Markets Weekly podcast - 17 May 2021
Will copper’s red-hot run turn the commodities boom into a new supercycle? And why are stock markets so spooked by inflation? Join host Henk Potts, Market Strategist, and Jai Lakhani, Investment Strategist, both of Barclays Private Bank, to discuss this and more on this week’s Markets Weekly podcast.
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Henk Potts (HP): Hello, its Monday the 17th of May and welcome to the Barclays Private Bank Markets Weekly podcast. The recording that will guide you through the turmoil of the global economy and financial markets.
My name is Hank Potts, Market Strategist for Barclays Private Bank and each week I'll be joined by guests, discuss both risks and opportunities for investors.
Firstly, I’ll analyse the events that moved the markets and grabbed the headlines over the course of the past week. I’ll then analyse the outlook for commodity prices. Finally, I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead.
The spectre of inflation loomed large over markets once again last week. Risk sentiment crumbled as investors reacted to surging commodity prices, high CPI in the United States and the pick-up in producer prices in China.
We know that markets are bracing themselves for a robust US CPI print for April. Year on year forecast was for growth of 3.6%, the actual figure came in up 4.2%. To put that in some sort of context that's the most since 2008, core CPI rose the most since 1982. Driven by increased prices for motor cars, transportation services and shelter prices which jumped the most in two years as rents and hotel costs advanced.
We should recognise the figures are flattered by the comparison with depressed inflation numbers a year ago when of course the economy was in lockdown. However, the report did intensify the debate about how high US inflation will rise and perhaps more importantly for how long.
Price pressures are also building outside the United States. China's factory gate prices surged more than expected in April. The producer price index rose 6.8% from a year earlier, it's the fastest pace in more than three years following a 4.4% gain in March, primarily fuelled by rapid gains in global commodity prices.
Rising domestic competition for raw materials driven by China's booming industrial construction and infrastructure sectors is also creating a self-fulfilling spike in local prices.
Rising cost pressures for the Chinese factories pose another risk for global inflation as manufacturers start passing on higher prices to retailers.
In commodities it was another violent week of volatility. The boom extended and broadened at the start of the week, however there was a dramatic reversal of fortunes in the last two sessions as Chinese authorities hinted they would use their powers to calm the trading frenzy.
Regulators have begun to implement higher margin requirements and narrow daily trading bands, authorities could also consider releasing some of the countries strategic reserves to improve supply.
In terms of asset class performance, yields rose and equities sold off. 10-year Treasury yield fell on Friday but rose 6.3 basis points over the course of the week.
In terms of equities the S&P 500 rose rest for a second day on Friday, actually quite a good session up 1.5%, but was down 1.4% over the course of the week that's the biggest weekly decline since the week ending February the 26th. In terms of Europe, the Stoxx 600 was down half of 1% over the course of the week.
We do know rising inflation can impact equity market performance. Number one it can encourage policymakers to lift rates earlier thereby slowing growth. Number two higher real bond yields will result in an increase in the discount rate applied to future cash flows and compress valuations. And number three rising input costs could also pressure profits, thereby reducing the appeal of stocks which as we know have already been trading at elevated levels.
In terms of the outlook for inflation, economists have been hiking their inflation forecasts. What's been driving that? Well the relaxation of restrictions that’s anticipated to lead to the unleashing of pent up demand. Price pressures are also coming from ultra-accommodative monetary policy and that flood of fiscal support. Technical and statistical factors along as we've been talking about surging commodity prices certainly playing their role.
Given the broad range of demand, pull and cost-push inflationary pressures it's perhaps no surprise that year on year inflation prints could significantly rise over the course of this year. For the UK, Europe and the United States headline inflation is projected to be one percentage point higher than in 2020.
However, a number of facts suggest the inflationary pressure we've been seeing is transitory, unemployment rates are elevated compared to pre-pandemic levels therefore the wage growth often associated with core inflation pressures is not being seen.
The rapid digitalisation and ongoing investment in technology is reducing price pressures. The level of spare capacity in many economies remains high compared to the start of the recession, that should also help to anchor inflationary pressures.
