Conclusion: As the global economy slows sequentially, we expect the price of copper to decline as inventory builds and currency tailwinds unwind.
Position: Short Copper (JJC).
Refined copper imports by China (the world’s largest consumer) grew in July for the first time in four months. The 6% M/M increase reflects May and June demand for imports (it takes one to two months for the imports to arrive in Shanghai), which was high, as higher prices in Shanghai prompted arbitrage trade. A recent report out of Orient Securities Futures suggests the window for arbitrage may be closed, which is bearish for Chinese copper imports going forward. Also, it is important to note that this important number is down -23% on a Y/Y basis. So, while copper inventories are low in China, the culprit is really low imports rather than accelerating end market demand.
Admittedly, we were early shorting copper from a timing perspective, but we continue to have conviction on the short side – despite current low inventories. Copper stockpiles as measured by the London Metals Exchange hit the lowest levels since November 11th and are down 2.8% this month after declining 8.3% in July. Since the YTD high of 555,075 tons on February 18th, copper stockpiles on the LME have declined 27.6%. We have seen a similar decline in stocks on the Shanghai Futures Exchange, down 42% since the high of 189,441 metric tons in the week ending 4/29.
Interestingly, and despite these bullish fundamentals, copper is only up 0.2% since Feb. 18th and down 1.3% since April 29th. On a two and three month basis, however, copper is up 14.1% and 11.8% respectively, which is supported by dollar weakness (the Dollar Index is down 3.1% and 2.9% over the same durations). The fact that the price of copper has barely moved in a declining inventory environment is a bearish indicator for us as it relates to the future direction of price.
Normally, we look to the price of copper as a leading indicator for global growth, but with the mixed signals we have been receiving from a price perspective as a result of prolonged periods of dollar strength and weakness, we must turn to our outlook on global growth to forecast where we think Dr. Copper is headed. As a reminder, we are bearish on global growth in 2010 and we have a 1.7% estimate for 3Q10 and 2011 U.S. GDP growth (roughly half of consensus estimates), which is largely driven by our forecast for housing prices to fall 15-20% in the next 12 months and rising structural unemployment. In addition, we have been bearish on Chinese growth since January 15th, and with consumer price inflation hitting a 20-month high in July, we don’t expect China to loosen its tightening measures anytime soon. Additional factors supporting our bearish stance on global growth are austerity in Europe and slowing end demand from Western consumers which may serve to reduce industrial production and trade internationally.
With the looming global growth backdrop, we expect copper inventories to build, or at least see a deceleration in the rate of declines. Either result is incrementally negative for price. Furthermore, we could see dollar strength from accelerated dollar purchases by central banks globally as exporting nations from Asia to Latin America look to increase their slice of the contracting pie that is global trade in 2H10.
As always, our style of investing requires a prudent risk management approach that is duration agnostic. We will continue to analyze and interpret the near-term risks to our short position in Copper. Those risks include further dollar weakness from here and reduced production in China, the world’s largest smelter of the material.
We expect tomorrow’s existing home sales to be a bomb, in the range of down 20%-30% M/M. Obviously, this will come as a shock to investors (consensus estimates are for a 12% decline), which will likely serve to conjure up more calls for increased stimulus in order to avoid a pending double dip in housing. If Bernanke and Co. give in to market pressure, we expect the dollar to resume its decline after closing up on a weekly basis for the previous two weeks. Further dollar debasement from here is positive for copper prices (r-squared = 0.69 on a two-month basis).
With regard to supply, the latest rumors out of China claim that the government may shut smelting plants that violate environmental rules as it looks to tighten regulation after a series of industrial accidents led to waste spilling into rivers and seas. The latest data (2008) show that China accounts for nearly one fourth of total world copper smelting output, so a reduction in production there will provide support for the price of copper. Accidents are running at an annualized rate of 204 in 1H10 compared with 171 in all of 2009, according to China’s Environmental Protection Ministry.
Absent the development of these risks, we expect the price of copper to decline from here as the fundamental and currency tailwinds look to unwind. For now, copper is bullish from a TRADE ($3.25/lb) and TREND ($3.14/lb) perspective with TRADE resistance at $3.31/lb.