CHINA & THE COMMODITY COMPLEX

Transcription

1 CHINA & THE COMMODITY COMPLEX EXPECT FURTHER STIMULUS & POLICY EASING AS THE PREMIER FACES A WEAKENING ECONOMY October 1, 214 Northern Trust Asset Management South La Salle Street Chicago, Illinois 663 northerntrust.com Edward Trafford Basic Materials and Industrials Analyst et44@ntrs.com CONCLUSION As the impact from China s initial mini-stimulus wears off, the government needs to decide whether to double-down with more stimulus and policy easing or stay the course and attempt to move the economy toward a market-based model. A clean China with less corruption, pollution and government involvement is less of a win should it result in social unrest and a sharp economic slowdown. As such, we remain of the mindset that the government will need to once again tap the accelerator. This aligns with recent press reports that People s Bank of China (PBoC) Governor, Zhou Xiaochuan, is possibly on the way out, given his somewhat aggressive stance on reform that has contributed to stunted economic growth. While the most likely replacement, Guo Shuqing, has a reputation as being more pro-reform than Xiaochuan, we believe the Premier will be able to direct Shuqing toward policies that are more aligned with stabilizing the economy. We reiterate our concern over the long-term viability of China s economy and see political and social unrest as increasingly likely. Shifting from an investment-driven economy toward a consumer-driven model while facing a weakening employment picture, a decline in consumer sentiment and slowing growth in retail sales, may prove quite challenging. In that vein, China s September Services PMI hit an 8 month low dragged down by weakness in the property market. Regarding state-owned enterprises (SOEs), we believe that reforming the SOEs is required for China s economy to move toward a capitalistbased model where resources are efficiently allocated. However, we fear that a softer touch may be needed, as some of the more recent actions, including cutting salaries by % to 7% for executives at certain SOEs, could backfire through either political or market instability. CHINA EQUITY MARKET PERFORMANCE Many were taken off-guard by the strong performance of the Chinese markets in the third quarter given the slew of weak economic data from the region. For perspective the Shanghai Composite generated a total return of 17.6% in the third quarter versus the S&P s anemic 44 basis points (bps). We stand by our so bad it is good thesis, whereby the weak underlying macroeconomic data increases the likelihood that the government will stimulate the economy and deemphasize polices which could stunt growth. We would note that markets typically move based on data points relative to expectations rather than the absolute data. In this vein, we have found efficacy in using the Citigroup China Economic Surprise Index as a guide/indicator for adding or trimming exposure. The index measures data surprises relative to market expectations. As Exhibit 1 highlights, adding exposure near the troughs in the Citigroup China Economic Surprise Index, when economic estimates are meaningfully missing consensus, and selling opportunistically when the index pushes into positive territory would likely have proven efficacious. We have found that meaningful moves in valuation multiples, rather than an absolute level, also has efficacy in determining when to add or reduce exposure. Exhibit 2 suggests that stepping in when there is a 1.+ standard deviation correction in the forward price/earnings multiple and selling into the rally would also have added value.

