Base metals’ fundamental backdrop to remain healthy in year ahead: 2022 preview
Six things you need to know about base metals markets in 2022
In 2021, global economies reopened, triggering a positive shock for base metals’ fundamentals and prices. Going into 2022, overall sentiment remains optimistic and the fundamental outlook of base metals continues to be healthy.
We asked our base metals analysts what factors they think will move the markets in 2022. Here they share their top six.
1. Slowdown in global industrial production growth: a headwind for base metals
Industrial production growth peaked at 17.9% year on year in April 2021 and slowed to +4.0% y/y in October, according to CPB Netherlands Bureau for Economic Policy Analysis (CPB). Based on Oxford Economics’ projections, global industrial production growth will decelerate from +6.9% in 2021 to +4.3% in 2022.
Among the sub-sectors, global industrial production in domestic appliances is forecast to contract by 0.8% this year, after a rebound of 9.8% in 2021. The only sub-sector that will experience accelerating growth is production in motor vehicles and parts (+6.5% in 2022, up from +5.6% in 2021), largely due to easing supply disruptions.
If the relationship between global industrial production growth and base metals prices holds in 2022, base metals could experience some price weakness in the year.
2. Macro volatility but fundamental support
We do not see prolonged price weakness; rather, we expect a temporary consolidation, which should eventually trigger a “buy on the dips” response due to the robust fundamental backdrop of the base metals market.
While we acknowledge that slower global industrial production growth will translate to softer demand growth for refined base metals consumption, we expect base metals to remain in a deficit in 2022, meaning that demand should exceed supply.
Our research shows that base metals should record refined market deficits of between 0.4% of consumption (lead) to 2.0% of consumption (nickel).
We expect the volatility in base metals prices to stem from negative macro factors such as a stronger dollar on expectations of a faster removal of liquidity by the United States Federal Reserve and weaker global risk-taking appetite due to the removal of liquidity from the system. This could prompt investors to unwind some of their net long exposure to all risk assets, including commodities and base metals.
On the bright side, the macro environment for commodities could improve in case of a meaningful easing cycle from the People’s Bank of China (PBOC). In contrast with the Fed, Chinese policymakers have turned more dovish since late last year in response to the economic slowdown in China. Easier financial conditions in China could cause a rebound in the credit impulse, which has empirically been a positive leading indicator for industrial production growth and base metals prices.
We define the credit impulse as the 12-month change in the 12-month sum in total social financing (a broader measure of credit), in terms of percentage of gross domestic product.
The current gap between base metals prices and China’s credit impulse makes us somewhat worried and reinforces our view that base metals could experience a temporary consolidation in 2022. An increase in the credit impulse would reduce the likelihood of a pronounced correction in base metals prices.
Importantly, the macro environment does not impact all the base metals the same way. Some base metals tend to be relatively more macro-driven - such as copper - while others are more influenced by their fundamentals - such as tin.
In the table above, we show the percentage of macro factors and the percentage of micro factors influencing the base metals market over the past year. The results suggest that a negative turn in the macro environment is likely to impact relatively more copper, zinc and nickel than tin, lead and aluminium.
3. Tight fundamental indicators
The present fundamental backdrop of base metals is markedly tight, which can be visible in the London Metal Exchange nearby spreads and the drawdown in exchange inventories.
Looking at LME nearby spreads, all base metals except aluminum show a backwardation. In the chart below, we use the LME cash/three-month spread in percentage of the LME three-month price to normalize the spreads across the complex.
The backwardation at the front end of the curve for most base metals points to tightness for immediate physical consumption, thereby exerting upward pressure on prices.
Looking at exchange inventories, most base metals have registered significant outflows over the past year.
Global exchange inventories, including at the LME, Shanghai Futures Exchange and Chicago Mercantile Exchange, have declined since 2021 for all the base metals except zinc. The meaningful drawdown of inventories across the board is a clear indication of refined market tightness, in our view.
4. Technicals make us cautious
Our technical analysis prompts us to temper our bullish view on base metals prices. An indicator that we like to track is the monthly moving average convergence divergence (MACD). This indicator allows us to gauge the strength of the trend in motion and the momentum. When the monthly MACD line crosses from above to below the signal line, this suggests that the prevailing trend has become exhausted and usually reverses. Let’s take copper as an example.
The monthly MACD showed a negative cross in January 2007, in September 2011, and June 2018. Each time, the prevailing trend became exhausted, which was eventually followed by a price downtrend. At the start of 2021, the MACD is weakening but we are not seeing yet a negative cross. However, we caution that if a negative cross occurs, a multi-month consolidation could take place as momentum-based traders switch their exposure to copper from net long to net shorts.
5. Supercycle or not?
In our view, we are in the very early stages of the commodity bull market. After the deflationary shock in 2020 caused by the Great Shutdown of the global economy, we have experienced a robust recovery. Even though the world continues to be impacted by supply chain disruptions and the Covid-19, global economic growth should remain above-trend.
Because the Green Transition is expected to intensify and all the major economies are implementing a net-zero strategy at the same time, the implications for base metals’ fundamentals - especially copper, aluminium and nickel - will be profound.
Even though base metals have registered significant price gains from their macro lows in April 2020, they remain close to their 20-year trend.
Let’s take the case of nickel. In the chart below, we show the deviation of the LME nickel cash official price from its 20-year trend. In the previous bull market (2003-2008), the deviation peak reached 250%. At the start of 2021, nickel prices traded only 12% above their 20-year trend.
The argument is valid for all the base metals that we track. In our view, the long-term upside potential for base metals prices is significant and we have seen almost nothing yet.
6. Our top pick
To determine the base metal which we like the most, we perform an analysis to measure the degree of divergence between fundamentals and prices. The greater the divergence (fundamentals>prices), the better the opportunity. In this regard, even though we like tin’s fundamentals, tin prices are already historically high, and we think that the fundamentals are largely priced in. In contrast, we do not think it is the case for nickel and copper, and therefore, express a preference for both of these metals.
To quantify the gap between current prices and fundamentals, we attempt to remove the macro factors from base metals prices. While we cannot remove all the macro factors, we exclude a big one - the dollar. To put it in another way, we purge base metals prices from their dollar effects. That is, we determine the value of base metals prices if the dollar effects were removed. To do so, we run a regression of base metals prices against the dollar and use the de-standardized residuals as the dollar-adjusted base metals prices.
We find that nickel and copper present the largest divergence. In other words, we think that even though copper’s and nickel’s fundamentals are robust, prices have been capped by the negative dollar effects. Copper and nickel tend to be relatively more sensitive to macro factors than the rest of the market. Therefore, we believe that their fundamentals are not accurately priced in, which constitutes a buying opportunity.
What it all means for the year ahead
Going into 2022, investors appear more confused because supply is expected to rebound, demand growth is expected to soften, and the level of liquidity in the system will be reduced. While this environment is likely to cause volatility in base metals prices, our research shows that fundamentals remain solid.