Base metals: Decoupling from equity markets, but economic risks persist

Base metals prices lost some ground this week amid growing concerns over the slowdown in US economic growth. Base metal prices tumbled even after the release of the March ISM data, which was higher than expected, but still below the 50 mark, signifying that the economy is in contraction.

Moreover, the strengthening US currency also weighed on prices. Nickel was hurt the most and fell again below the USD 29,000 threshold. Aluminum and zinc prices suffered quite strong as well and are now trading around USD 2,900 and USD 2,300,  respectively. Copper prices are trading only slightly lower at around USD 8,500.

As we have already argued in previous issues of the Research Weekly Commodities, base metals prices are input factors for the economy and thus are very dependent on the economic situation. Indeed, taking a look at Figure 1, where we compare YoY changes for the US ISM Manager index and copper prices, we can conclude that copper prices follow similar cycles to those of the US ISM Manufacturing index with a lag of 6 months. Our current copper price forecasts for end- Q2 2008 and end-Q2 2009 (indicated by the red points) incorporate the current uncertainty about the economic situation in the USA, reflected by the modest YoY growth number.

Another way to look at the sensitivity of base metals to the overall economic situation is to have a look at the correlation between equity and base metals returns. For the analysis, we compared the returns of the MSCI world index to the returns of the respective sub-indices of the DJ AIG Commodity index. Figure 2 shows that base metals are, with an average correlation of around 30% since 2000, clearly the commodities sector with the closest relationship to the equity markets. With the sub-prime crisis that started in August 2007, the correlation has been increasing quite considerably and even reached a six-month correlation of almost 80% at the end of last year. Base metals prices thus suffered quite strongly on concerns about the US economy and the weak equity market.

However, since the beginning of the year, base metals performance has decoupled from the performance of the equity markets and the six-month correlation of the weekly returns between the MSCI world and the DJ AIG Industrial Metals index has come down to about 20%. This is due not only to strong liquidity inflows into the commodity markets, but also to supply side problems and strong demand from China.

While these factors should be supportive, especially for aluminum and nickel prices, we think that the weak demand from western countries should remain the main drag on the base metals sector. This is especially true for copper. Consequently, while we take a positive stance toward copper prices, we remain more cautious until we see clear signs of a recovery in the US economy.

source: CS