Fade the Metal Rally
In the last two years, there has been an impressive rally in industrial metals. From the lows during early 2016 until today, copper is up 50%, zinc is up 100%, aluminum is up 50%, and lithium is up 120%. When industrial metals rallied, stocks in the metal and mining sector rallied sharply as well.
The major driver of the rally is the supply cut from China. Realizing the overcapacity of industrial metal production, the Chinese government decided in early 2016 to cut capacity by 20-30% by 2020 to improve the demand-supply balance. Considering China is by far the largest producer of industrial commodities, the capacity cut drove a sharp rally.
Now, if you look at the chart, which shows the CPI and PPI in China, you can see the PPI has risen significantly since early 2016. It now sits at 6.3%. However, the CPI was stable during the period and the latest print is 1.8%. The gap between the PPI and the CPI is a signal that the rising cost of industrial production is not being passed to consumers. This is a sign that the end consumer demand didn’t pick up enough to allow companies to increase the price for consumer goods.
A supply cut can drive up the price temporarily, but to sustain the higher price, there needs to be corresponding demand. Since there is not currently demand rise, the risk that the metal rally will fade in coming quarters is high.
Industrial commodities have experienced a sharp rally since early 2016. But the gap between the PPI and the CPI in China is a sign producers are having difficulty passing the increased production cost to consumers. Investors should take caution and may want to use this rally to reduce exposure to industrial metals.
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