Is the main driver of industrial metal demand about to shift into reverse?

The Chinese manufacturing purchasing managers index is closely watched for signs of an uptick in demand for commodities. The reason for this is that it gives a forward view of the potential demand for industrial metals such as copper, nickel and aluminium and to a lesser extent energy and agricultural commodities. Since the start of 2016 all the signs have pointed up as Chinese manufacturing activity surged higher, and metal prices have followed in lockstep.

But what if there is a more important, even more forward looking indicator of potential demand?

A recent note from PIMCO highlights the role that credit plays as a leading indicator. China’s “credit impulse,” as its known measures the change in the growth rate of aggregate credit to GDP, bears close watching: It has tended to lead the Chinese manufacturing Purchasing Managers’ Index (PMI) by 9-12 months and the U.S. Institute for Supply Management’s (ISM) manufacturing index by about 14 months.

Whats been happening to the credit impulse? Here’s PIMCO.

The sharp downturn in the Chinese credit impulse starting in 2016 portends a material drag on Chinese growth in the year ahead. Looking back on the past three years, the Chinese credit impulse turned positive sometime between late 2014 and mid-2015. Given China’s exchange rate volatility in August 2015, it took longer than normal for credit to gain traction. The Chinese credit impulse peaked in March 2016 and slowed sharply after the second quarter. It is only now that the impact of that reduced stimulus should be felt. PIMCO has already factored credit-related drag into its Chinese growth outlook, but the decline in the credit impulse has been sharper and more extreme than many expected.

The question now is not if China slows, but rather how fast. Equally important perhaps is the extent to which commodity prices will correct lower, especially in light of the current enthusiasm about the potential strength of the global growth cycle. The impending slowdown in China could be compounded by ongoing government efforts to rein in shadow bank credit; the cost of policy mistakes rises once the credit impulse goes into reverse.

All of which means the outlook for industrial metals could look a lot bleaker in the second half of 2017.

Related article: Where do we stand in the commodity cycle?

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When will the 5 year agricultural bear market come to an end?

Whether it is wheat, corn or soybeans prices have been falling since 2012 as enormous harvests and stocks bursting at the seems weighed on market sentiment.

Grain and bean futures have been pricing in a lot of bad news recently with funds holding a record short position. Given the slew of bearish news investors have had to digest in recent years it was perhaps not surprising that prices have been pricing in so much bad news.

Although wheat futures in particular prices surged earlier this week as some of those positions unwound – traders taking their cue from bad weather in the US – the longer term picture has been grim.

Although each of the three main agricultural commodities (soybeans, wheat and corn) have seen frequent attempts to break the long term downward trend only wheat futures have managed to achieve it, if only briefly – earlier this year in March and this week.

The main agricultural commodity futures markets remain heavily in contango indicating that the markets are still heavily oversupplied. Year ahead futures contracts are 10%-13% higher than the front month traded contract. If the futures curve is in contango, as they are now then a farmer may want to put his grain into storage and sell it at a higher price in the future.

Other commodities have seen strong price rebounds over the past year. Industrial metals (zinc, lead and more recently copper) and energy (coal and oil in particular) have risen sharply on stronger, more broad based economic growth and restrictions on supply (whether that is planned as in coal in China and oil in OPEC) or unplanned (strikes in copper mines in Chile). The natural extension of this is that we are now at, or very close to a recovery in grain prices.

Related article: Where do we stand in the commodity cycle?

Other indicators also point to a recovery in prices. Higher oil prices increase the input costs for farmers, and they are important in driving corn prices since corn can be used in ethanol as well as in food or animal feed.

Related article: Wheat prices: The top 10 most important drivers

Weather related factors could play a larger role in supporting higher prices should El Niño return. The World Meteorological Organisation sees a 60% probability of the weather phenomenon returning later this year. But even here the evidence is mixed. Compared with tropical agricultural commodities such as coffee and cocoa the impact on wheat, corn and soybeans tends to be limited. In part this is due to their geographical diversification – a disruption to supply in Australia doesn’t tend to coincide with a fall in output in the US.