Is tighter monetary policy on the horizon? Well given the medium term inflation forecasts remain below central banks mandated levels the impact of stronger inflationary pressures on monetary policy we think is likely to be more muted than recent movements in bond markets suggest.
We forecast the Fed, the European Central Bank and the Bank of England will keep rates on hold this year and next. Investors do need to be aware of inflation risks. Those seeking protection, there are a wide range of options available to mitigate inflation risks by using equities, fixed income and of course precious metals.
In equities we think investors should focus on companies and industries that offer pricing power, luxury goods, chemical companies and selected industrials fit quite nicely into this category.
The real sectors to avoid are those that struggle with inflation they tend to be these highly competitive ones and those are extensively regulated, they include the likes of the telecoms and the utilities.
But in bond markets inflation linked bonds, floating rate bonds and also high yield bonds can help to mitigate inflation risk to a certain extent but none of the bond segments are a perfect hedge and additional risk and factors should be taken into consideration.
So that was a global economy and financial markets last week. We’ve been talking about commodity prices surging base metal hitting record highs and I’m pleased to be joined by investment strategist Jai Lakhani to discuss the commodity sector and the outlook for the market.
Jai, great to have you with us today. To get us started what has been driving the strong performance we've seen in commodities during the course of this year?
Jai Lakhani (JL): Well good morning Henk and thank you for having me. You're right it has been quite extraordinary with the Bloomberg spot commodity index up 63.6% over a one-year period and 19% year to date.
Commodities can be broken down into raw metals, energy and soft commodities. Across all three components what we've seen is very strong demand and at the same time weak supply.
Raw metals have really led the charge in commodities and demand here has been driven by the importance they have in facilitating green energy. I'm talking here specifically about copper, platinum lithium and cobalt.
The economic recovery, infrastructure demand in China for Q1 has been substantial and governments globally putting forward green energy investment plans has been crucial here.
However, supply and Capex has been particularly weak for some time. Copper has been in a supply side deficit for four years ending 2020 and platinum looks set for a third year in a row of supply side deficits.
The situation definitely wasn't helped last year from outages, COVID-related disruptions and the recent shut downs in South Africa, Chile and Peru.
On the energy front, oil has benefited from the global monetary and fiscal stimulus, the vaccine distribution leading to reopening of economic activity and OPEC+ committing to a tighter oil market. There has also been boosted temporarily by further supply side constraints such as the cyber attack on the Colonial pipeline.
When you look at soft commodities many countries have responded to supply chain disruptions of the past by building up food reserves, which has aided demand.
China has exhibited strong demand for pork, beef, corn and soya beans. Of course the demand in particular for pork and grain feedstock has been particularly due to the pork swine fever they had last year which diminished stocks by a third.
And again on the supply side at the same time yields of soya bean and corn were diminished as a result of dry weather in South America. And this has meant prices have risen to multi-year highs.
HP: Well as you mentioned one metal that's certainly been making the headlines is copper. What can you tell us about its recent performance and what's the outlook for it?
JL: Sure. So answering the first part of the question copper has been breaking record highs almost every week and its recent performance is impressive. It’s up around 33% year to date.
And put quite simply, copper is a very important metal and used extensively across domestic and industrial products. It's also at the forefront of renewable energy and expands across all the technologies. If you think about geothermal, solar, wind all of it needs copper due to its properties.
Well what are these properties? Its ductility means it can be rolled into sheets and pulled into wires without breaking. It’s got electrical and thermal conductivity and low reactivity.
Driving the demand has undoubtedly been China. They account for 58% of global demand for copper and as I mentioned Q1 infrastructure investment has been significant. Infrastructure investment just cannot be done without copper.
And infrastructure more generally, we've seen President Biden's 2.2 trillion dollar infrastructure proposal and the European recovery fund. And more generally we're seeing the economic recovery and the need to address climate change.
