January/February 2008
The U.S. and global economic juggernauts encountered serious head winds in 2007 with the U.S. subprime mortgage crisis, rising inflation concerns, higher energy costs, and other issues. Are the good times over? Or is this only a temporary setback in the global economic super cycle?
By Robert J. Garino
A head wind is a wind blowing in a direction opposite the course a ship or plane is taking, impeding its progress. Aircraft pilots and ship captains know all about head winds as a force of nature. Economists also use the term to describe certain fundamental factors that may be acting against the larger economy. In both instances, it's the relative strength of the wind that determines the course of a craft or the direction of a business cycle.
As 2006 drew to a close, the global marketplace seemed in flux. Analysts hinted at a potential slow start to 2007 but a more robust second half, with a strong Asia and Europe offsetting assumptions about a relatively sluggish U.S. economy that year. The principal worries at the time included increased inflationary pressures, higher-than-expected energy prices, a greater-than-expected slowdown in the U.S. economy (triggered by the changing housing market), and commodity price volatility—head winds all, but the consensus was that none of these items was strong enough to prevent the economy from enjoying another positive year.
In the end, we will remember 2007 as the year of the subprime mortgage credit crisis—a head wind that few would have predicted a year earlier, but one that morphed into a financial and economic tsunami, affecting both the domestic and the global economies. Initial projections pegged U.S. lenders' financial losses at around $50 billion to $100 billion based on the assumption that the subprime mortgage market was a small piece—about 12 percent—of the more than $10 trillion U.S. mortgage market. As additional revelations surfaced, however, the financial losses snowballed, ultimately taking down several high-profile banking and investment CEOs.
Now, the total projected domestic writedowns for collateralized debt obligations, collateralized mortgage obligations, structured investment vehicles, and unsecured loans is closer to $300 billion to $500 billion. As of November, several large banks had written down some $40 billion to $50 billion, according to Bloomberg.com (New York) and Global Insight (Waltham, Mass.).
The Federal Reserve responded to the gathering storm by decisively injecting money into the financial system, lowering interest rates and the discount rates in September, October, and November. Those moves sought to ensure market liquidity and restore financial confidence, even though most sectors of the domestic economy—except manufacturing—already were expanding at a faster-than-expected annual rate. Along with the lower interest rates came an even weaker U.S. dollar and its subsequent inflationary effect on commodities, especially in the energy and precious metals arenas.
Equity markets initially applauded the Fed's decisions, but the Dow Jones Industrial Average exhibited considerable volatility, trading around 13,000 but unable to shake the credit worries that permeated the investment community. The Dow stubbornly remained some distance from the record 14,165 level it reached Oct. 9, 2007, with most financial professionals expecting the economic fallout to remain in the forefront as 2007 wound down. Some 2 million subprime adjustable-rate mortgage loans valued at $600 billion are due to reset at higher amounts in the next eight months. Not all of these mortgages are in trouble, of course, but homeowners who default or fall behind on payments could cause an unprecedented economic shock.
The combination of rising inflation expectations, higher energy costs, the weakening U.S. dollar, and an overly anxious investment community offer compelling evidence that the U.S. faces serious impediments to its ongoing economic growth. Some even envision a "perfect storm" in 2008 in which inflationary pressures continue to threaten, forcing the Fed to raise interest rates and all but assuring a stagflation-type environment for the domestic economy.
Although the U.S. gross domestic product grew at a reported 2.4 percent to 2.5 percent annual rate in 2007, according to the Fed, it predicts GDP will grow only 1.8 percent to 2.5 percent in 2008—lower than the 2.5 percent to 2.7 percent rate it projected last June. The factors that led to this lower growth projection included the tightened terms and reduced availability of subprime and jumbo mortgages, weaker-than-expected housing data, and rising oil prices.
