by Vanya Dragomanovich
AlphaWeek – Just as institutional investors started once again warming up towards commodities after a long period of falling prices, the decision by the US to introduce tariffs on imports of steel and aluminium is threatening to disrupt the investment flow into commodities.
The tariffs, which go into effect before the end of March, have already triggered a domino effect in the heavily intertwined global commodities trade and it is far from clear where the last domino will fall.
The first, albeit wrong, assumption of outsiders of the metals markets was that the tariffs would protect the US steel industry from cheap Chinese imports. But China is only number ten on the list of countries exporting steel to the US, with Canada and Brazil being in the top two slots. Similarly, Canada and Mexico are among the two of the top four exporters of aluminium into the US.
Although Trump initially proposed to apply tariffs to all countries selling steel and aluminium to the US this was quickly amended to exempt Canada and Mexico. The US can’t really afford to start a serious trade war with its two neighbours as it depends too heavily on them for many raw materials. For instance, “while the US produces plenty of light sweet crude oil at home it imports the heavier crude oil used for transport fuels from Canada,” says Carsten Fritsch, analyst at Commerzbank. “If there was a tit for tat reaction from Canada the prices of petrol would rise” creating the exact opposite effect of what Trump was trying to achieve, he said.
And this is just the first layer of implications. The tariffs are designed to help US producers restart some of their steel and aluminium plants which they have boarded up over the last 5-10 years because prices for both metals declined. To restart the plants there needs to be a viable financial proposal behind them, such as: cheap electricity, access to raw materials and a domestic market where there are buyers of the end product. The US can tick the first and the last boxes: it has a lot of gas and cheap electricity and the economy is expanding, which implies future demand.
But the second box is a problem. The US imports the iron ore needed to produce the steel and the alumina which is the raw material for aluminium. Brazil, likely to be hit by the tariffs, is, along with Australia, the world’s largest supplier of iron ore and a large alumina exporter. The country has already promised it would take retaliatory action but has not yet specified what it would be. If the US ends up having to buy its iron ore and alumina elsewhere and potentially having to pay higher prices this will result in higher production costs and higher end prices for steel and aluminium.
The EU, one of the USA’s largest trade partners, has on the one hand threatened to block some US imports but on the other has tried to negotiate an exemption from the punitive steel tariffs. In response to Europe’s threats, Trump responded with a counter-threat saying the US would impose tariffs on the imports of EU cars.
If this happens, “the metal-intensive automobile industry could face price-induced demand destruction in the US,” according to Michael Haigh, managing director and global head of commodities research at Societe Generale in New York. Car producers are large buyers of aluminium, copper, nickel and zinc, not to mention platinum and palladium, which are used in catalytic converters and are necessary to cut car emissions.
So what does this spectacular mess mean for investors?
Steel is mostly traded in physical markets rather than as futures and doesn’t feature normally in commodity investment baskets.
For aluminium, the immediate price effect would be very localised, says Darius Tabatabai, portfolio manager at Arion Investment Management.
“If the US did introduce aluminium tariffs there would be a micro effect only in one region: it would affect physical premiums in the American Midwest,” Tabatabai said. The premium is the price paid over the aluminium futures price to buy the physical aluminium in a specific region, in this case, the Midwest where US aluminium plants are located.
But Tabatai points out that although the net-net price movement would not be very noticeable in the short term, if the situation results in a tit-for-tat trade the market can expect overall consumption to go down and the overall metals and materials prices to decline.
Over a half of all commodity trading advisors and managed futures managers trade commodities based on technical indicators rather than fundamentals – a legacy of the last decade during which institutional investors lost a lot of money on directional trades. Although that kind of trading intrinsically protects investors, big allocators particularly in Europe are still sceptical about commodities and witnessing the mess created by the US tariff decisions, could end up holding back from commodities.
But this may not be necessary. To start with, not all commodities will be affected the same way.
“Why would you want to pull out of oil because of the tariffs?” asks Carsten Fritsch, analyst at Commerzbank. He doesn’t expect oil futures prices to be significantly affected by what is playing out in the metals markets and says that the forward curve on oil still promises good returns over the next twelve months in the region of more than 6%.
Societe Generale’s Haigh points to soybeans as another commodity that could be affected by a trade war. “Within agriculture, US soybean exports are the most vulnerable,” he said. “China is reflecting on its own set of possible countermeasures, including taking aim at the $10bn soybean US-to-China import market.”
One point is clear: trying to gauge commodity prices for the next year has just become that much harder. On the one hand, if the tariffs result in a trade war it will affect all industries including the tech sector, and it could shake consumer confidence and reduce demand. But higher raw material prices could create localised pockets of higher prices. For investors this means that commodities will need much closer monitoring for sudden price moves creating risk as well as opportunity.