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Commodities investors keep one eye on China

Economic stimulus should help maintain demand for Canadian metals

By: PAUL BRENT

Date: November 03, 2015

When investors turn their attention to commodities, it is understandable that they focus on oil and natural gas. But Canada produces a lot of more of what makes the world run than just energy. Think iron ore, copper, zinc, potash, precious metals, forest products and food.

For so many of those staples that make up Canada’s export economy, the X factor is China. In the past few years, a slowdown in growth there has been bad news for commodity prices.

Just how bad? In a Sept. 28 report, Bank of Nova Scotia economist Patricia Mohr noted that her firm’s commodity price index fell to its lowest level in a decade, as investors worried the final pages have been written for the China growth story.

Ms. Mohr, who was in China recently, is betting that monetary and fiscal stimulus in the world’s most populated country will keep annual growth near the government’s 7-per-cent target and that over the next few years “China’s potential to significantly lift world demand will remain intact.” Demand will stay strong even as the world’s second-largest economy transforms from its current heavy-industry and export orientation to one led by consumer products and services.

With 6.9 per cent GDP growth for the third quarter, the country appears to have pulled out of the “hard landing” expected by some.

China already has world-class traffic, and it’s going to worsen over the next decades, which is good news for Canadian metals exporters. “The expansion of motor vehicle ownership will be very metal-intensive (boosting demand for aluminum, zinc and copper) as well as gasoline-intensive,” Ms. Mohr wrote in an e-mail during her China visit.

China is already the world’s largest automotive market, but there’s still plenty of room for growth. Vehicle ownership is low by world standards at 104 cars per 1,000 people – that compares with 803/1,000 in the United States, 651/1,000 in Canada). Beijing recently announced stimulus measures to spur auto sales.

The health of China’s economy is important to Canada because of its outsized appetite. According to Scotiabank, China dominates world demand for the four key base metals – copper, zinc, nickel and aluminum – accounting for an estimated 48.6 per cent of 2015 world demand. The U.S. uses just 9 per cent.

China also accounts for 50 per cent of world steel production, so it also dominates demand for coal and iron ore.

Canada’s weak economy and this year’s flirtation with recession can be traced to weak commodity prices. David Watt, chief economist at HSBC Bank Canada, went so far as to compare the economy to those of emerging markets plagued by commodity price-induced swings.

The comparison can be backed up by observing how the S&P/TSX Composite Index has moved almost in lockstep with the MSCI Emerging Markets Index over the past decade. That relationship will continue until the country “overcomes its productivity and competitiveness hurdles.”

Mr. Watt, like Ms. Mohr, has not given up on the China story. For him, future demand will be fuelled by “the massive rural to urban population shift” of approximately 1 million people per month for the next 20 years moving from farms and villages to cities. While that will happen more slowly than in the two prior decades, “that is going to mean a lot of need for infrastructure,” he said.

He is also not counting on the mighty U.S. economy to pull up Canada’s economic prospects.

“Before we start getting all excited about U.S. demand pulling Canadian non-energy exports upward, we have to realize we have lost a lot of market share in the United States,” he says. He refers to a chart that shows that Canada attracted just 0.2 per cent of the $111-billion (U.S.) worth of worldwide automobile investment since 2009.

“Most of it has gone to Mexico and the southern United States,” he says of auto investment in North America, with Canada getting just 1.4 per cent. “We will get some benefit from the U.S. rebound, but we are going to have to share the wealth, and we might have to share a little bit more than we think.”

The Chinese-driven “super cycle” for commodities that began at the turn of this century and doubled the commodity index prior to the 2008-2009 financial crisis is likely a once-in-a-lifetime event, says David Jacks, a professor of economics at Simon Fraser University in Vancouver. The urbanization of 300 million people and creation of the world’s number two economy in 20 years will likely never happen again. “This is the hangover,” he says.

Dr. Jacks predicts the next upturn for commodities will happen in four or five years.

“This is more of a commodity picker’s market,” he explained. “It is going to be driven by those industry-specific” factors such as future production, investment decisions and merger and acquisition activity.

Ms. Mohr is starting to see signs of life for non-energy commodities.

“I expect zinc prices to start rallying once the market recognizes the tightening zinc supplies due to Glencore’s announced 500,000-tonne mine cutbacks,” as well as mine depletions and delays in new mine development around the world, she says. A copper rally will have to wait until a current wave of new mine development ends in 2017-18. Similarly, iron ore investors will have to wait out expansions in Australia and Brazil.

“Over all, metal prices will start rallying in the 2017-20 period,” she concluded. Meaning that investors waiting out the China hangover will have to pick their spots for a while longer.

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