2 EXHIBIT 1 EXHIBIT 2 INVEST NEAR TROUGH IN SURPRISE INDEX INVEST AFTER 1.+ SD CORRECTION IN P/E 2, 14. Shanghai Composite 13. 2,3 P/E of Shanghai Composite 13. 2, , () 1. Citi China Surprise Index (1) 9. (1) 9. 9/3/212 9/3/213 9/3/214 1/2/212 1/2/213 1/2/214 Source: Bloomberg, Citigroup Global Markets Source: Bloomberg Index Value Index Value WHAT CAN CHINA S GOVERNMENT DO TO SPUR ECONOMIC GROWTH MONETARY POLICY China s government has already done much in the way of encouraging growth through infrastructure projects (fiscal stimulus). While more is likely coming, we expect increasingly accommodative monetary policy including cuts to both lending rates and bank reserve requirement ratios (RRRs). As noted below, the government has reduced restrictions on real estate transactions and lowered mortgage rates, but we expect further action. We would flag the slowdown in loan growth as a key issue that the government must address to ensure that the 7.% gross domestic product (GDP) target is met. However, we would not place too much scrutiny on the GDP print given that the government has been known to massage the data. In that vein, we would view a weak print (sub 7.2%) as a good thing as it provides the government the leeway to enact further stimulus. There is little doubt that the trend of slowing economic growth will continue, and we therefore expect the government will target approximately 7.% GDP growth for 21. As Exhibit 3 shows, August s total social financing (TSF) fell 39.6% year-over-year (yoy). While less bad than July s 66.6% decline, we see this as reflecting the crackdown on non-standard, or shadow banking practices. To compensate for the weak TSF data, with the goal of spurring loan growth, the PBoC announced on August 27 it would increase its re-lending quota to the agricultural sector by RMB2 billion (approximately US$3.3 billion) in addition to reducing interest rates to the sector by 1bps. In mid-september, the PBoC provided $81 billion worth of low-rate loans to five banks under the auspices of seasonality and a potential liquidity crunch given initial public offerings. For perspective, the impact from the loans is estimated to equate to a bps cut to the RRR. We think the liquidity injection should be viewed more within the context of an easing measure, in light of weak economic growth. Of note, low inflation (Exhibit 4) and spare capacity within the economy provide the government with the requisite latitude to enact further accommodative policies. At the September 21 G2 meeting in Australia, China s Finance Minister, Lou Jiwei, noted that China will not dramatically alter its economic policy because of a single economic datapoint. The market seemed to interpret this to mean that monetary easing would be unlikely. Our take differs, as we anticipate several metrics including retail, housing and employment to weaken further and thereby expect the PBoC to undertake an increasingly accommodative stance. PE of Shanghai Composite 2

3 EXHIBIT 3 EXHIBIT 4 TSF DECLINED SHARPLY IN JULY & AUGUST LOW INFLATION ALLOWS FOR EASING 3, China Total Social Financing 7% 2, 6% China Inflation CNY (Billions) % Change in TSF 1, 4% 3% 2% 1% % -1% 9/1/29 2/1/21 7/1/21 TSF % Change 12/1/21 /1/211 1/1/211 3/1/212 8/1/212 1/1/213 6/1/213 11/1/213 Source: National Bureau of Statistics of China (China NBS) 4/1/214 MORE FISCAL STIMULUS ANNOUNCED On August 27, the government announced another round of stimulus given the weakening economic backdrop. The marked slowdown in foreign direct investment (Exhibit ), the magnitude of which was last seen in 29, is acting as a further impediment to the broader economy. We believe the government will focus on programs that will appease the populous and mitigate the risk of social unrest by investing in hospitals, gyms, nursing homes, pollution control, water safety and clean-energy. However, Exhibit 6 shows government spending already makes up roughly half (47.9%) of China s economy, a level that we do not view as sustainable. For perspective, this number is more than 1 points greater than the next economy (India at 3.