Copper: short-term recovery, but long-term uncertainty!

Yvan Berthoux - 13 February 2020

Growing uncertainty around the coronavirus has led to sharp downward revisions in growth expectations in China and thence to the collapse in some commodity prices such as oil and copper. While real GDP growth was expected to flirt with the 6 per cent level before the Covid-19 pandemic, sell-side institutions have marked down their forecasts of economic activity to a mere 1 percent pace in the first quarter in the base case. Worst case scenarios extend to a 4 per cent contraction if Covid-19 is ‘not contained’. A sharp recovery in copper prices should accompany a normalisation of activity, but the longer-term outlook is cloudy.  

Since the SARS epidemic in 2003, China’s economic importance has increased substantially to represent about 17 per cent of the world’s GDP in 2018. The downward lurch in the Chinese economy will spread globally through the reduction in exports (to China) and the paralysis of Chinese supply chains. Over the past 15 years, China has transformed from being the top importer for 5 countries to the top importer for more than 50 countries. 

Figure 1 (left frame) shows that copper futures prices have diverged significantly from global economic fundamentals. While the economic surprise index for the G10 economies has continued to recover in the past few weeks, the copper price was down over 10 percent in January. One of the main drivers of copper in the past cycle has been the China credit impulse, which remains only marginally positive. The recent liquidity injection from the PBoC (figure 1, right frame) has not imparted any momentum to the industrial metal, which is still trading at compressed levels relative to the beginning of this year. 

Figure 1: 

Data source: Eikon Reuters, PBoC

One interesting observation is that copper has tracked the China 10Y bond yield closely over the past 6 years and has been trending lower since early 2018 as investors have been piling into ‘safe-haven’ assets such as government bonds and the US Dollar, leaving some commodities under pressure. While this relationship is not set in stone, it infers that copper prices will struggle to regain a positive trend in the medium term unless global bond yields rebound. 

There is also a notable divergence between the CPI inflation rate and the 10Y bond yield in China. Despite repeated new highs in Chinese inflation (consumer price inflation has reached a 7-year high of 5.4 per cent, well above the official 3-per cent target, amid soaring food prices due to the African swine fever), the 10-year yield has plunged below 3 percent for the first time since November 2016.


Figure 2:

Data source: Eikon Reuters

Notably, copper has struggled to make headway in what remains a risk-on equity market. While the Powell pivot of early 2019 and subsequent Fed funds rate reductions have set a floor under equity prices, copper prices traded sideways last year, figure 3 (left frame). A reappraisal of post-Covid-19 China’s growth prospects should help to realign copper prices to the favourable risk environment.  

After the exaggerated drawdown in copper prices in January, even a modest improvement in China sentiment could drive a rebound. Previous monthly falls of 10 per cent or larger have generally been corrected by sharp rebounds in the following month, except after the Global Financial Crisis. However, we will need to see persuasive evidence of abatement in the spread of Covid-19 in the next few weeks to be confident that copper prices can regain positive momentum. Figure 3 (right frame) shows that the industrial metal is currently flirting with its short-term support at US$2.50/pound and has been slowly approaching its long-term upward trending support line, which many experts consider critical. The loss of this level would constitute a major setback, suggestive of a bear market.


Figure 3:

Data source: Eikon Reuters

 



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