes they expect to dominate the headlines in the year to come.