The International Monetary Fund (Washington, D.C.) projects 1.9 percent U.S. GDP growth in 2008, almost 1 percent lower than its previous projections and the same rate as its 2007 U.S. forecast. Though it's not calling for a recession—defined as two consecutive quarters of negative growth—the IMF sees a housing-led slowdown dominating the domestic economic landscape this year. "Ongoing difficulties in the mortgage market are expected to extend the decline in residential investment, while higher energy prices and weaker house prices are likely to dampen consumption spending," it stated. Standard & Poor's (New York) also forecasts U.S. GDP growth this year at 1.9 percent, placing the risk of a recession at 40 percent.
In November, the White House also lowered its 2008 economic forecast, predicting that unemployment will rise as the housing slump and tight credit weigh on the U.S. economy. The administration's forecast calls for GDP growth of 2.7 percent this year, down from its previous projection of 3.1 percent, and a rise in the unemployment rate to 4.9 percent, up from the previous forecast of 4.7 percent. Inflation, however, should decline, the administration predicts, with consumer prices increasing only 2.1 percent, down from its previous forecast of a 2.5-percent rise.
The contrary view holds that there are inevitable business cycles, but the U.S. and global economies are in the midst of a "super cycle" that began around 2001 and could continue for several decades. Any economic forecast should not dwell on a U.S.-centric view of the world, according to super-cycle proponents. After all, they argue, China, India, and Russia accounted for half of global growth last year, all fueled by rapid industrialization. What's more, they note, U.S. GDP growth continues to make a strong showing, with preliminary third-quarter 2007 GDP posting a better-than-expected 4.9 percent annual growth rate. That performance provides proof, they say, that the U.S. economy is far more resilient than people acknowledge.
Nevertheless, significant questions for 2008 remain: Have the economic head winds gained velocity? If so, what will they do to the U.S. and global economies this year—specifically, to those business sectors closest to the scrap recycling industry? And what are the ongoing as well as emerging worries this year?
According to IMF's forecast last October, global growth will slow from 5.2 percent in 2007 to 4.8 percent in 2008. China will continue to lead global economic growth, with its GDP and industrial production again expected to post double-digit growth rates this year.
Offering a more conservative view, Lynn Reaser of Bank of America (Boston) sees global GDP expanding 3.1 percent in 2008, down from an estimated 3.4 percent rise in 2007. Europe's economy will face significant deceleration this year, she says, with Japan, Latin America, and Asia slowing at more moderate rates. Although the United States continues to be an international economic driver, internal economic demand in such powerhouse countries as China and India will continue to provide a "significant independent thrust," Reaser says.
Against this backdrop of uncertain head winds, we offer these predictions for key commodities in 2008.
Copper
Among the exchange-traded nonferrous base metals, copper commands the most international attention from metal producers, consumers, scrap processors, and financial institutions. Many consider it the most economically sensitive metal due to its myriad familiar end uses, and for many LME and Comex traders, copper remains the commodity pace setter.
For 2007, market watchers expected new copper supply to rise at least as fast as consumption, potentially leading to a statistical surplus for the year. Although the World Bureau of Metal Statistics (Ware, England) and International Copper Study Group (Lisbon, Portugal) reported metal deficits through most of last year, ICSG's October forecast projected a 110,000 mt surplus for all of 2007. In 2008, ICSG expects a larger surplus of about 250,000 mt based on estimated global consumption of 18.7 million mt against projected refined copper output of almost 19 million mt.
Some analysts maintain that copper will not be oversupplied this year because of ongoing production losses due to strikes, lower ore grades, other mechanical problems, and natural disasters such as earthquakes. Others contend also that underlying global consumption, led by China, is always understated and that overall consumption will post a year-on-year increase despite an assumed slower pace of Western World industrial production and metal usage in 2008. Both Barclays Capital (London) and Paris-based Société Générale see small deficits this year for refined copper.
