Will economies follow industrial metal bounces?

The global flow of base metals from mine to smelter to factory (or exchange warehouse) offers useful trading opportunities. Just as important, it provides a helpful economic pulse.

That follows because non-ferrous, non-precious metals such as aluminum, copper, zinc, nickel, lead and

tin that trade primarily on the London Metal Exchange (LME) play crucial roles in industry. When manufacturing heats up at the end of a recessionary period, the purchase of materials signals as an early stage of economic recovery. That shows on price charts and in metal warehouse statistics.

In fact, Paul Kasriel, an economist at The Northern Trust Co., says, "Metal prices were a pretty accurate indicator in 1991."

"Auction market indicator" proponents such as Kasriel look first at the spread in the yields of the Fed funds rate and 30-year Treasury bonds. A widening spread suggests an economic pickup with about two quarters of lag.

For corroboration of that sign, Kasriel looks next at industrial commodity prices, the base metals among them. Purchase of materials supports the yield signal and foretells economic growth, with perhaps a one-quarter lag.

Broad money supply growth provides further confirming evidence, usually coincident with the commodity prices.

Metals prices lately have seemed more reliable than yield spreads. For much of 1991, for example, the yield spreads was fairly wide, Kasriel points out. But, after a mild surge of activity, the U.S. economy faltered again.

To a commodity price observer, that should have been no surprise. As Kasriel noted week after week in his outlook papers, the corroborative price surge never materialized.

By February, though, all the signs seemed in sync: Yield spreads were wider, metals prices picked up, lumber was up sharply, and broad money supply was growing.

"A pretty potent combination of signs of pickup," Kasriel says, but "it could be a very temporary thing."

In part, that is because some metals analysts and traders don't trust the January runup in aluminum prices.

"That was a dead cat bounce," says London metals trader Paul Shuman, meaning there's no life in the move.

Ted Arnold, Merrill Lynch metals analyst, looking at the same data, tends to agree: "Sentiment was too bearish. Now it's too euphoric."

To him, the importance of recent price runups, especially in aluminum, was probably overdone. Taking a broad view, he says nickel is surely overvalued, while aluminum may be. Coppers is trading in a good comfort range. Zinc is "fairly valued."

"Aggressive Chinese selling of lead has a lot of that stuffs swilling about the world," Arnold contends.

He says lead prices could sink another 2 [cents] per lb. or so. Tin is a disaster area, with no buying and just enough marginal supply from the defense sector to keep prices pressured.

So none of the metals markets promise much relief soon.

LME warehouse stocks provide one clue to the fundamental situation base metals markets face.

"The LME is truly international and the only place to trade most of those metals," Shuman notes. "Less than 10% of all the metal traded there is of U.K. orientation."

He points out more than 1 million metric tons of aluminum resides in LME warehouses.

"That's 10% of yearly production - a lot of unused, unwanted spare metal," he says. "Until about a third of that goes back into industry, there will be no significant increase in price."

Most consumers are living hand to mouth and will continue doing so. While aluminum prices rose in January, they remain lower than at any time since 1984. That suggests the buying surge was bargain hunting and is unlikely to be sustainable.

Though that surge led to a 10% price move one week in January, there was no

fundamental reason for it.

"There'll be no significant price change until market participants can seriously say they've come out of this world recession," Shuman says.

However, he adds many of his customers have already written off 1992 and are looking to 1993. Therefore, long-term, Shuman says he would be a seller.

Arnold basically agrees with Shuman on 1992 aluminum prospects.

"Aluminum is now in such a dreadful oversupply situation that 1992 is effectively a writeoff in price terms," Arnold says. "It would take a miracle of economic growth to save the aluminum price."

Part of the problem is that, while recent loss of capacity will mean 730,000 metric tons less in annual output, new capacity in 1992 will cancel about 82% of that. Achieving supply-demand balance will take as much as 30,0000 metric tons more in cutbacks.

Even that may be optimistic, according to Arnold. It assumes a rate of aluminum consumption growth unlikely to be sustained by a recession-plagued world.

Arnold suggests prices may have to sink as low as $900 a metric ton (41 [cents] per lb.) before producers reduce capacity enough to affect the market. That, more than economic growth, seems to him the key to higher prices this year.

Output enigma

One hard-to-gauge supply factor involves Russia.

Significant aluminum undersellers, Arnold says, the Russians will offer major European merchants discounts of about $100 a metric ton to the LME price.

Several European trade groups have appealed to the European Community for tariffs against the so-called dumping by Russia. Arnold doubts a tariff, or any punitive action, will emerge.

"All of that is so political," he says. The Germans and Swiss, and to some extent the Spanish, are high-cost producers and so come bleating for protection. But the Brussels people are aware of the big picture - that these people, though once enemies, are now friends."

Arnold says traders should see Russian pricing from their point of view.

"A price might seem cheap to a Western firm, but to Russians it might be a bonanza in ruble terms," he explains.

Or a mine manager might be able to trade outside the East Bloc for scarce goods (computers or food). The nation as a whole desperately needs the foreign exchange that brings.

So the Russians will be major exporters this year and next, although Arnold expects little action in the near term because the region's rail cars are tied up hauling grain.

Another unknown in the Russian prospects, says Craig E. young, MG Futures Inc. senior vice president, is the scarcity of alumina, a material stage between raw ore and finished metal. Joint ventures may be hard to find, and foreign exchange may have to go for other uses. That would be a bit bullish for aluminum.

It's hard for Westerners to comprehend how high a priority food is in that trade.

After January's surge, according to Young, the markets are looking for direction - looking for followthrough without which prices will likely flutter back down.

Conventional wisdom says there's too much metal on hand and being produced, so prices must fall back. Maybe. But Young sees on new factor in all the commodities, including metals, that could change that: For the first time in seven or eight years, investors seeking value may want to buy and hold commodities.

Significant investment money out on the street is looking for a home. With certificate of deposit interest rates so low and with too much money chasing too few stocks, Young suggests investors will ask where the value might be.

With a cheap U.S. dollar and cheap commodities, people might decide commodities offer true value.

"That introduces a new set of fundamentals based on investors looking for asset value appreciation - capital gains," Young says.

Granted, that has inflationary implications. But if even 1% of all pension money were invested on that basis, it could have major ramifications for commodities markets. The base metals could ignore their true fundamentals for some time, and the markets could see major rallies.

Barring something like that, Young says the usual fundamentals will take over metal markets. And those are all bearish.

Then the January surges will indeed be "dead cat bounces," and the markets and the economies, like the cat, will remain inert.