JANUARY/FEBRUARY 2007

2007 Market Forecast—Shifting Gears 

Despite worries about weakness, particularly in the first half of the year,
experts expect 2007 to show modest continued growth. In the context of recent history, the question is whether this economy will stay stronger for longer.

BY ROBERT J. GARINO

Reports of the economy’s demise are greatly exaggerated.”
    Echoing the famous quote by Mark Twain, Brian Wesbury, chief economist of First Trust Advisors LP (Lisle, Ill.), made that assessment in November 2006 of the direction of the U.S. economy.
   Even that weak show of confidence—that the economy’s not dead yet—set Wesbury apart from some other analysts. As the final months of 2006 got underway, most of the familiar domestic macroeconomic indicators were yielding mixed results at best. Consequently, the business community had little overall conviction regarding the direction of the U.S. economy in general—or the recycling industry in particular. To say there was a difference of opinion is a mild understatement. At most, a broad consensus held that the pace of economic growth was easing and inflation was picking up, leaving only one question: Is the United States economy heading for a hard or soft landing?
   All this despite encouraging early fourth-quarter performance on Wall Street, with the Dow Jones industrial average surging ahead to record highs, crude oil prices trending lower, and several base metal prices scoring all-time highs. At the same time, though, housing construction plunged to its lowest level in more than six years, and the closely watched, metals-intensive ISM Index for November contracted for the first time in three-and-a-half years. Many also wondered and worried whether the well-publicized collapse of Amaranth Advisors (Greenwich, Conn.), a
$9 billion commodity hedge fund, was a precursor of bad things to come.
   About the only thing analysts did not consider a significant factor influencing next year’s economy was November’s midterm elections. The sweeping changes voters made in the U.S. Congress are not expected to signal any fundamental change in policy or the marketplace.