However, supplying copper has been the key problem creating the imbalance. Copper mine supply has been struggling for some time before the pandemic. If we take a look at supply growth that's been pretty much flat over the last five years. And of course COVID-19 has made the problem worse.
Chile is the world's largest exporter of copper and it had significant outbreaks last year. Its Escondida mine, the world's largest mine, reported a production drop of 8% in the nine months to the end of March.
Capex really plummeted last year and despite the recent surge in demand Wood Mackenzie notes that producers continue to lack conviction with regards to Capex plans on the underlying momentum of demand recovery.
What has this meant for inventories? Well their depleted and there at levels last seen 15 years ago. Inventories can only cover 3.3 weeks’ worth of demand seen in March. So strong demand this year and very weak supply help explain the price move thus far.
In terms of the second part of the question, the outlook. It’s important to distinguish between short to medium term, say this year and partially into next year, and longer term dynamics. So short to medium term there are some concerns on the demand side for copper.
China accounts for 58% of copper demand. But as it stands a lot of fiscal and credit impulses suggest demand from the region could be slowing and this could be a partial headwind.
However, supply being so constrained is something that could support prices. Chile and Peru not only have their COVID outbreaks to deal with, but there are also political implications of higher taxes. And the mining sector in general has to face environmental and health regulation.
While scrap supply has been argued to alleviate the pressures faced it only makes up 25% of total supply and prices would need to rise much more for this to really encourage old scrap to be built up and sold.
Longer term, however, demand is certainly there. ESG and renewable energy has got some room to grow. Its currently only making up 3.5% of copper demand. But without carbon capture and storage, electrification of renewable energies is essential.
When we think about electric cars they use five times more the amount of copper than internal combustion engines and even then we have to think about charging stations which will require copper.
When we think about substitutes to copper, while the closest substitute is aluminium and it's nowhere near as effective.
Also when we think about copper as a share of the global economy, it's a very small share of it. So price rises may not infringe on the economic recovery.
Even if copper hit $12,000 a tonne its usage would not exceed peak levels seen in 1970. So you can see further room here for demand which can outpace supply and this is why we are more constructive on the metal longer term.
HP: Thank you. So putting this all together would you say that we're now at the point of entering a commodity supercycle?
JL: Well this is the question we’re continuously getting asked. And of course many research houses have come out and argued in favour of a supercycle.
Whilst there's no exact definition for a supercycle it is broadly defined as an extended period during which prices are well above their long term trend. They tend to be much longer than business cycles and there have been four in history according to commodity strategist since the early 1900s.
The last supercycle ran from 1996 to 2014 and it was really driven by rapid economic growth in China, in particular, and other emerging economies. And prices peaked in 2011 a 33% above their long term trend.
When we think about the backdrop in which they tend to occur, it's a result of unexpected demand leading to an increase in prices. Supply then takes time to react as producers weigh up the momentum of demand and then begin their Capex projects.
So taking a look at what we're seeing right now demand so far has been strong and there's no doubt on base metals it has the legs to continue over the longer term.
Is it strong enough to create a supercycle? This is something that remains hard to tell and it's unlikely continued and sustained increases in demand aren’t met with supply eventually.
I think the takeaway is regardless of a supercycle there are certainly reasons to be constructive within the commodity space. Particularly with base metals such as copper and given its procyclicality we could see further upside from here.
HP: Well thank you Jai for those insights. There's no doubt investors will be watching commodity prices and of course the influence on inflation very carefully during the course of this year. We will of course keep you updated.
Moving on to the events for this week the markets will focus on the FOMC minutes to give us a guide to the Fed's view of the outlook for the US economy and distinguish the impact that inflation is likely to have on central bank policy.
In terms of data, investors will wait for tomorrow's UK labour market figures which is projected to show unemployment ticking up to 5%.
Wednesday's UK CPI data for April is forecast to rise by 8 tenths of one percent month on month or 1.7% year on year.
Investors will of course await the European manufacturing and services PMI data for May on Friday which is expected to display a moderate improvement.
With that we’d would like to thank you once again for listening may we wish you every success in the trading week ahead.
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