Base Metals Winners In 2013

Our Commodity & Energy Strategy service is looking to upgrade base metals from neutral to overweight soon, as evidence accumulates that Chinese growth is in a sustainable upswing. But which base metals should fare the best?

Base Metal Winners In 2013

C hina bears dominated in 2012. But a glance at the performance of base metals, an asset class closely tied to the health of the Chinese economy, tells a different story.

Tin, a metal widely used as solder in the electronics industry rose 21%. This makes sense given the 12% growth in cell phone usage over the past year, and similar strength in the adoption of PCs, TVs and other electronics. Closely following tin are lead and zinc, two metals that are tied to the booming automotive and infrastructure industries, respectively.

According to our commodities team, 2013 could be the year for copper and nickel.

  • First, many Chinese indicators have bottomed and/or are now inflecting higher and nickel has one of the highest sensitivities to a rising Chinese PMI.
  • Second, the supply stories for both metals are much less bearish than their performance rankings in 2012 would imply, suggesting some mean reversion.

Bottom Line: Nickel should shift from laggard in 2012 to leader in 2013H1, while copper should also outperform over a one-year horizon.

A Sea Change In Japan

Shinzo Abe and the Liberal Democratic Party (LDP) won a crushing victory in Japan’s general election this weekend. In the coming months, Japanese equities will behave as a bellwether for the LDP’s progress in pressuring the Bank Of Japan (BoJ) to become more aggressive.

Bullish Case For Japanese Stocks

A s we have previously highlighted, the bullish case for Japanese equities depends strongly on domestic politics and monetary policy. This weekend’s general election was unambiguous and gives the LDP a strong mandate. The party is calling on the BoJ to act aggressively: to increase the inflation target (currently 1%) and begin unlimited quantitative easing.

It is widely known that Japanese equities offer good value, but the strong yen continues to suffocate growth and sustain price deflation. Hence, the precondition to unlocking the Nikkei’s value is to reflate the economy and end deflation, both of which will require a substantial devaluation in the yen.

The sea change in political leadership offers the best chance in many years for this to occur. At the cusp of change, we recommend investors stay long the Nikkei on a hedged basis.

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Italy Needs Structural Reform, Not Austerity

The objective of Germany and other northern creditor nations should be to improve the solvency of southern debtor nations like Italy and Spain. The best strategy is not to impose harsh austerity.  

Italy Needs Structural Reform, Not Austerity

S ilvio Berlusconi may have many faults, but when he claims that Italy’s austerity policies have become self-defeating by causing an “endless recession”, he is making a valid point. Austerity is paradoxically worsening the distressed nations’ solvency; by reducing growth more than the deficit, the strategy is becoming self-defeating.

As such, instead of imposing harsh tax hikes and spending cuts, Italy needs to focus on structural measures such as labour market reforms to boost its productivity growth. Since the launch of the euro, Italy’s labour productivity growth has underperformed not only Germany’s, but also France’s and Spain’s. However, to stay solvent, Italy needs steady state nominal GDP growth of around 3%. This is achievable, but will be much easier if there is some contribution from real productivity growth on top of inflation.

Policymakers are slowly but surely softening their tone on the pace of austerity (for example, by extending timetables for deficit reductions in Greece and Spain).

A dramatic easing of austerity could be the big U-turn of 2013.

Stay tuned.

Commodity Pits: Chinese Related Plays Ready For Take-Off?

Diminished global tail risks suggest that base metals prices, as well as other Chinese related plays, could outperform the broader commodity complex in the first half of 2013.

Commodity Pits - Chinese Related Plays Ready For Take-Off?

A variety of China plays have traced out similar patterns over the past two years. The most notable feature is that the trends in these assets have been dominated by non-China factors since early 2011. The EMU crisis in the second and third quarters of 2011 spurred a selling climax in our favorite China plays (industrial mining stocks, nickel, palladium and the Aussie dollar).

Resulting policy responses in the form of Fed QE2 and ECB LTROs did not bring deflation to an end, but were sufficient to “put in the lows” for growth-sensitive asset prices that do not have strong links to European macro trends, yet are responsive to EMU breakup tail risk. Since then, many China plays have formed an extended bottom even as the global growth backdrop has been fraught with uncertainty.

These dynamics should change in the first half of 2013. 

As long as the global economy does not slide back into recession and European tail risks can remain subdued, then the strength of the Chinese capex recovery will be the critical ingredient to determine the strength of the upswing in Chinese related commodity plays, as well as the base metals complex more generally. 

Stay tuned.

Monti’s Resignation: The Bark And Bite Of Austerity And Political Uncertainty

Italy is back in the spotlight.

I taly’s Prime Minister Monti has promised to resign, at the latest once the governments’ 2013 budget passes into law. The budget in question includes further austerity measures for Italy, after the country has already imposed tax increases and spending cuts over the past year. Monti’s resignation and potential failure for the budget to pass underscore that the mood toward austerity in Europe is changing, as politicians and bureaucrats increasingly argue that austerity may have gone too far.

It is not surprising that sovereign bond yields have moved higher because the resignation injects new uncertainty into the European political landscape. Recall that since the announcement of the ECB’s OMT program in September, periphery bond yields have melted, in part because the program is conditional on the country in question first seeking an international bailout. Imposing this conditionality means that there is a greater chance that structural reforms would be made in a country that relies on ECB purchases.

The bond market reaction to Monti’s resignation announcement underscores that the political risk premium in Europe has not been eliminated. Nonetheless, the OMT ‘backstop’ is still in place: any flare up in periphery bond yields should remain muted relative to the experience of the past few years.