%) and a far jump from other emerging markets, with Brazil at 19.7% and well above that seen in the developed world with the United States and the U.K., both below 1%. In regards to the level of construction-related spend already undertaken, between 211 and 212, following the prior recession, China consumed more cement than the United States did during the entire 2th century. Following this pull-forward of activity, we do not believe the government has a lot of runway left for further value-add infrastructure projects. While it may be fair to describe the government s actions within the context of pushing on a string, we think this is more of a rope and that China s leaders must be careful not to choke the nation s long-term prospects while pursuing shorter-term growth targets. EXHIBIT EXHIBIT 6 FDI DECLINED SHARPLY IN JULY & AUGUST GOVERNMENT SPEND MAKES UP ~1/2 OF GDP 6 19 China Foreign Direct Investment 48 Investment / GDP (LHS) Total Employed People (RHS) (2) (4) 34 1 YoY % Change 1/1/21 6/1/21 11/1/21 4/1/211 9/1/211 2/1/212 7/1/212 12/1/212 /1/213 1/1/213 3/1/214 8/1/214 % of GDP Inflation Rate 12/1/199 % 4% 3% 2% 1% 1/1/1992 6/1/211 8/1/1994 9/1/211 6/1/ /1/211 4/1/1998 3/1/212 2/1/2 6/1/212 12/1/21, IMF 9/1/212 1/1/23 12/1/212 8/1/2 3/1/213 6/1/27 6/1/213 4/1/29 9/1/213 2/1/211 12/1/213 12/1/212 3/1/214 6/1/214 Millions 3

4 REAL ESTATE: REVERSAL IN POLICY Indicative of the government refocusing on economic growth and stability, we have seen a sharp reversal in policy. Recall that prior measures were put in place to hinder speculative activity in the real estate markets. We view the new measures as helping to temporarily prop-up the economy while increasing the longer-term risk profile. China has removed home purchase restrictions in 41 of the 47 cities that had implemented such policies. On September 3, the PBoC formally announced the rumored changes to the mortgage and banking markets. To stimulate first time home purchases, mortgage rates will be offered at a 3% discount to the benchmark rate versus the prior -1% discount. In regards to 2 nd homes, and where the buyer owns the other property outright, the shift is dramatic with the PBoC now offering the 3% discount to the benchmark rate (versus the prior 1% premium) and a down payment minimum of 3% (versus the prior 6%). In addition, banks are no longer prevented from offering mortgages to those who already have 2+ residences. The property sector will likely benefit as commercial banks are now being encouraged to issue mortgage-backed securities. In regards to social housing, banks are being encouraged to extend the duration of loans from the current ten years toward a maximum of twenty-five years. In order to aid credit availability for developers, the government will allow for the issuance of corporate bonds and shorter-term debt instruments and will be rolling out REITs. We do not find this shift in policy terribly surprising, given that housing inventory (months of supply) for August rose 38% yoy, albeit showing some improvement from July s 4% increase. Despite these government actions, we have yet to see home prices stabilize. 64 of 7 cities that we track saw monthover-month (June/July) price declines accelerating from the seen in the prior period. Exhibit 7 highlights this trend, where we show the month-over-month declines in Shanghai, Beijing and Guangzhou. We link the well-reported housing collapse in Handan to the weakening demand for steel within China, noting that Handan is located in Hebei province, China s primary steel-making region. Given that real-estate has been an investment vehicle for the affluent, we once again flag the risk of contagion to consumer spending. It is estimated that real estate may account for more than one-third of household net worth not an inconsequential value. As Exhibit 8 shows, the trend in consumer sentiment, not surprisingly, follows a trend similar to that of real estate values which we attribute in part to the negative wealth effect. EXHIBIT 7 EXHIBIT 8 HOUSE PRICES ROLLING OVER NEGATIVE WEALTH EFFECT EVIDENT China Residential Real Estate Existing House Prices Beijing Shanghai 12 1 Guangzhou China Consumer Sentiment () 112 YoY % Change 3/1/29 8/1/29 1/1/21 6/1/21 11/1/21 4/1/211 9/1/211 2/1/212 7/1/212 12/1/212 /1/213 1/1/213 3/1/214 8/1/214 WHAT IS DRIVING THE SLOWDOWN IN CHINA 9/1/213 1/1/213 11/1/213 12/1/213 1/1/214 2/1/214 3/1/214 4/1/214 /1/214 6/1/214 7/1/214 8/1/214 9/1/214 Source: Deutsche Boerse AG THE CONSUMER Exhibit 9, the employment sub-index within the Purchasing Managers Index (PMI), reflects how China s labor backdrop is deteriorating. Of note, the HSBC PMI employment sub-index reached a five-year low as of August. Weaker employment results in a negative feedback loop to both Index Value 4

