Summary: In the short term, supported by a strong overseas market and a weakening US dollar, Shanghai zinc is likely to run high. After concentrated peak-season demand is released in mid-to-late September, the main SHFE zinc contract is expected to test 21,500 yuan/mt. Previous long positions may be held.
Trend rating: Zinc: Bullish | Report date: September 2, 2020
1) Survey feedback from enterprises and institutional statistics both show that since July, consumption of zinc alloy and brass has gradually picked up. In addition to seasonal characteristics, export orders for end products are indeed gradually recovering. Among them, the recovery in foreign trade is evident in Europe and Southeast Asia, while US foreign trade has yet to show clear signs of recovery. With continued recovery in external demand and some October orders moved forward to September, a demand peak for zinc alloy is expected in September.
2) The persistently high zinc price will suppress end-user demand for zinc alloy. For downstream processing enterprises, the price elasticity of raw materials is greater than that of finished products. When zinc prices rise rapidly, corporate profit margins are compressed, and willingness to take orders weakens. In addition, during periods of rapid zinc alloy price increases, many producers choose lower-cost aluminum or stainless steel to replace zinc alloy, and this substitution process is usually irreversible.
3) Differences in regional industrial structures and company sizes lead to divergence in corporate capital positions. Downstream enterprises in zinc alloy and brass are small and fragmented. Recently, some downstream enterprises have seen tighter capital positions, which will to some extent curb their enthusiasm for inventory replenishment.
Recently, the core driver of zinc prices has gradually shifted from earlier macro inflation expectations to actual demand recovery. The market's focus is on whether peak-season demand will be released as expected. Among the factors, infrastructure investment continues to support the galvanized sheet sector. Although galvanizing plants in Tianjin's Daqiuzhuang Industrial Park need to undergo rectification for one month due to environmental policies, this is a temporary production suspension caused by policy, not a trend decline in end demand. This event may delay the peak season but will not make it disappear. As external demand recovers, zinc alloy and brass demand will continue to improve month-on-month. In the short term, supported by a strong overseas market and a weakening US dollar, Shanghai zinc will run firm. After the peak-season demand is released in mid-to-late September, the main SHFE zinc contract is expected to test 21,500 yuan/mt, and previous long positions can be held. In terms of arbitrage strategies, investors are advised to pay attention to the long SHFE zinc 2009 / short SHFE zinc 2011 calendar spread.
Risks: Counter-cyclical regulation intensity falling short of expectations; external demand recovery falling short of expectations.
1 Survey target: zinc alloy and brass enterprises in Zhejiang Province
Since April, infrastructure investment has driven galvanizing demand, and social inventories of zinc ingots have continued to decline. It can be said that galvanizing consumption is one of the core factors supporting the recent rise in zinc prices. However, considering that this part of demand expectations may have been fully reflected in prices, we turn attention to two sectors that account for a relatively relatively lower proportion of primary consumption but have larger room for month-on-month improvement: zinc alloy and brass.
Zinc alloy and brass account for about 13% and 11% respectively of China's initial downstream zinc ingot consumption. Their downstream consumption is fairly similar: downstream customers are small and scattered, distributed across hardware and sanitary ware, auto parts, locks, clothing accessories and other fields, with a high proportion of finished products exported. It is precisely because foreign trade orders account for a relatively high proportion that, since the overseas outbreak of the pandemic this year, die-cast zinc alloy and brass have experienced poor demand due to shrinking external demand, becoming the main drag on zinc ingot consumption in the first half of the year. Recently, with the gradual economic recovery of overseas countries, external demand has shown signs of improvement. This time we visited zinc alloy and brass producers in Zhejiang Province to understand the recovery status of this part of demand.
2.1 Zinc alloy orders improve month-on-month, mainly due to recovery of external demand
During the survey, both zinc alloy and brass producers indicated that downstream orders have continued to improve month-on-month since July. Zinc alloy enterprise A said the worst order situation this year was from May to June, when production line workers worked one week and rested the next. Recently, as orders improved, the schedule was adjusted to four days on and three days off. Zinc alloy enterprise B said that due to poor orders, output in March and April fell by 30%-40% from the same period last year, while August output is expected to be flat year-on-year. Brass enterprise C said that although orders have not yet returned to the level of the same period in previous years, they continue to recover on a month-on-month basis.
Institutional statistics also confirm this. Looking at the operating rate of die-cast zinc alloy enterprises, apart from the seasonal factor that saw operating rates fall to about 20% around the Spring Festival, operating rates also hovered at low levels from April to June. In July, the operating rate increased by 6 percentage points month-on-month, and August is expected to record another month-on-month increase. In addition, considering that downstream enterprises in the Guangdong region are mainly die-cast zinc alloy producers, changes in social inventories in that region can, to a certain extent, reflect the consumption of die-cast zinc alloy. The sustained drawdown in social inventories in Guangdong since August also shows that alloy consumption is gradually improving.
There are two main reasons for the recent improvement in zinc alloy and brass downstream consumption. First, traditional seasonal factors. The traditional off-season for the alloy industry is June-August, while the peak season runs from late August to October, mainly because in hot summer weather, die-casting production lines run hotter and workers find it hard to work during the day. Second, downstream orders are indeed gradually recovering. In the first half of the year, exports of end products were hindered by the overseas pandemic. Recently, external demand has begun to gradually pick up. By country, export orders from Europe and Southeast Asia have recovered to some extent, while foreign demand from the United States has not yet improved significantly.
We remain optimistic about subsequent downstream demand. First, due to traditional seasonal factors, demand in September and October is usually strong. Second, the recovery of overseas economies is just beginning, and we expect external demand to improve further in the coming period. In addition, considering the nearly 10-day National Day holiday, some of those orders will be placed in advance in September, meaning September will actually need to produce nearly 40 days' worth of orders. Therefore, we expect alloy demand to peak in September.
2.2 Persistently high zinc prices curb release of zinc alloy end demand
However, it should be noted that as zinc prices have risen to a more than one-year high, the end demand for zinc alloy may be suppressed as a result.
First, for end-processing enterprises, the prices of finished products are relatively rigid, while raw material prices are more elastic. For example, for end lock manufacturers, the price of zinc alloy has risen by nearly 40% from the low in March this year, but the price increase of locks may be less than 20%. Since the price of end products does not rise as much as raw materials, enterprises cannot pass on all increased raw material costs to downstream customers. This means that during the rapid rise in zinc prices, the profit margins of end-production enterprises will be significantly compressed. In order to maintain profitability, on the one hand, end enterprises will stock up more when prices are low and give priority to consuming earlier raw material inventory when prices rise. On the other hand, when raw material prices are too high, the willingness of end enterprises to take orders also drops significantly.
In addition to demand temporarily suppressed by higher prices, some end demand will disappear permanently because of higher prices. In recent years, during each upward cycle of zinc prices, part of the downstream demand for zinc alloy has been replaced by stainless steel and aluminum. Moreover, because zinc alloy prices have long been higher than stainless steel and aluminum prices, this substitution process is often irreversible. For producers of sanitary hardware and locks, some products can also use stainless steel and aluminum as raw materials. And this raw material change only requires changing molds and simply adjusting production lines, so conversion costs are not high. Therefore, when zinc alloy prices are in a rapid upward cycle, many producers will choose to change molds and use aluminum or stainless steel as raw materials to reduce costs, and the loss of such demand is often permanent.
2.3 Corporate capital positions are clearly differentiated; capital for downstream small and medium-sized enterprises remains tight.