Real Asset Strategy

Timely discussion of the recent commodity, REIT, and real asset markets and what it may mean for investors.

December 21, 2017

John LaForge, Head of Real Asset Strategy

Why We See Lower Copper Prices in 2018

  • 2016 and 2017 were great years for copper prices, likely due to better economic expectations and copper demand from China.

What it may mean for investors

  • Despite this fact, we doubt that copper prices will rise again in 2018. Much of the good Chinese news already appears “baked into” copper prices.

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“Sudden events cannot be handled by the unprepared mind.”
—Mo Di

We often discuss how the super-cycle impacts commodities as a family and how super-cycle bear markets last 20 years on average. In today’s report, we will review what that bear super-cycle looks like for oil, what forces are conspiring to keep oil prices range-bound for years to come, and what would need to happen for a bull market to begin.

In 1990, China accounted for less than 5% of world copper demand. Twenty-seven years later, in 2017, China accounts for nearly 50% (Chart 1, orange line).

So, when we’re asked why copper prices have risen 24% in 2017—our first instinct is to look at demand trends inside China. It turns out that China has been accumulating more copper. Yet, some of the charts we’re about to show you suggest that copper’s run may soon be done.

Chart 1. Chinese commodity consumptionChart 1. Chinese commodity consumptionSources: Bloomberg, U.S. Department of Agriculture (USDA), World Bureau of Metal Statistics, Wells Fargo Investment Institute. Yearly data: December 31, 1980 through December 31, 2016. Dates selected to show dramatic rise in China's metals consumption.

2017 was the second year in a row for copper price gains. In 2016, copper prices rose 17%. This was after six straight down-trending years, from 2010 through 2015. Chart 2 highlights why copper prices may have followed such a wild path over the past eight years. The blue line represents China’s gross domestic product (GDP) year-over-year growth rate. The orange line is the price of copper, year-over-year. Notice that China’s GDP growth rate was cut in half from 2010 through 2015, from 12% to roughly 6%, and copper prices followed suit. A bit later in this report, we’ll tackle why we believe copper prices have been rallying since 2016, while China’s GDP growth rate has risen only slightly.

Chart 2. Copper versus China GDPChart 2. Copper versus China GDP Sources: Bloomberg, National Bureau of Statistics of China, Wells Fargo Investment Institute. Quarterly data: March 31, 1992 through September 30, 2017. Past performance is no guarantee of future results.

China’s GDP growth rate plunged from 2010 through 2015, largely because the country slowed its building of everything from roads and bridges to buildings. This slowing was mandated by the government’s five-year plan, released in 2011, with details discussed in 2010. China’s five-year plan is a series of social and economic development initiatives. Why the 2011 plan was so significant to building, and ultimately copper prices, was that the plan emphasized “consumer-led” growth over “building” or “capital-type” growth (also known as capital expenditures). The 2011 plan was a sea change from the prior decade, which stressed “capital-type” growth. The blue line in Chart 3 shows China’s ratio of “capital” to “consumer” GDP growth. A rising blue line means that China’s “capital-led” GDP growth is exceeding its “consumer” growth. A falling blue line denotes the opposite; that “consumer” growth is outpacing “capital” growth.

Chart 3. Investment/consumption ratio—China versus global averageChart 3. Investment/consumption ratio—China versus global averageSources: World Bank, Wells Fargo Investment Institute. Yearly data: December 31, 1995 through December 31, 2015.

Why China decided to emphasize “consumer” over “capital” growth in 2010 and 2011 is best answered by the Chinese government. Our best guess, though, is that the government decided that it wanted to be recognized as a developed country rather than as a developing country. As this relates to GDP, developed countries generate most of their GDP from the consumer, not from capital. U.S. GDP (Chart 4, red line), for example, was about 65 percent consumer and 35 percent capital, in 2010. In 2010, China’s GDP mix (Chart 4, blue line) was the reverse—roughly 35 percent consumer and 65 percent capital.

Chart 4. Consumption as a percent of GDP—China versus U.S.Chart 4. Consumption as a percent of GDP—China versus U.S.Sources: Bloomberg, National Bureau of Statistics of China, Bureau of Economic Analysis, Wells Fargo Investment Institute. Yearly data: December 31, 1960 through December 31, 2016.

So, let’s go back to the question of why copper prices have risen so significantly since 2016, while China’s overall GDP growth rate has risen only slightly. Part of the answer has nothing to do with copper—but instead—with the reality of lower GDP growth rates in countries as they become more mature, and more consumer-driven. Unfortunately, consumer-led GDP growth tends to come with lower GDP growth rates, as many a developed country can attest. In other words, it is hard to move the growth needle higher as a country matures.

With that said, China’s GDP growth rate technically has risen over the past two years (Chart 2, blue line), which has been a marked change from the 2010-2015 period. Part of the copper price bounce, since 2016, may very well have been linked to the fact that China’s GDP growth rate had stopped falling. There is no question, though, that China has been buying more copper in recent years, which has impacted the price. The orange line in Chart 5 is the price of copper, while the blue line represents China’s net copper imports.

