Vijay Kumar Gaba

The Nifty Metal Index has gained over 10% in the past one month; outperforming the benchmark Nifty50 (+4.5%) by 2x. Six out of the total fifteen Index components have gained over 10%, with Hindalco (+16%) being the top gainer amongst the metal producers.

In this period, the Bloomberg Commodity Index is down by ~2%; LME aluminum futures are down ~2.5%; LME copper futures are down ~9.5%; Brent Crude prices are down ~11%; NYMEX gold futures are down ~5.5% and China Steel Bar prices are down ~10%.

Also, in the past one month, the benchmark US 10yr Treasury Bond yields are down 9% from 3.13% to 2.78%; and the US Dollar Index (DXY) is up by 1.9%.

I find the divergence between performance of metal stocks and global trends a little intriguing. The global commodity prices, bond yields and US Dollar movement etc. are all pointing to a significant slowdown (if not recession) in demand. The outlook for the domestic demand in India is also not enthusiastic in the near term. The 1QFY23 results have indicated pressure on margins; attracting earnings downgrades.

In my view, the investors holding metal stocks in their portfolios need to analyze the following three scenarios:

1.    The ~33% correction in Nifty Metal Index during April – June 2022 quarter is an overreaction to the slowdown concerns and imposition of export duty on some steel products. The market is now rationalizing the excessive correction.

2.    The slowdown/recession concerns may be overblown, especially in the context of Indian producers of industrial and base metals. The demand for metals will remain strong in India, even if global slowdown extends to 2023 due to monetary tightening and war. The government may withdraw the export duty and even provide additional protection from cheap imports to help the domestic producers. The producers with significant global operations like Tata Steel and Hindalco will manage to recover their volumes and margins in a couple of quarters if the economic slowdown is managed well.

3.    The global commodities, especially the base and industrial metals, have not seen any significant capacity addition since the global financial crisis. During the lockdown in the wake of Covid pandemic, the inventories have been utilized. For most metals, the inventories are at historic low levels. The monetary tightening by the global central bankers is making inventory carrying cost expensive and hence discouraging inventory restocking. The global bond markets and inflation forecasts are indicating that the monetary tightening cycle may end sooner than later; and the central bankers like the US Federal Reserve may actually embark on a path of monetary easing as early as 1Q2023. In that case, we may see a sharp surge in commodity prices in 2023-2024 as the demand-supply gap tightens further.

As a strategy, I usually avoid commodity stocks in my portfolio due their cyclicality, volatility and unpredictability of their earnings and consistent need for capacity building. However, I am inclined to believe more in the third scenario playing out over the next 3-5yrs. I would therefore be on the lookout for some metal producers that have decent operating leverage (unutilized capacity); unlevered balance sheet; offering decent valuations. As of this morning, I found nothing that fits my criteria.