Signs of recovery, but demand still a key challenge

Last Updated: Wed, Dec 12, 2012 21:35 hrs

While both globally and in India we are still far from a meaningful recovery in economic growth, there are indicators suggesting that some recovery is on the horizon. The first part of the 'Road to Recovery?' series, on Wednesday, talked of macro indicators like purchasing managers’ index (PMI) and gross domestic product (GDP) growth, which point to some recovery. Even on the commodity front, there are indications that things are looking up.

Take, for instance, the recent rise in metal prices on the London Metal Exchange (LME). Tin, aluminium and zinc have gained between 11-13 per cent since the start of November 2012, while nickel, lead and copper are up between three and eight per cent during the same period. Gains across a section of commodities have led to the US-based CRB All Commodities Index rising 1.5 per cent in the last one and a half months.

The CRB Commodities Index is a measure of price movements of 22 sensitive basic commodities whose markets are presumed to be among the first to be influenced by changes in economic conditions. As such, it serves as one early indication of impending changes in business activity.

In India, steel, paper and soap manufacturers too, have started increasing prices, which indicates their ability to pass on cost increases. Steel companies have announced an increase of Rs 1,000 to Rs 1,500 per tonne this month. A weak rupee has also provided some cushion to domestic steel companies against benign global prices allowing them to raise prices and still remain competitive against imported material. Even in the UK and Europe, Tata Steel had recently raised steel prices by about five per cent.

“There are early indications of the pricing environment improving for commodity companies though selectively. Steel companies are seen benefiting, as reflected in the increase in volumes as well as price increase. Cement prices though, were soft till last month. But, they also tend to firm up post-December,” said Kamlesh Kotak, head of equity research, Asian Markets Securities.

This means companies like Tata Steel, Hindalco and Sterlite Industries should benefit in the form of better realisations. Not surprisingly, their stocks, which had underperformed the Sensex in the last one year, have done better since late-November 2012 rising 8-18 per cent against Sensex’s six per cent gain.

The net financial (earnings) gains for metal companies, however, will depend on other factors like their cost of production, debt levels and so on.

However, how long metal prices will continue to rise is still not clear, given the looming US fiscal cliff issue. Bhaskar Basu, research analyst with Bank of America Merrill Lynch, said, “Our metal analyst has cut 2013-14 price estimate for aluminium by 8.3 per cent and zinc by 11.4 per cent as fiscal cliff is a key risk to markets in the quarter beginning January. But a resolution of macro issues like fiscal cliff in US, Europe issues and China recovery may support metal prices from July 2013 onwards.” In the near-term too, there are certain events that may cap further upside in metal prices. “China has already started buying metals for reserve purpose. However, in January 2013 China will celebrate the Lunar New Year and long holidays, and how long metal will remain insulated from it will be an issue.”

Jigar Shah, senior VP and head of research, Kim Eng Securities India Pvt Ltd, said, “While people are banking upon China’s demand for revival, there are no clear signals suggesting that China’s revival is sustainable. Slower China growth could be a challenge that markets may have to face.”

The outlook for crude oil, another key commodity, is not encouraging though. Oil prices are likely to remain benign for most of 2013, both due to an increase in supply and slower demand globally. Morgan Stanley has cut its oil price estimates for 2013 from $115 to $110 per barrel. The US is expected to report record production of crude oil, which will also increase the pressure on crude oil prices. Brent crude oil is down 6.33 per cent to $108.5 in the last three months on slower demand and an increase in production from non-Opec countries like the US.

This should come as good news to economies like India which are heavily dependent on oil imports. If oil prices remain benign through this fiscal, it would help lower India's fiscal deficit. Oil prices have a cascading effect on the economy as a whole, and lower prices should also reflect positively on India Inc’s earnings.

For other commodities like rubber and palm oil, things are still sour as prices are down six to eight per cent since the start of November 2012. This, however, should benefit tyre companies given that rubber prices are at four-month lows. Likewise, palm oil, which is used by soap makers, has also become cheaper, and should benefit companies like Hindustan Unilever, ITC and Godrej Consumer in the listed space.

While there are challenges on the demand front in the domestic metal market given that key consumers like infrastructure and housing sectors are at the receiving end (higher prices will hurt them if order book/execution do not pick up), there are no clear signs of a revival in demand from China (a key global consumer of commodities, especially metals).

The recent rise in prices though, has provided some hope. And if the US Fed and ECB keep the global liquidity tap open, and if RBI cuts rates and the government takes more steps to push reforms (especially towards infrastructure spending), it should help strengthen the recovery in commodity prices.

This is second of a three-part series on the downturn in the global economy and its probable recovery

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