Red hot metal prices call for caution

But, the good news for investors in Indian metal shares is that their earnings will increase to the extent their realisations are tied to the landed price of imports


Steel companies will see their costs increase as both iron ore and coal prices are rising, but steel prices too have been increasing. Photo: Mint
Steel companies will see their costs increase as both iron ore and coal prices are rising, but steel prices too have been increasing. Photo: Mint

Have commodity metals taken a temporary vacation from their senses or is there some fundamental change in the underlying factors governing them? On Monday, iron ore imported by China scaled the $80/tonne level, marking an 82.2% increase from the start of 2016. On the non-ferrous side, zinc has seen a similar leap, up by 86.2% on the London Metal Exchange, while copper is up by 27.2% and aluminium by 18%.The past one month has seen a sharp jump, especially in copper, whereas zinc has been rising throughout the year. It is no wonder then that the Bloomberg Commodities Industrial Metals sub-index is up by 32.9% in 2016 so far.

There have been times in the past few years when the metals index has risen and then declined but the rise has been steep in recent times, up by 16% over a month ago. The good news for investors in Indian metal shares is that their earnings will increase, to the extent their realisations are tied to the landed price of imports. The risk is also that this rally will unravel, as it has sometimes in the past, which will bring the shares crashing back to reality.

The Trump phenomenon is the most recent one to fire up commodities. The difference this time is the US presidential verdict saw the dollar gain ground, usually a sign for commodities to fall. Gold has been true to that trend. But industrial metals are defying that trend for now. That’s one sign that this may not last for long.

The new US administration, it is believed, will roll out major investments in infrastructure. In turn, that will fuel demand for metals, and hence the run-up in their prices. There is an opposing view that there is limited fiscal room for the US to head down this path and while there may be announcements, there will be a very gradual uptick in investments.

A recent Morgan Stanley Research report says it expects US to benefit from a fiscal boost, and it has lifted its 2017 GDP growth forecast by 50 basis points to 1.9%. It has also pencilled in a deficit/GDP ratio of 4.5% in 2017, after reaching a low of 2.5% in 2015. This comes at a time when interest rates are set to increase, and a faster pace of increases may emerge in the second half of 2017, according to the report. What fiscal policies the new administration adopts will play a key role in whether metal prices hold on to these gains in 2017.

China is another factor that has surprised on the upside. The economy is rebalancing towards a consumption-led growth, away from a commodity-intensive investment-led growth. But 2016 has seen the government provide a fiscal stimulus supporting growth, which has led to an uptick in demand for commodities. There are doubts on whether this stimulus can be sustained. The same Morgan Stanley report says it expects China’s GDP growth to decline from 6.7% in 2016 to 6.4% in 2017 and then to 6.2% in 2018. It says that the cyclical near term growth has come at the expense of quality, citing the rise in debt/GDP and deteriorating return on capital employed. It expects that cooling housing market activity and a slowdown in the automobile market will moderate growth in 2017.

Speculative buying in commodities is another risk that has been flagged as this can quickly unwind, either because of being overbought or because of government clampdowns, as has happened in China in the past. A meltdown in this market can have an adverse effect on the earnings of commodity companies as well.

Lastly, metal supply has turned tight after companies temporarily shuttered those plants that had turned unviable due to falling prices. At some point, companies will lift the dust covers off their factories to sell more at higher prices. Depending on the industry, restarts can be quick or a slow process, but it can be done. More supply will obviously be a dampener for prices.

These are the risks then. As things stand, Indian companies stand to benefit from the uptrend in prices. The recent depreciation in the rupee offers them a further upside as landed cost of imports will increase.

In particular, the run-up in zinc prices and rising metal output at its mines should see Hindustan Zinc Ltd benefit. Its parent company, Vedanta Limited, too should benefit from this, as also from the surge in iron ore prices. However, its investments in the petroleum sector may underperform. Higher copper prices should benefit state-owned Hindustan Copper Ltd but its output has disappointed in the first half of FY17. If it can pick up pace, then it can benefit. Another state-owned mining company, NMDC Ltd should benefit from higher iron ore prices. Steel companies will see their costs increase, as both iron ore and coal prices are rising, but steel prices too have been increasing. So they may benefit from that.

The larger point here is that investors would do well to keep a watch on the factors mentioned above, as these commodity prices can crash as quickly, if events don’t turn out as expected.

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