Getting 2006 (mostly) correct
Looking at predictions of U.S. economic performance dating back to late 2005, many correctly guessed that the 2006 economy was poised for a strong first half followed by more moderate expansion in the second half. Using the nation’s gross domestic product as a reasonable measure, first half ’06 growth came in at slightly better than a 3.75-percent annual rate. Looking further back to the fourth quarter of 2005, the expectation for the full year ahead was growth ranging between 3.5 percent and 3.9 percent. So did the second half of the year hold up?
   Reports initially put third-quarter GDP at a lackluster 1.6-percent annual growth rate, but those subsequently were revised to a more encouraging 2.2-percent rate. This followed a 2.6-percent increase in the second quarter and the more robust 5.6-percent rate in the first. The third-quarter number will be revised once more before becoming final, but at any rate, economists cited a sharp decline in residential investment, the relatively large trade deficit, and inventory replenishment as factors that might contribute to a weak second half. These, too, have hit close to the mark.
   Inflation indicators proved a bit dodgy to most analysts. The U.S. Consumer Price Index “core” rate (without food and energy) rose to a 10-year high over the summer months, and key commodity prices soared to record highs in May. On the other hand, data released in November revealed that October’s CPI actually declined 0.5 percent, its second consecutive decline of that magnitude.
   Thus, in the eyes of many, after five years of positive growth following a brief downturn in 2001, the pace of growth had decelerated with only modest inflation creep. Annual U.S. growth for 2006 now looks like it will settle in a range of 3.1 percent to 3.2 percent, with inflation (as measured by the CPI) at just under 3 percent. Some analysts are calling this a Goldilocks economy: not too hot, not too cold.
   So how long can the upswing last, and what kind of economy can we expect in 2007?
Holding steady at “just right”?
   There is no ironclad rule dictating how long economic expansions can endure, Lynn Reaser, chief economist of Bank of America (Boston), wrote in November, noting that the last expansion persisted for a full decade. Her view, then, was that—barring a major policy mistake or external shock—the U.S. economy “should continue to grow.” She anticipated real GDP growth of “around 3 percent” in 2007, with weakness most apparent in the first two quarters of the year. Though admittedly growth might not prove “spectacular,” it will be enough to generate moderate gains in jobs and earnings, she contended.
   For inflation, Reaser also saw a more moderating rate in 2007, with stable or lower oil prices removing much of the upward pressure. She expected consumer prices to rise an average of 2 percent in the coming year compared with the 3.3 percent projected for 2006.
   This past August, the Survey of Professional Forecasters, the oldest quarterly survey of macroeconomic forecasts in the United States, projected 2007 growth at 2.8 percent, down from a previous estimate of 3 percent, with inflation (CPI) running at 2.6 percent, up from 2.4 percent previously. The forecast from Wachovia Bank (Charlotte, N.C.) placed domestic growth at 2.5 percent for 2007; the bank had estimated 3.3-percent growth for 2006. Still other reports and indicators confirmed economic uncertainty, hinting at a somewhat negative bias for the industrial sector for the balance of 2006 and into 2007 despite the obvious gains in productivity at virtually all levels.
   The International Monetary Fund (Washington, D.C.) released an economic outlook later in November estimating that the U.S. economy would grow “around 2.5 percent” in 2007, down from its earlier 3.3-percent estimate in part because of a fast-declining housing market. (Housing construction plunged to its lowest level in more than six years in October.) The IMF report noted, though, that decelerating growth in the United States will be offset by “higher growth in the euro area and Japan, and continued high growth in emerging Asia.”
   In that vein, it’s interesting, and perhaps significant, to note that the IMF’s September forecast for global economic growth in 2007 was 4.9 percent, up from its previous projection of 4.7 percent, with 5.1-percent growth expected for 2006. Even with this upward revision for 2007, IMF officials acknowledge that “the balance of risk … is slanted to the downside.” Causes for concern included increased inflationary pressures, higher-than-anticipated energy prices against limited spare capacity, a greater-than-expected slowdown of the U.S. economy triggered by a depressed housing market, commodity price volatility (“particularly sharply lower non-oil commodity prices”), and a lack of progress in liberalizing international trade.
   The Council of Economic Advisers (Washington, D.C.) weighed in with a November forecast of 2.9-percent GDP growth in 2007, with the CPI at 2.6 percent. Treasury Secretary Henry Paulson remarked that “…the U.S. economy is moderating to more sustainable growth levels, firmer labor markets, and steady inflation rates.”
   Will this be another Goldilocks year? Macquarie Bank (London) summed up its thoughts on the U.S. and global economies by stating that any slowdown in 2007 means “a weaker year within that stronger for longer period.”
   China, of course, looms large in any discussion of projected U.S. or global economic growth. It is, after all, the world’s fourth largest economy (following the United States, Japan, and Germany), the world’s largest producer of crude steel and stainless steel, and the largest consumer of both aluminum and copper, to cite just a few examples. For these reasons, many now believe that an anticipated U.S. economic slowdown in the first half of 2007 will have less severe effects globally than it once would have. The Paris-based Organization for Economic Cooperation and Development recently highlighted this concept of “growth rebalancing,” as did the IMF, which sees a shift toward Europe and the emerging market economies of Asia as drivers of global growth. The OECD’s Economic Outlook called for the U.S. economy to grow 2.4 percent in 2007, while also projecting a “soft landing.”
   As for China, the best guess is that China’s economic engine will continue to expand in 2007, but not as rapidly as it has in recent history because of government intervention regarding internal interest rates, currency appreciation, inflation worries, overinvestment and overcapacity, and the overall health of its banking system. Forecasts place China’s 2007 growth below the more than 10-percent rate it experienced in the first half of 2006. Bank of America estimates that China will likely grow at a 9.5-percent rate in 2007, above its targeted growth rate of 8 percent.
   Given this relatively upbeat outlook for the U.S. and global economies for this year, let’s take a look at the key commodities and end-use products that serve as global economic building blocks, critical to the health and prosperity of the domestic and global recycling industries. (Price forecasts reflected the views given in November and December 2006.)