5 housing and retail. Exhibit 1 highlights the slowdown in consumer spending and why we see the government s 214 retail sales growth target of 14.% at risk. We would note that August auto sales were up a rather anemic 4% yoy, a marked slowdown from the 8% clip seen in the first half of the year. Food & Beverage was the other key category that missed expectations which we attribute in large part to the government s anti-corruption and austerity campaigns. EXHIBIT 9 EXHIBIT 1 CHINA EMPLOYMENT PMI IN DECLINE RETAIL SALES GROWTH SLOWING China GDP (LHS) 24 2 China Retail Sales Growth Employment 16 6 PMI (RHS) China Unemployment YoY % Change % Unemployment 1/1/1999 4/1/2 7/1/21 1/1/22 1/1/24 4/1/2 7/1/26 1/1/27 1/1/29 4/1/21 7/1/211 1/1/212 1/1/214 Employment PMI YoY % Change Source: China Federation of Logistics & Purchasing, China NBS 1/1/2 1/1/21 1/1/22 1/1/23 1/1/24 1/1/2 1/1/26 1/1/27 1/1/28 1/1/29 1/1/21 1/1/211 1/1/212 1/1/213 1/1/214 MANUFACTURING AND INDUSTRIAL TRENDS Given the weak data, we are not surprised by the government s increasingly growth-focused policies. While some may note a disconnect between the improvement in September s manufacturing data (PMI as the proxy) and the weak Industrial Production readings, we would note that exports, a component of the PMI, was the key factor driving the better than anticipated print. PMI While August s HSBC PMI (.2) missed expectations by a wide margin (1. estimated) and has fallen back to levels last seen in March, September s Flash (subject to revision) print was more reassuring (. versus. estimated) at least on the surface. The market viewed the August data as particularly jarring, given the sharp slowdown from the July s reading of 1.7, which represented an 18- month high. We believe manufacturers were destocking both inputs and finished products, in light of weak end market demand coupled with the declining Producer Price Index (PPI). We view the data as indicative of a slowing manufacturing economy, which is in sharp contrast to that seen in the United States (Exhibit 11). China s July new orders took a two-point hit month-over-month, driven in large part by weaker European export demand. Of real concern, the employment PMI sub-index is falling further into negative territory, with August down 1.2 points from July s 49.4 figure. September s PMI reading was bolstered by new export orders, hitting a 4-1/2-year high. While, the new orders sub-index moved back above, we view the better than anticipated PMI print as a reflection of strength in the United States, where demand is picking up and would be careful to not presume this is indicative of strength in the local Chinese economy. As the outlook for Europe weakens, we have some concern as to whether China exports will hold-up.

6 EXHIBIT 11 EXHIBIT 12 STRENGTH IN U.S. PMI VERSUS CHINA PMI CHINA PMI PROPPED-UP BY STRONG EXPORTS PMI Value China Germany Japan Europe U.S. PMI 1/1/21 /1/21 9/1/21 1/1/211 /1/211 9/1/211 1/1/212 /1/212 9/1/212 1/1/213 /1/213 9/1/213 1/1/214 /1/214 9/1/214 Source: ISM, Markit, China Federation of Logistics & Purchasing YoY % Change - Exports (1) (2) 9/1/212 11/1/212 1/1/213 3/1/213 /1/213 7/1/213 9/1/213 11/1/213 1/1/214 3/1/214 /1/214 7/1/214 Industrial Production (RHS) China Exports (LHS) YoY % Change - IP INDUSTRIAL ECONOMY Exhibit 13 shows August s power consumption growth was notably weak, declining 2.2% yoy and marking the fourth sequential decline. We would note that power generation is a good indicator of the broader industrial economy and less subject to government manipulation. Excavator sales, another government-immune statistic we track, remain in negative territory for the sixth consecutive month, with July and August down 31% yoy and 3% yoy, respectively. We see this as indicative of the health, or lack thereof, of the real estate and broader construction markets. Heavy-duty truck sales look to be holding up, exhibiting growth still lower than GDP but remaining in positive territory, as the government enforces its stricter NS4 emissions regulations. We anticipate this 3.