Last year's price forecasts spanned a relatively wide range, with the LME cash consensus price settling around $3 a pound. As of November 2007, the LME cash price was $3.25. For this year, the forecast—distilled from projections in fourth-quarter 2007 and perhaps overly influenced by the upbeat sentiment at LME Week in the second week of October—is for copper to average about $3.10, with predictions ranging from $2.61 (Natixis, New York) at the low end to a high of $3.68 (Mitsui Bussan Commodities, London). This consensus price is positive compared with Reuters' July 2007 midyear forecast of $2.85 a pound.
Aluminum
Most accounts best described the global aluminum market in 2007 as "well-supplied," with China again setting the production pace. Data for the first 10 months of 2007 show global primary production at 23.3 million mt, up 11.5 percent over comparable 2006 figures. Estimates for the full year have production exceeding consumption, possibly leaving the market with a several-hundred-thousand-ton surplus after being near balanced or undersupplied in recent years. Macquarie Bank (London) asserted in November that aluminum production was growing "at a faster rate than can be absorbed by consumption." Although analysts considered aluminum's aboveground stocks "relatively tight" last year, they were far from the panic levels seen in some other LME-traded metals. Higher global consumption driven by China more than offset lower U.S. consumption last year.
With the perception that the market is in surplus, aluminum prices on the LME held within a rather narrow band most of last year, trending lower in the second half. LME cash averaged $1.21 in the first 11 months of 2007.
The outlook for 2008 suggests more of the same—that is, new production equaling or, more likely, exceeding consumption, resulting in another surplus for the year, albeit not to the extent expected for 2007. Thus, with this fundamental underpinning, price forecasts for this year expect little change from last year, centering at $1.14 a pound. Notably, analysts see less downside risk for aluminum prices this year compared with other nonferrous metal prices. Rising costs for bauxite and alumina, higher energy costs, and lower Chinese exports are providing a solid floor for aluminum, offsetting worries that overall consumption might falter as the global economy slows, analysts note. Many, in fact, see potential for greater-than-expected real demand this year and restocking along the supply chain. At the same time, some forecasts see diminished U.S. consumption prospects due to forecasts of lower automobile production this year.
Iron and Steel
For the fourth year in a row, global steelmakers surpassed the billion-ton mark in their crude steel production in 2007, with China serving as the dominant producer. On the demand side, apparent steel use (steel deliveries plus imports) totaled about 1.2 billion mt, up 6.8 percent over 2006, according to the International Iron and Steel Institute (Brussels). Based on its October 2007 projection, IISI expects steel use to grow 6.8 percent again this year.
Experts estimate China's crude steel production ended 2007 around 490 million mt, representing more than one-third of total global output. Even though it consumes the vast majority of its production domestically, China has become a major steel exporter, shipping more than 75 million mt last year, with Europe feeling the effects to a greater degree than other regions. Steel analysts are quick to note that China's exports in 2008 will be the swing factor in the global steel market balance. Forecasts by the China Iron and Steel Association place 2008 crude steel production at 540 million mt, which would be a 10 percent increase over 2007.
Goldman Sachs & Co. (New York) maintains that 2007 will be the peak for U.S. steel imports from China, which is facing rising freight rates and significantly higher raw material costs, such as iron ore prices expected to increase 30 percent this year. HSBC (New York) and Macquarie Bank also forecast higher steelmaking costs, predicting that iron ore prices will increase 40 percent (HSBC) or closer to 50 percent (Macquarie) this year.
Locker Associates (New York) expects the Chinese government will curb the country's steel production through closures and consolidations. Other factors also could mitigate China's global impact and influence on prices for both finished steel and scrap, including export taxes, the elimination of value-added tax rebates, and continued strong internal demand, the company says.
In the U.S. market, the American Institute for International Steel (McLean, Va.) expects steel shipments last year reached 104.5 million net tons, down from the 109.5 million tons shipped in 2006. Despite this decline, it expects U.S. steel consumption to post an increase due to destocking. AIIS also estimated total U.S. steel imports at 33.5 million tons in 2007, compared with 45.3 million tons in 2006. This drop-off in imports is due to higher prices abroad and higher transportation costs, which have doubled. U.S. exports of steel soared last year, reaching a projected 10.9 million tons compared with 9.7 million tons the previous year.