Copper
Many metal analysts believe the red metal is the pacesetter among the nonferrous group: As copper goes, so does the rest of the LME base metal complex.
   As last issue’s “Marketrends” column (November/ December 2006) noted, the 2006 copper market continued to surprise market participants, with a projected supply deficit, technically driven fund buying, and outright speculation supporting cathode and scrap prices. Through the first 11 months of 2006, for example, LME cash copper averaged slightly above $3 a pound, more than 80 percent above its 2005 average of $1.67.
   For 2007, more current data suggested that another supply shortfall is far from assured, but many believe the market might come up short, albeit modestly in comparison to 2006 due to assumed mine production increases and a slower rate of global demand for copper units. Analysts also expect copper demand to post a lower year-on-year increase compared with 2006, in part due to assumed product substitution and economization.
   Ongoing mine and smelter production disruptions and the level of Chinese consumption remain constant concerns in 2007, as do the lingering effects of 2006’s well-publicized production losses of refined copper. Increased product substitution due to the relatively high copper prices and last year’s price volatility also were being factored into the demand equation. As 2006 ended, new mine supply continued to lag copper consumption, though the global copper market posted a production surplus, according to the International Copper Study Group (Lisbon).
   Several investment bankers, primary copper producers, and independent market analysts were projecting 2007 LME cash copper average prices at $3 a pound. Those less convinced included Macquarie Bank, with an LME forecast of $2.60; the Australian Bureau of Agriculture and Resource Economics (Melbourne), whose ’07 average settled at $2.83; and the Société Générale (London) December Commodities Review, which came in at $2.77. On the high side, Barclays Bank (London), in its Nov. 28, 2006, report, offered a $3.43 price as copper’s 2007 average; on the low side is Merrill Lynch & Co. Inc. (New York) at $2.40 a pound.

Aluminum
In contrast to copper and several other LME-traded metals, aluminum was termed an “underperformer” throughout most of 2006. Though the three-month contract traded to an 18-year high of $3,320 in May, prices subsequently eased from that lofty level, averaging around the $1.15-a-pound mark through the first 11 months of 2006, “only” 35 percent above its 2005 annual average.
   Looking at aluminum’s supply/demand balance, most analysts believed that the global picture would come up short in 2006, marking the third consecutive supply deficit. SG forecasted 2006 world consumption at 34 million mt, 6.4 percent greater than 2005. Supporting the ’06 market were above-trend demand, prime aluminum inventories that some termed “relatively tight,” rising production costs for energy, and, to a degree, the herd mentality associated with high prices of other commodities—also known as hedge fund activity.
   Limiting aluminum’s upside in 2007, however, is the belief that a more readily available supply of alumina, aluminum’s assumed inventory position, and a slower rate of global consumption will give the market adequate primary aluminum this year despite another projected deficit. Some analysts consider China a significant concern as a major supplier to the West despite optimistic projections of internal consumption.
   Price projections at the end of 2006 ranged from below $1 a pound (LME cash basis) to a high of $1.24 (Barclays Capital). The world’s number-three aluminum producer, Rusal (Moscow), predicted an average 2007 price of $1.04, whereas analysts at September’s Metal Bulletin Aluminum Conference believed it would average between $1.03 and $1.09. Finally, a mid-December forecast by Davenport & Co. (Richmond,?Va.) placed the LME cash average at $1.22 for 2007.