% yoy growth rate seen in July will turn negative as we move toward the end of the year and the pre-buy has run its course. Exhibit 14 shows the continued slowdown in industrial company profit growth with July up only 13.% versus June s 17.9% growth rate. The precipitous decline in August is notable with the growth rate falling by over 14 percentage points month-over-month and representing the first negative print since August 212. Of concern, inventory is trending upward, with July up 14.6% yoy versus June s 12.7%. We believe the deceleration in industrial profit growth, coupled with the increase in inventories, was one key factor driving the government to engage in its second mini-stimulus. As we noted, China s IP has been on a downward trajectory since July 213, with the August print reaching levels last seen in 29. We believe the apparent disconnect between the PMI and IP data relates to exports, which have been trending upward since late in the first quarter. It is hard to paint an overly upbeat picture of the strength in exports, given that it is essentially a reflection of economic strength outside of China. 6

7 EXHIBIT 13 EXHIBIT 14 ELECTRICITY DEMAND TURNS NEGATIVE AS DO PROFITS WITHIN THE INDUSTRIAL SECTOR China Electricity Generation 2 China Industrial Profits () () YoY % Change 7/1/29 12/1/29 /1/21 1/1/21 3/1/211 8/1/211 1/1/212 6/1/212 11/1/212 4/1/213 9/1/213 2/1/214 7/1/214 YoY % Change COMMODITIES BULLISH OUTLOOK ON DOWNSTREAM/PROCESSED COMMODITIES; NOTING A POSITIVE BIAS TOWARD ALUMINUM AND U.S. STEEL OVERVIEW While we are calling for further stimulus to support China s economy, we do not view this as the key driver to the direction of commodity prices. Given the decline in upstream commodity prices, the downstream/refining companies are able to capitalize on lower input prices. Our approach to the complex remains unchanged as we recommend exposure to those commodities that benefit from curtailed supply, escalating demand, pricing power and where management teams are acutely focused on return on invested capital (ROIC). While our approach to the commodities complex remains intact, the underlying fundamentals for the individual commodities are in flux and are hardly homogenous for example the drivers for corn and aluminum prices are distinct. The United States remains the sole geography where we are broadly positive and have concern over those commodities leveraged to Europe, South America and China. As such, we retain a positive outlook on aluminum and U.S. steel, have a negative outlook on seed pricing and think iron ore and copper are beginning to look interesting as the commodities find cost-curve support. We attribute the weakness in the commodity complex within the third quarter (S&P GSCI Index down 12.68%) a reversal from what we saw in the first half of the year to a more-muted impact from China s government stimulus and a strong, albeit lagged, supply response from upstream producers across a spectrum of commodities ranging from agriculture, energy, bulk commodities (iron ore) and the base metals (copper). We thereby recommend a neutral weighting within the overall commodity complex with a meaningful tilt toward downstream value-add, refined commodities. Being cognizant that the U.S. dollar could push higher, we are currently not advocating an increased weight to the complex with Exhibit 1 reflective of the inverse relationship. We would be looking to increase weighting to the complex should the trend in the U.S. dollar reverse, we see increasing supply discipline/cuts by upstream producers, and an improving outlook for demand from Europe and the emerging economies. Regarding the emerging markets, we are increasingly focused on India as this appears to be one of the few countries where the economy is inflecting upward. Exhibit 16 shows that the nation s GDP and OECD Leading Economic Indicators look to have bottomed and are trending upward. 7