The 2008 outlook for domestic steel producers and ferrous scrap consumption looks reasonably positive. Goldman Sachs sees risks in demand based on last year's "sluggish" fourth quarter, but it also predicts "some improvement" in the first half of this year, "if only due to seasonal patterns." It expects U.S. auto production to be lower this year, however. Nevertheless, most analysts are confident that domestic mills will be able to raise prices, even if demand remains weak, because of the country's net supply shortage of finished steel, relatively low levels of inventories, and reduced imports.
World Steel Dynamics (Englewood Cliffs, N.J.) also sees cost pressures building that could underpin finished steel prices this year. The company maintains that domestic steelmakers will face a $50-per-ton production cost increase this year due to higher raw material and bulk freight costs. On the price front, Locker Associates says U.S. hot-rolled band will fetch $600 a ton this year, while Purchasing magazine pegs the price at $623 and GFMS Metals Consulting (London) has it at $635. For ferrous scrap, GFMS sees Midwest shredded scrap averaging $314 a gross ton, ex-yard.
Nickel and Stainless Steel
Long considered among the most volatile and perplexing LME-traded metals, nickel only bolstered that reputation in 2007, when its LME prices skyrocketed to $54,300 a mt in early May, then plummeted to $25,055 in mid-August—a 54 percent retrenchment. As November ended, LME cash nickel was $26,750, or $12.13 a pound.
The stainless steel industry, which consumes roughly two-thirds of the annual nickel supply, responded to the high nickel prices with "a massive series of production cuts," one analyst says. Global stainless steel production in the first six months of 2007 was growing at a 9.1 percent rate, but expectations are that output for the rest of the year declined due to the higher nickel prices and subsequent destocking by producers, leaving the full year essentially unchanged from 2006's 28.4 million mt of production, according to the International Stainless Steel Forum (Brussels). Others are more optimistic. Michael Wright of ELG Haniel Metals (Sheffield, England) said in October that global stainless output would end 2007 around 30 million to 31 million mt, with 2008 production reaching 32.5 million mt. Austenitic grades, he said, will increase "in line with 2006" based on what he termed "more realistic nickel pricing."
The 2007 global nickel market moved swiftly into surplus from its 2006 deficit position, with Macquarie Bank placing the oversupply at 62,000 mt. LME inventories trended higher, reaching levels last seen in January 2000. For 2008, Macquarie expects aboveground stocks to be worked down as the nickel supply grows 5.5 percent and nickel consumption rises 9 percent, leaving the market with a modest 16,000 mt surplus.
On the price front, nickel averaged $17.33 a pound through the first 11 months of 2007. Forecasts for 2008 range from $13.55 a pound by Barclays Capital to $17 by Goldman Sachs, with the consensus LME cash average at about $14. Michael Wright sees nickel ranging from $11.34 to $15.88, terming stainless steel scrap supplies "sufficient" to meet the mill demand.
Lead and Zinc
Although lead and zinc are geological sisters, that's where the similarity ends. Looking at last year's price performance through November, zinc was the worst performer among the major LME-traded nonferrous metals while lead was the biggest gainer. For both metals, supply/demand fundamentals set the tone last year.
Analysts believe the global zinc market ended last year with a modest deficit, but it will likely post a surplus of "just under a quarter-million tonnes" this year as demand grows 5.1 percent and refined metal output expands 7.8 percent, according to ILZSG. Barclays Capital saw zinc shifting into oversupply in fourth-quarter 2007 based on improved zinc concentrate supply and weak domestic consumption. Zinc's surplus in 2008 will be more "convincing," Barclays predicts, while Société Générale and Macquarie project the oversupply at 250,000 mt and 300,000 mt, respectively.