Chart 5. Copper prices versus China net importsChart 5. Copper prices versus China net importsSources: Bloomberg, Wells Fargo Investment Institute. Monthly data: March 31, 2008 through November 30, 2017. Data shown in log scale. Past performance is no guarantee of future results.

So, the question still remains—why is China buying so much more copper in recent years, with its GDP growth rate only marginally higher? The answer may lay in future economic expectations. Chart 6 shows the year-over-year change in copper prices (orange line), versus the year-over-year change in the China Business Cycle Signal (blue line). This signal has been a leading indicator for China’s economy. Its rise, since 2016, suggests a pickup in Chinese GDP in the coming years. The connection between the price of copper and this leading economic index is not always perfect, but it has been a tight one in recent years.

Chart 6. Copper versus China Business Cycle SignalChart 6. Copper versus China Business Cycle SignalSources:: Bloomberg, National Bureau of Statistics of China, Wells Fargo Investment Institute. Quarterly data: March 31, 1992 through September 30, 2017. Past performance is no guarantee of future results.

If one of China’s leading economic indices is suggesting better times ahead, why are we saying that copper prices may be set to fade in 2018? Our answer is tied to Chart 7, which plots this same leading Chinese economic index against actual Chinese GDP growth. Notice that most of the time, since 1992, the leading economic index did a good job of calling the direction in GDP growth—but not in the past few years.

We suspect that something has to give with Chart 7; either China’s GDP growth picks up, or its leading economic indicator turns back down. Neither of these scenarios seems likely to lead to meaningfully higher copper prices in 2018. Chart 6 suggests to us that copper prices already have priced in the likelihood that the leading economic index is right. For copper prices to move meaningfully higher from here, we likely would need to see another step-up in the leading economic index. This is always possible, but it probably is a stretch, considering that today’s index reading sits at its highest level, since 2010. And then there is the scenario that the leading index is wrong, or at the least, ahead of itself. If so, watch out below for copper prices, again, based on the connection that we see in Chart 6. Lastly, China has not changed its long-term plans to stress consumer-led growth over capital-led growth, and we doubt that it will. Copper, and other industrial metals, will be fighting this long-term headwind for years to come. Our copper bottom line for 2018— we’re expecting lower prices.

Chart 7. China GDP versus China Business Cycle SignalChart 7. China GDP versus China Business Cycle SignalSources:: Bloomberg, National Bureau of Statistics of China, Wells Fargo Investment Institute. Quarterly data: March 31, 1992 through September 30, 2017. Past performance is no guarantee of future results.

Risk Considerations

Investing in commodities is not suitable for all investors. Exposure to the commodities markets may subject an investment to greater share price volatility than an investment in traditional equity or debt securities. The prices of various commodities may fluctuate based on numerous factors including changes in supply and demand relationships, weather and acts of nature, agricultural conditions, international trade conditions, fiscal monetary and exchange control programs, domestic and foreign political and economic events and policies, and changes in interest rates or sectors affecting a particular industry or commodity. Products that invest in commodities may employ more complex strategies which may expose investors to additional risks, including futures roll yield risk.

Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Small- and mid-cap stocks are generally more volatile, subject to greater risks and are less liquid than large company stocks. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. High yield (junk) bonds have lower credit ratings and are subject to greater risk of default and greater principal risk. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility. Real estate has special risks including the possible illiquidity of underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions.

Alternative investments, such as hedge funds, private equity/private debt and private real estate funds, are speculative and involve a high degree of risk that is suitable only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of an investment in a fund and for which the fund does not represent a complete investment program. They entail significant risks that can include losses due to leveraging or other speculative investment practices, lack of liquidity, volatility of returns, restrictions on transferring interests in a fund, potential lack of diversification, absence and/or delay of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than mutual funds. Hedge fund, private equity, private debt and private real estate fund investing involves other material risks including capital loss and the loss of the entire amount invested. A fund's offering documents should be carefully reviewed prior to investing.

Hedge fund strategies, such as Equity Hedge, Event Driven, Macro and Relative Value, may expose investors to the risks associated with the use of short selling, leverage, derivatives and arbitrage methodologies. Short sales involve leverage and theoretically unlimited loss potential since the market price of securities sold short may continuously increase. The use of leverage in a portfolio varies by strategy. Leverage can significantly increase return potential but create greater risk of loss. Derivatives generally have implied leverage which can magnify volatility and may entail other risks such as market, interest rate, credit, counterparty and management risks. Arbitrage strategies expose a fund to the risk that the anticipated risk that the anticipated arbitrage opportunities will not develop as anticipated, resulting in potentially reduced returns or losses to the fund.

Definitions

An index is unmanaged and not available for direct investment.

China Business Cycle Signal Index is considered a leading index released by the National Bureau of Statistics of China. It is used for monitoring the situation of the macro-economic performance and forecasting the trend of future development. The index takes into account measures of: industrial production, fixed asset investment urban cumulative, retail sales, exports, imports, government revenue, per capita urban disposable income, loans from financial institutions, m2, cpi, and industrial profits.

Global Investment Strategy (“GIS”) is a division of Wells Fargo Investment Institute, Inc. (“WFII”). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

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