8 EXHIBIT 1 EXHIBIT 16 APPRECIATION OF U.S.$ ACTING AS HEADWIND INDIA S ECONOMY INFLECTING UPWARD Copper Price ($/ton) 12, 1, 8, 6, 4, 2, US $ (RHS) Copper (LHS) 1/3/199 1/3/1997 1/3/1999 1/3/21 1/3/23 1/3/2 1/3/27 1/3/29 1/3/211 1/3/213 Source: Bloomberg, London Metal Exchange (LME) US Dollar Index YoY % Change - Indicator India GDP (RHS) OECD Leading Indicator (LHS) 9/1/29 2/1/21 7/1/21 12/1/21 /1/211 1/1/211 3/1/212 8/1/212 1/1/213 6/1/213 11/1/213 4/1/ Source: India Central Statistical Organization, OECD YoY % Change - GDP STEEL BULLISH U.S. OUTLOOK We remain bullish on the U.S. steel markets, given industry consolidation both domestically and globally; rational behavior by major players; trade cases increasingly being ruled in favor of domestic producers; and non-residential activity inflecting higher as evidenced by the Architectural Billing Index (Exhibit 17) climbing to.8 in July from 48.8 in March. We also cite solid demand from the auto and oil and gas sectors, as well as attractive industry fundamentals, as evidenced by inventory, pricing and shipments. We see greater upside in non-integrated mills that will directly benefit from the collapse in iron ore. U.S. PRICING REMAINS STRONG Typically, we see steel companies achieving pricing power at operating rates exceeding 7%. Given that the United States steel capacity utilization (Exhibit 18) is running at 8.3% provides us with greater confidence in the outlook for pricing. Steel Dynamics raised rebar prices by $2/st on August 1, with Nucor following with a $1/st lift. Nucor also announced a $3/st price increase on carbon and alloy plate and a $4/st increase on heat-treated plate. Given the sharp drop in iron ore, we would not be surprised to see some pressure on steel prices but would focus on the spread to scrap and iron ore rather than the absolute steel price in isolation. FUNDAMENTALS ARE SOLID Shipment volumes increased 6.9% yoy in July, accelerating from the.2% year-to-date pace. While inventory months of supply (MOS) increased to 2.4 from June s 2.3, inventory levels still remain below the long-term average. We see the increase in inventories as reflective of service centers looking to accumulate product in light of a positive outlook for demand and concern over further price hikes. We would turn more cautious on the complex should shipments and/or prices soften while MOS trend upward. 8

9 EXHIBIT 17 EXHIBIT 18 ABI TRENDING UPWARD CAPACITY UTILIZATION YIELDS PRICING POWER Architectural Billings Index (ABI) 9 Inquiries Index Value /1/199 4/1/1997 9/1/1998 2/1/2 7/1/21 12/1/22 /1/24 1/1/2 3/1/27 8/1/28 1/1/21 6/1/211 11/1/212 4/1/214 Utilization Rate (%) U.S. Steel Capacity Utilization Source: American Institute of Architects, U.S. Census Bureau Source: American Iron & Steel Institute IRON ORE PRICING Exhibit 19 shows that iron ore is now sitting at a five-year low. Given that the major producers, including BHP, are focused on maximizing production rather than an oligopolic approach focused on industry returns, it is logical that price would fall toward cost-curve support. Prices are currently sitting near $79/mt, hovering just above cost curve support which we estimate to be in the $7 range. One of the major global producers noted that the recent decline in ore prices reflects the underlying supply and demand for the commodity, with the inventory levels, Exhibit 2, highlighting this negative dynamic. We believe recent downward pressure on price stemmed from news reports on Rizhao, the second largest Chinese iron ore port, where investigations are currently underway regarding the fraudulent use of iron ore in financial transactions. The ore, used as collateral, will likely find its way to market thereby pressuring price. THE OUTLOOK The risk-reward is clearly improving, as the commodity is nearing cost-curve support which we estimate to be approximately $7. Note this is not a static number, with the curve shifting lower as producers, such as BHP, reduce lifting costs. Sentiment within the complex is horrendous, given that pricing cleanly broke through the 212 low and Chinese steel demand recently turned negative year-over-year. For us to actively recommend the iron ore equities, we would need to turn bullish on the global steel demand (Europe, China and India being the key geographies we are monitoring) in addition to seeing mines shuttered and/or production cut. 9