Related article: Materials Risk explains: How El Niño affects commodity prices

If this is the bottom of the market then watch the price of wheat. Historically it has signaled a change in market direction well before corn or soybeans.

Related article: Curve appeal: Why investors looking to profit from higher commodity prices need to look to the future

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Palladium prices: The top 10 most important drivers

1) Vehicle demand

Roughly 75% of palladium demand is from the autocatalyst sector. Unlike diesel cars that use platinum, petrol fueled cars use palladium as a catalyst to reduce noxious vehicle emissions. Tighter vehicle emission standards is likely to increase demand for palladium.

Palladium is more exposed to the Chinese and US markets where diesel hardly features in the passenger vehicle segment. Chinese demand is particularly important in that almost one-third of net palladium demand (accounting for recycling) comes from the Asian economy.

Apart from catalytic converters, palladium sees usage in a wide range of industrial applications, including fuel cells, dentistry, and medicine.

2) Russia

Norilsk Nickel is the largest producer of the precious metal, accounting for about 40% of global supply. Any disruption to exports from Russia perhaps in the form of sanctions could be expected to reduce the supply of the metal onto the global market.

3) South Africa

Around 40% of all mined palladium comes from South Africa. Supply constraints in the form of intermittent electricity supply, rising fuel and construction costs and industrial action have all curtailed output from South Africa in the past.

4) Investment

The launch of a number of Exchange Traded Funds have helped support investor demand, opening up the possibility of investing in palladium to a wider group of investors. Investors should be cautious though. Unlike gold and to a lesser extent silver, the palladium market is a lot more opaque while swings in investment fund flows can have a disproportionate affect on prices.

5) Substitution 

High prices incentivise vehicle manufacturers to look for alternatives or reduce the amount of metal used in their catalytic converters. This could involve substituting palladium with other metals such as platinum or rhodium.

6) Recycling

Higher prices typically incentivise the recycling of palladium catalytic converters, a source that typically accounts for up to 30% of total supply. But since palladium forms a very small proportion of the value of a vehicle high palladium prices only have a marginal impact on the incentive to recycle. High steel prices encourage dismantlers to recycle vehicles and take palladium and other materials as byproducts.

7) US monetary policy

Although not just a fiat commodity in the same way as gold, palladium shares some of the properties of gold. Higher interest rates, reflected in higher bond yields reduce the attractiveness of holding non-interest bearing assets like palladium. However, it is not the nominal interest rate that affects the price of palladium but the real interest rate, i.e. after inflation.

When real yields are low the opportunity cost of owning palladium drops. Investors are then likely to be willing to pay a higher price relative to palladium’s long-run estimated real value.

8) US dollar

A weaker dollar can also act as a disincentive to producers to increase output. For example, a depreciation of the US dollar against the Russian ruble will (all other things being equal) reduce profit margins for Norilsk Nickel, the largest producer of palladium. All of its revenue will be received in US dollars, which will now buy less rubles, but some proportion of the costs will be denominated in rubles and will remain constant (at least in the short term). The prospect of a lower profit margin acts as an incentive to decrease the supply of palladium on to the global market.

9) Stockpiles

Stockpiles of palladium in Russia have been an important source of supply in recent years. However, the amount of metal held in the form of stockpiles is a secret so there is uncertainty over the exact amount of metal held.

10) Seasonality

Of all the precious metals palladium exhibits the strongest degree of price seasonality. Palladium prices tend to show the strongest gains during the first quarter of the year.

Previous episodes

Gold prices: The top 10 most important drivers

Silver prices: The top 10 most important drivers

Natural gas prices: The top 10 most important drivers

Copper prices: The top 10 most important drivers

Livestock prices: The top 10 most important drivers

Sugar prices: The top 10 most important drivers

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