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12/12/2016

Is there a doctor in the house?

Dr Copper's diagnosis

Dr Copper was jokingly awarded its economics PhD in the 1980s by financial practitioners who suggested it was a useful predictor of the world’s economic health. The red metal was again in focus during the run-up to the global financial crisis as China’s rampant economic growth caused surging demand. Unfortunately, much like its peers with the genuine qualification, its record of prediction has been mixed. Copper prices did fall ahead of recessions in the US in 1981, 2001 and 2007, but gave no such warning of recessions in 1980 or 1990.

Recently, copper has been in the headlines again. Prices have risen dramatically from $5,000 to over $5,800 per tonne, reportedly on hopes that president-elect Trump’s forthcoming policies will spur growth and inflation (figure 1). Copper has not been the only beneficiary – iron ore, coal and zinc have also experienced big gains.

However, this rationale does not stand up to fundamental analysis. Last year the US consumed 1.8 million tonnes of the metal compared with China’s consumption of 12 million. Even if the US were to increase its consumption by 10% – a large increase – this would not be particularly significant in the context of global demand.

Supply and demand

Nonetheless, there is another more compelling reason for the increase in prices. Downturns in commodity prices since the financial crisis have seen many commodity producers decrease capital expenditure and take production facilities offline. This reduces supply until such time as the demand increases the price to a level where it becomes cost-effective to restart production projects.

Before the recent price movement, copper had been a significant laggard in the metals sector, behind the likes of steel and iron. These metals are used in the earlier stages of construction and have seen a rise in price this year due to China's fiscal stimulus measures. Copper, on the other hand, is mostly used in the latter stages, such as wiring, so its lack of relative progress is understandable. Inventories of the metal held in London Metal Exchange warehouses have fallen 36% since the end of September (figure 1). This situation has led to a tighter market than has been seen for a few years. If Chinese demand holds up (or indeed increases) prices will continue their upward trajectory.

Trend-following strategies

Another explanation of these recent price moves is a more technical one: algorithmic trading. Commodity trading advisers, a type of hedge fund, are characterised by ‘trend-following’ strategies, the most simple of which involves buying (or selling) futures contracts that are making new high (or low) prices compared with a recent period. In relatively illiquid contracts, such as copper, the effect buyers have on the price can be marked and the subsequent momentum attracts more interest.

At 8% of the Bloomberg Commodity Index, our own exposure to copper is modest but not insignificant, as the fourth largest constituent behind gold, natural gas and brent crude.

Figure 1: In the headlines again

Copper prices have risen dramatically, while the London Metal Exchange (LME) Copper Inventory has fallen. 

 

Source: LME, Bloomberg, Kleinwort Benson

Past performance does not guarantee future performance.

 

 

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