2 Reasons Why the Outlook for Commodities Remains Bearish

The key determinant of commodity prices is China. China is the single largest consumer of commodities globally. Its rapid economic expansion and insatiable hunger for raw materials created a commodities super-cycle, which caused the prices of a range of commodities, including iron ore, copper, coking coal, nickel, and zinc, to spiral skyward.

This was a veritable boom for mining stocks, driving their share prices to heights thought to be impossible. But like all good things, it had to come to an abrupt end.

There are two key indicators which show that despite the recent rally in commodities, sharply weak prices are here to stay.

Now what?

Firstly, China’s economic growth is now in decline with its 2015 GDP expanding at its slowest rate in 25 years. Along with China’s construction and manufacturing sectors being caught in intractable slumps, this slow growth is directly responsible for the marked decline in demand for commodities.

What many investors don’t appreciate is that this weakness is set to continue.

Not only did China’s second-quarter 2016 GDP growth rate come in at its lowest level since the global financial crisis, but the recent credit-fueled rebound in construction activity, which was responsible for the rally in commodities, appears to be short-lived.

Then there is the property sector, which remains in decline with oversized housing inventories weighing heavily on demand. As long as this supply overhang remains, there will be no improvement in the outlook for the construction sector.

Meanwhile, China’s manufacturing sector, once considered to be a vital engine of economic growth, is struggling. For June 2016 the purchasing managers’ index, or PMI–a measure of manufacturing activity–plummeted to a four-month low. This can be attributed to a number of China’s key export markets, including the European Union, being caught in their own deep economic slumps.

The uncertainty surrounding the health of the global economy is only compounding the poor outlook for China’s exports; this uncertainty is being compounded by events such as the Brexit.

Secondly, the outlook from a supply perspective also remains grim.

At the height of the commodities super-cycle, all parties were investing heavily in the development of mining assets. This means that supplies of coal, copper, nickel, zinc, lead, iron ore, and steel now far exceed global demand, creating tremendous supply gluts that are placing considerable pressure on prices.

Then there are the moves by a number of miners to boost output of these and other commodities regardless of weak commodity prices.

Global mining behemoth BHP Billiton Limited has already embarked on a plan to expand its coking coal output by 8%, despite prices being close to their lowest point in a decade.

The world’s second-largest copper miner Freeport-McMoRan Inc. plans to continue expanding its copper production in order to generate sufficient cash flow to reduce its mountain of debt. Its second-quarter 2016 copper output grew by 16% year over year, and this growth can only continue because a range of projects are under development.

There is also Chile, the world’s largest producer of copper, where the government is heavily investing in boosting copper production to replace important revenue lost because of weak copper prices. Chile seeks to boost output by a third over the next eight years. 

So what?

The sharp decline in demand for coking coal and copper coupled with the growing supply glut doesn’t bode well for the fortunes of miners such as Teck Resources Ltd. (TSX:TCK.B)(NYSE:TCK) and First Quantum Minerals Limited (TSX:FM).

Both have been among the key beneficiaries of the recent optimism surrounding commodities; their share prices spiked by 283% and 118% for the year-to-date, respectively. Nonetheless, with weak commodity prices now appearing to be the “new normal,” these rallies appear to be overdone.

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Fool contributor Matt Smith has no position in any stocks mentioned. The Motley Fool owns shares of Freeport-McMoRan Copper and Gold.

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