Iron and Steel
In November, the OECD’s Steel Committee concluded that 2006 will mark steel’s fifth consecutive year of strong global output and demand growth, with estimates of 2006 world crude production at a record 1.22 billion mt, 8 percent more than 2005. Not surprisingly, the committee credited China for setting the pace: Reported production there hit 339 million mt through the first nine months of 2006 en route to an estimated 450 million mt for the year.
   Other regions expected to hit records as well. At the October BIR meeting in Brussels, speakers predicted steel production within the 25 European Union countries to reach 200 million mt in 2006, with scrap consumption of approximately 106 million mt—“a new record,” according to Anton van Genuchten of TSR Recycling GmbH & Co. (Bottrop, Germany).
   For the United States, the International Iron and Steel Institute (Brussels) estimated steel production through October at 83.8 million mt, or 100.6 million mt for the year. Numbers from Goldman Sachs Research (New York) put ’06 production at 101.8 million mt, up 7.4 percent over 2005. A closer look, though, showed a U.S. market in transition in the final months of 2006. New orders had fallen and overall demand “seems to be slipping,” World Steel Dynamics (Englewood Cliffs, N.J.) noted in November.
   Domestic finished steel prices, as measured by hot-rolled coil, exhibited a wide spread among sellers, while mills cut back production at a rate faster than final demand. Ferrous scrap prices (No. 1 HMS composite) also softened as 2006 wound down, averaging just below $200 a gross ton in the fourth quarter compared with $222 over the January-September period. Unless imports increase beyond expectations, analysts believe that newfound producer discipline should lead to declining inventories going into 2007, and prices should respond in kind.
   For 2007, IISI remained generally upbeat but cautioned that world “demand overall is seen slowing.” It singled out North America and China as spots where growth is expected to slow, mainly due to inventory adjustments. Even so, IISI’s October forecasts placed apparent steel use in ’07 at 1.18 billion tons, up 5.2 percent.
   Domestic shipments, meanwhile, should reach 106.1 million net tons, down 3.1 percent compared with 2006, according to Goldman Sachs. It estimated finished steel imports at 26 million net tons and exports at 6 million tons. WSD weighed in with a prediction of 104 million tons shipped in 2007, including 37 million tons of imports and 8 million tons of exports.
   Price forecasts for finished product and ferrous scrap were elusive compared with the nonferrous metals, with few analysts even venturing a guess. WSD admitted, for example, that “any forecast for steel scrap … is prone to substantial error.” The same caveat applies to finished steel. In 2006 the spot Midwest market for HR sheet averaged in the upper $570s a net ton but was clearly trending lower after peaking at $630 in the third quarter. Wachovia Bank
is on record with a forecast of a $450 average price for 2007, while GFMS Metals Consulting (London) forecast a spot Midwest average of $580 with shredded ferrous scrap averaging $243 a gross ton, virtually unchanged from its 2006 estimate.

Nickel and Stainless Steel
Last year reinforced in spectacular fashion the axiom that stainless steel drives the nickel market. Most analysts agree that Asia will remain the growth engine for years to come, with China as the major contributor to supply and demand.
   Currently, market research shows that Asia produces more than 50 percent of the world’s stainless steel, with China’s annual production capacity expected to approach 4 million mt. Michael Wright of ELG Haniel Metals Ltd. (Sheffield, England) estimated that global stainless ingot production would reach 27.1 million mt in 2006. The International Stainless Steel Forum (Brussels) placed the ’06 production figure closer to 27.8 million mt, which would indicate an eye-opening 14.3-percent year-on-year growth.
   ELG also estimated world primary nickel demand at 1.3 million mt, with scrap’s component at 691,000 mt, or 34 percent of the total nickel units required for all uses. Stainless steel applications account for nearly two-thirds of all primary nickel units consumed.
   Other market analysts and researchers see greater opportunities for scrap due to last year’s much, much stronger-than-expected stainless demand and well-documented global
production shortfalls. Nickel supply has not kept pace, thus aboveground inventories have reached record low levels.
   Given the solid fundamental picture of a global nickel market in deficit, the price response also has been unprecedented. At the end of 2005 LME nickel was trading in a range of $12,000 to $13,000 per mt, but by late November 2006, the LME recorded fresh all-time records above the $34,000 level.
   Not everyone agreed that the supply/demand picture led to the LME’s price response, though, instead positing that institutional investment buying and outright market speculation moved prices well beyond nickel’s fundamental picture. These differences of opinion resulted a wide range of price forecasts in the final months of 2006. Barclays Capital and Wachovia Bank anticipated an average 2007 price above $31,000, while Westpac Banking Corp. (Sydney, Australia) pegged 2007 at $14,350 in September. Most forecasts were around $22,000, though, with supporting assumptions about a more balanced supply/demand market, less speculative activity on the LME, and more product substitution away from nickel-intensive grades of stainless.