10 EXHIBIT 19 EXHIBIT 2 IRON ORE PRICES AT YEAR LOW IRON ORE INVENTORIES AT RECORD LEVELS 2 12, US $ / Dry Metric Ton , Tons 11, 1, 9, 8, 7, Iron Ore (62% Fe) Price 6, China Iron Ore Port Inventories Source: The Steel Index Source: Shanghai Steelhome Information COPPER DEMAND WEAK The physical premium of copper, the price above spot to secure the metal, has fallen by.3% from its peak in August 213 through the end of September 214 (Exhibit 21). We think this reflects weaker real demand coupled with lower demand for copper used in financing transactions. Cancelled warrants reflect inventory that is slated for delivery and is thereby indicative of demand for the commodity. Exhibit 22 highlights that cancelled warrants have been trending down since July 213, with September s print rather jarring, down 91.2%yoy. We expect prices to remain below $3.1/lb as incremental mine supply, coupled with weaker fundamental demand, prevent much price appreciation. With China being key to the demand equation and the power grid one of the larger end-markets, we would note that investment in the grid has meaningfully missed expectations; up only 6 bps yoy (yearto-date through July) versus the government s full year target of 13%. We attribute much of this to weak power demand growth coupled with the ongoing corruption investigations slowing the infrastructure build out. QINGDAO We expect copper investors to remain on edge, given the September 2 disclosure of $1 billion in fraudulent trading in Qingdao, a figure that is meaningfully larger than the market initially anticipated. Recall that the copper was used as collateral to support what are now known to be fraudulent and speculative loans. Estimates range between -7 metric tonnes of copper that the banks will need to liquidate. The obvious issue is that bringing this amount of copper to the market would further pressure the price. 1

11 EXHIBIT 21 EXHIBIT 22 COPPER PREMIUM IN DECLINE CANCELLED WARRANTS COLLAPSE 22 4, Copper Physical Premium 2 3, (Shanghai) 17 3, 2, 1 2, 12 1, 1 1, 7, US $ / Metric Ton # of Warrants Copper Cancelled Warrants Source: Metal Bulletin Source: London Metal Exchange ALUMINUM DEMAND STRONG Demand for aluminum remains very strong and would note that it was the best performing metal in the third quarter (up 3.6%). The multi-year upward trend in cancelled warrants (Exhibit 23) remains intact with September tonnage up 2.7%yoy. In addition, the price of aluminum relative to copper (see Exhibit 24) has been declining for over 1 years. This trend has spurred substitution toward aluminum from other metals where feasible. Spot prices for alumina, the feedstock for bauxite and aluminum, have trended upward since July as Indonesia's export ban reduced global supply thereby adding further support to the aluminum price. The stigma associated with aluminum use in autos is abating as consumers become increasingly comfortable with its use in cars and trucks. The metal is moving its way down the chain from high-end (Audi, Range Rover) to mid-range (Ford F-1) vehicles and we look for further penetration and adoption as the government s fuel economy standards (CAFE Corporate Average Fuel Economy) are implemented thereby necessitating the light-weighting of vehicles. There are reports that the Toyota Camry, the bestselling car in the United States, will start using aluminum for its hood and lift-gate starting in 218. The key risk to aluminum (and the related equities) is the eventual unwinding of the carry trade, which will drive inventories into the market and pressure the price. EXHIBIT 23 EXHIBIT 24 WARRANTS INDICATE STRONG DEMAND ALUMINUM INCREASINGLY COMPELLING 3,,. Aluminum Cancelled Warrants 3,, 4. 2,, Copper / Aluminum Price 2,, 3. 1,, 2. 1,,, 1.. # of Warrants Source: London Metal Exchange Ratio of Copper / Aluminum 1/3/199 1/3/1997 1/3/1999 1/3/21 1/3/23 1/3/2 Source: London Metal Exchange 1/3/27 1/3/29 1/3/211 1/3/213 11

