There's a bewildering rally taking place within the commodities markets, and few on Wall Street are buying it. Base metals, a group that includes everything from copper to zinc to aluminum, have shot higher in 2017 despite a relatively dismal year for the broader commodity market.
The PowerShares DB Base Metals Fund (DBB), which holds an equal-weighted basket of all three metals, has jumped 20.8% year-to-date, handily outperforming the 6.9% loss for the broad PowerShares DB Commodity Index Tracking Fund (DBC), the 13.3% swoon for the PowerShares DB Energy Fund (DBE) and the 7.4% decline for the PowerShares DB Agriculture Fund (DBA).
YTD Returns For DBB, DBC, DBE, DBA
Factors Driving Rally
Analysts attribute the base metals rally to a few factors, including rebounding growth in China and a weaker U.S. dollar.
GDP in China expanded by 6.9% during the first half of 2017, outpacing the government's target of 6.5% and even last year’s 6.7% growth rate. Meanwhile, the U.S. Dollar Index has slid 8.7% so far this year.
But those bullish factors aren't unique to base metals. Other commodities would seemingly benefit from a stronger Chinese economy and sliding greenback, but they haven't. That means it may be the supply side that's really powering metals higher.
"Our view is that there are several separate factors at play accelerating the metals' price boom. Demand conditions within China are supportive and the dollar has weakened,” said Dane Davis, commodities research analyst for Barclays. “That helps, but it’s not enough. What’s turbo-charging some metals are supply disruptions and tightness. Copper, for example, has seen disruptions ranging from weather to strikes, cutting 612 kt [612,000 metric tons] of production so far in 2017."
‘Tightening Environmental Controls’
Robin Bhar, head of metals research for Societe Generale, also sees the industry as getting a supply-side lift from environmental reforms in China.
"Supply-side reforms in China are a key factor" driving the rally, he noted, adding: "Tightening environmental controls/monitoring of mines and smelters (mainly aluminum and zinc) are constraining output. In aluminum, smelting capacity is being forced to close if it doesn’t have the necessary licenses from the central government."
While analysts largely agree on what's driving metals higher, they're split over whether the rally will continue. Most agree with Barclays’ Davis, who noted that "something seems off about this recent rally" and that he remains "skeptical of its strength and duration."
Keep An Eye On Iron Ore
Davis is especially wary of iron ore, a key ingredient in making steel. The steel market is running very hot at the moment in China, but that will likely change relatively soon, he says.
"While demand conditions are supportive in the short term, they’re running up against long-term head winds, including a China that is facing demographic pressures of a slowdown," Davis predicted.
Meanwhile, Bernard Dahdah and Alomgir Miah, analysts at Natixis, also believe the rally will run out of steam soon.
"Although in the long run we are bullish on copper and aluminium, we believe in the short to medium term they have overshot where they should be fundamentally due to the excitement of better- than-expected demand indicators in China," they said. "We expect prices for both metals to fall in Q4'17 after the end of leadership elections in China."
On the other hand, Societe Generale's Bhar believes there is ample support for a continued rally in base metals.
Though nickel in particular looks overvalued, "base metals overall from a supply/demand perspective are in better balance and inventories are falling," he said.
In Bhar's view, the base metals uptrend is sustainable through the end of the year, but the situation gets murkier in 2018 when he anticipates China's economy will slow.
Contact Sumit Roy at [email protected].