Metal prices firm despite U.S. slump

by Levi Folk | April 26, 2008

Prices for industrial metals appear to be holding up strongly in light of the U.S.-centred economic slowdown due to strong demand from emerging markets, most notably from China. There are risks to a full-blown global economic slowdown that would have significant impact on emerging-market growth through the trade account, but these risks remain small. Still, given the length of the commodity expansion and the downside risks to growth, investors should tread carefully in this sector.

In its recently released 2008 World Economic Outlook, the IMF paints a bleak picture for the U.S. economy and the financial sector, and downgrades prospects for world economic growth significantly, to 3.7% from 4.9% in 2007.

The IMF further warns that commodity prices are at risk of a pronounced slowdown given that "commodity prices have fallen, on average, by 30% during significant global slowdowns over the past 30 years."

The risk remains, but it represents a lower-probability outcome, and the more likely scenario is for continued strong demand for commodity prices over the next year from emerging markets offsetting slower demand in the developed world.

It is noteworthy that the IMF has put forth the direst forecast for the financial sector, predicting nearly US$1-trillion in credit losses globally over the cycle. Notwithstanding that point, emerging economies are expected to grow 6.7% in 2008, down from 7.9% in 2007.

The IMF assigns a 25% probability to the spectre of a more severe global economic slowdown whereby growth falls to 3% or less. In this scenario, emerging-market growth forecasts and commodity prices are expected to fall significantly, the transmission mechanism being largely through the trade account. It would entail a rise in U.S. savings and a reduction in imports from the United States as Americans rebuild their savings.

It is perhaps no secret that most of the growth in commodity demand in recent years has come from emerging markets. In fact, 90% of growth in oil and metals products is a result of demand from emerging markets. Therefore, a mild U.S. recession in 2008 followed by a sluggish recovery in 2009 could mean better outcomes than expected for the emerging markets and base metals demand.

Fundamentals in this sector are still very supportive of prices five years into the boom. Supply -- that is production -- is challenged to meet the growing demand. Companies have been spending tens of billions of dollars boosting production, but results have not been very good. They are dealing with significant cost inflation and the long-term reality of no significant finds in years.

The biggest international producers are therefore having production problems, but they are enjoying record earnings due to soaring commodity prices. Share prices have gone up considerably, but valuations are not excessive.

International metals producer BHP Billiton, for example, is trading at a historical price-earnings ratio that is near the low end of its five-year range, though its valuation has risen substantially from its lows touched in 2006. This is one area where M&A activity has remained active during the recent credit crunch, suggesting that materials producers are still cheap and they are less committed to spending on exploration than on acquisitions (BHP Billiton is attempting to take over rival Rio Tinto).

The risks are that a protracted economic slowdown causes a correction along historic al lines. To put the current boom in metals prices in perspective, it has so far lasted 2.6 times longer and risen 2.5 times higher than the long-term average dating back to 1960, according to an IMF study. In past cycles, economic downturns have often been the catalyst for derailing the rise in demand and prices.

While the opportunity for investors is clear, the risks are also obvious. Those interested in investing should do so with eyes wide open to the potential for a correction over the next year and should invest with a minimum three-to five-year time horizon.