Zinc and Lead
Among the nonferrous metals traded on the LME, zinc has proved to be 2006’s strongest performer, with cash prices up 137 percent over the January-November period. The market has benefited from ongoing tightness in the global zinc concentrate market, declining inventories of slab zinc, and strong global demand, especially for galvanized steel products.
   The net result is that the global zinc market will end in a deficit position for the third consecutive year, according to Merrill Lynch and other market researchers. Institutional investors and speculators also have been buying, adding fuel to what some would call an overheated market. But the facts supporting zinc are compelling: The supply of refined zinc is indeed tight, and aboveground stocks continue to trend lower. LME inventories, for example, fell 78 percent, to 15-year lows, over the January-November period, with little evidence that the downward trend will be reversed as 2007 gets underway.
   Given this apparent structural supply shortfall, most 2007 forecasts were at either side of $1.45 a pound, very close to cash zinc’s 11-month year-to-date average in 2006. Citigroup Bank (New York) and Macquarie were in the bullish camp, forecasting a cash average per pound of $2 and $1.90, respectively, while SG was a bit more conservative, forecasting a $1.28 average. Though published sources differed on how they believed prices would respond, they were in near-agreement on the ongoing supply tightness—and on the importance of considering the prospect of increased global mine supply. The consensus was that the global zinc market will again post a deficit in 2007, but that it will be trending toward surplus as the year progresses.  The International Lead and Zinc Study Group (Lisbon) predicted the Western World zinc market will record a 2007 deficit of 154,000 mt.
   The lead market, meanwhile, could trace its firming price trend on the LME all the way back to 2004. It peaked at an all-time-record high in February 2006, then it went through a setback and consolidation before again asserting itself in the third quarter. After averaging 44 cents a pound in 2005, lead’s LME cash year-to-date for January-November 2006 averaged just under 60 cents. No weakness was showing in early December, either, with prices trading above 75 cents and setting a fresh all-time record.
   As with zinc, its geological sister, lead’s global fundamentals have provided strong underpinnings for strong transacted prices, with demand paced by the battery industry as supply played catch-up. This was reflected in lead’s global supply/demand picture, which showed a steep deficit in 2004 that was trending toward a more balanced position in 2006. ILZSG anticipates, in fact, that the supply of refined lead in the Western economies will exceed demand “by a small amount in both 2006 and 2007.”
   With that assumption in mind, despite the realization that the market still remained vulnerable to global supply disruptions, price forecasts were growing more conservative. Barclays Capital was on the high side, forecasting a 2007 LME cash average of 72 cents. Macquarie Bank saw lead averaging closer to 61 cents, while SG’s latest came in at 49.9 cents. Reuters’ midyear 2006 survey of commodity analysts came up with a consensus guess of 44 cents.

Pulp, paper, and recovered fiber
U.S. paper and paperboard production—and total apparent consumption—have remained relatively steady at either side of 8 million short tons a month through most of 2006. For the full year, analysts expected total production to reach just under 92 million tons. Paperboard in particular had benefited from increased demand for corrugated boxes. Despite early fourth-quarter box shipments that were described as “weaker than expected,” the board market was expected to finish the year on the plus side. Paper production, however, was basically flat throughout the year.
   Market prices trended higher for the virgin pulp consumed in paper and paperboard production, with list prices moving steadily from $640 a mt at the start of 2006 to December’s $770, the highest price for northern bleached softwood kraft in a decade.
   The supply of recovered paper also was on track to grow in 2006. The year was characterized by a generally flat domestic market and a robust export outlet for scrap paper. According to the American Forest & Paper Association (Washington, D.C.), mill consumption of scrap paper, led by old corrugated containers, was virtually unchanged from the previous year’s cumulative total. AF&PA estimated 2006 domestic scrap paper consumption at 34.2 million tons. Scrap paper exports through October 2006 totaled 14.3 million tons en route to a record 17.2 million tons for the year.
   There is a high correlation between macroeconomic forecasts and paper and paperboard production and consumption, so if 2007 forecasts are close to the mark, next year’s paper figures are likely to remain positive. RISI (Bedford, Mass.) noted that paper faces a “clear downside risk” that prices could fall if growth disappoints. A rapid re-acceleration in global growth, however, would boost paper and paperboard output as well as recovered paper consumption—and NBSK prices would respond in kind.
   RISI’s 2007 forecast for domestic scrap paper has OCC averaging $87 compared with $79 in the fourth quarter of 2006 and $76 for all of 2006. It predicts ONP will average $83 in 2007, up from an estimated $74 in 2006, while mixed paper will average $54 in 2007. The strong export market will continue to set the tone for scrap paper in 2007. Most expect fiber-short Asia to be a major force to contend with in 2007, led by China, which has made what experts are calling a “massive” investment in recovered paper-based capacity.

Robert J. Garino is director of commodities for ISRI.