12 FUNDAMENTALS INTACT As Exhibit 2 shows, the aluminum market has entered a deficit, a condition last seen in 26. Key to our thesis on aluminum was a reduction in supply, as the major producers focused on profitability over volume. In addition, we had confidence that production would be cut in China as the government shuttered energy-intensive, low value-add, highly polluting and toxic industries. The demand outlook for aluminum within China is improving as the government is promoting the use of aluminum cable for power grid applications. While approximately 4% of overhead cables in the western world use aluminum, China s adoption rate has been closer to 1%. Despite the weaker outlook for power grid construction, we view this as an incremental positive for the commodity. Exhibit 26 highlights the scarcity of aluminum with buyers willing to pay increasing premiums simply to secure the commodity. EXHIBIT 2 EXHIBIT 26 ALUMINUM MARKET SHIFTS INTO DEFECIT INCREASING PREMIA REFLECTS SCARCITY 3,, 2 Aluminum 2,, Aluminum Premia at Record High Supply/Demand 2,, 2 Balance 1,, 1 1,,, Surplus 1 (,) Deficit (1,,) Metric Tonnes US$ / Metric Ton Source: World Bureau of Metal Statistics Source: Bloomberg Intelligence AGRICULTURE YIELDS RETURN TO TREND As seen in Exhibit 27, corn yield per acre estimates increased by approximately 37% from October 212 to August 214, as multi-standard deviation weather patterns abated. In light of recent meetings held with farmers, we believe pricing power is waning within the agricultural space and believe genetically modified seed pricing is most at risk. Reflective of the elasticity of demand, the incentive for the farmer to trade-up to next generation seeds is diminishing as his income takes a precipitous fall following the decline in soft commodity prices. Exhibit 28 highlights the roughly 49% drop in corn pricing from September 212. Given that corn is now trading near its marginal cost of production, leaving some farmers challenged to cover their land rent costs, we do not see meaningful downside to prices to the soft commodities but do anticipate a reduction in spend on the related inputs. 12

13 EXHIBIT 27 EXHIBIT 28 CORN YIELDS RETURN TO TREND DRIVING AGRICULTURE PRICES LOWER 18 1,9 17 1,7 16 US Corn Yield 1, 1 1,3 14 Soybeans (LHS) 1, Corn (RHS) 1 3 Bushels Per Acre 1/1/199 6/1/ /1/1997 4/1/1999 9/1/2 2/1/22 7/1/23 12/1/24 /1/26 1/1/27 3/1/29 8/1/21 1/1/212 6/1/213 Source: U.S. Department of Agriculture US $ / Bushel 1/3/199 1/3/1997 1/3/1999 1/3/21 1/3/23 1/3/2 1/3/27 1/3/29 1/3/211 1/3/213 Source: Chicago Board of Trade US $ / Bushel FOR MORE INFORMATION To learn more, please visit northerntrust.com or contact your Northern Trust relationship manager. IRS CIRCULAR 23 NOTICE: To the extent that this message or any attachment concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law. For more information about this notice, see IMPORTANT INFORMATION: This material is for information purposes only. The views expressed are those of the author(s) as of the date noted and not necessarily of the Corporation and are subject to change based on market or other conditions without notice. The information should not be construed as investment advice or a recommendation to buy or sell any security or investment product. It does not take into account an investor s particular objectives, risk tolerance, tax status, investment horizon, or other potential limitations. All material has been obtained from sources believed to be reliable, but the accuracy cannot be guaranteed. PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS. Periods greater than one year are annualized except where indicated. Returns of the indices also do not typically reflect the deduction of investment management fees, trading costs or other expenses. It is not possible to invest directly in an index. Indices are the property of their respective owners, all rights reserved. No bank guarantee May lose value NOT FDIC INSURED Northern Trust