Given zinc's supply picture, it isn't surprising that the metal's 2008 price forecasts range from $1.25 to $1.30, well below its 11-month 2007 LME cash average of $1.51 a pound. On the low side, Société Générale projects a 95-cent average for this year, a level consistent with "historically more normal levels."
As for lead, ILZSG expected the metal to end 2007 with an 89,000-mt deficit, moving toward a "close balance" in supply and demand this year. Most market researchers see lead recording a slight surplus this year.
Last year, lead faced ongoing supply problems that limited Chinese production as well as exports of refined metal to the West. The combination of reduced Australian concentrate supply, firm demand, higher Chinese export taxes, and commodity price speculation drove LME lead prices to an all-time high last summer, exceeding the 36-year inflation-adjusted monthly average set in May 1979. Lead surpassed zinc in value last August for the first time since 1980 and averaged $1.17 through November, essentially doubling its 58-cent average in 2006.
This year, lead's story again centers on supply factors, including the availability of concentrates, the production of refined metal, higher global consumption, and exports of metal from China. With the supply side less than secure due to mining difficulties and environmental considerations, and with lead demand less vulnerable to substitution compared with other metals, the 2008 outlook hints at a relatively balanced market and potentially several additional years of above-trend prices. LME lead price forecasts for this year are around $1 a pound, well above the metal's historic average and miles from analysts' lead price predictions for last year.
Pulp, Paper, and Recovered Fiber
Global demand for paper and paperboard continues to expand, with annual growth figured at about 12 million tons—a level that's reportedly stretching world fiber supplies. China has led the papermaking increase, accounting for half of global growth since 2003.
Pulp prices, as measured by northern bleached softwood kraft, averaged $825 a mt last year, ending December 2007 at $880, 11 percent higher than the price at the start of the year and the highest since the mid-1990s. Firm global demand and relatively low producer stocks defined last year's pulp market, allowing North American and European NBSK producers to increase list prices five times during the year.
For 2008, the view from Citigroup Global Markets (New York) points to a somewhat "looser" market for NBSK as new pulp capacity ramps up around the world. Although some downward price correction might be in store early this year, the weak U.S. dollar will "contain" pulp's price downside this year, the company says.
U.S. scrap paper consumption last year should exceed the 53.5 million net tons consumed in 2006, which yielded a 53.4 percent recovery rate that year, according to the American Forest & Paper Association (Washington, D.C.). The United States now recovers more than 360 pounds of paper for every man, woman, and child in the country, and the paper industry has set a goal to recover 55 percent of all U.S. scrap paper by 2012.
For domestic paper recyclers, last year's market issues included the continuing decline of domestic newsprint production, another year of record export shipments, and—for shippers—container shortages and fast-rising freight rates. Bulk scrap paper grades enjoyed a solid year, with second-half OCC tags averaging above $130 a ton (f.o.b., picked up), 16 percent higher than prices in the first half of 2006. Mixed paper also held firm above $90 a ton in the second half, and ONP averaged $112, according to Moore & Associates (Atlanta)—all well above earlier expectations.
For 2008, bulk grade price forecasts (spot and contract prices) point to a firm first half followed by somewhat lower second-half average prices for OCC, mixed paper, and ONP, Moore & Associates says. The lower averages, it notes, reflect both seasonal considerations and a U.S. economy that's expected to post slower second-half GDP growth. The forecast average for OCC, for example, is in the upper $130s in the first quarter but loses $15 to $20 a ton in the final months of the year. Mixed paper and ONP could face a similar fate, registering slightly lower averages for the full year compared with their second-half 2007 averages, Moore & Associates predicts. •
Robert J. Garino is director of commodities for ISRI.
The U.S. and global economic juggernauts encountered serious head winds in 2007 with the U.S. subprime mortgage crisis, rising inflation concerns, higher energy costs, and other issues. Are the good times over? Or is this only a temporary setback in the global economic super cycle?