Macquarie Research notes “after last year’s LME week, the consensus was that we were in for a major prolonged slowdown in the wake of the global financial crisis. There were also fears at the time (fulfilled for a while) that China would also be part of a synchronised slowdown. As it turned out, China turned its economic policies on their head from a tightening bias at mid-2008 to a loosening bias by year’s end, stimulating one of the strongest demand recoveries ever witnessed in that country, and that is saying something!

“So far the Chinese recovery has not stimulated any significant inflationary pressures, implying that it can be sustained for a while yet. Of course, we expect the sustainability of the Chinese boom will be a major talking point during the week. Some will be asking when the Chinese will be back in the market in force again as underlying consumption is continuing to improve. Others will fear that future Chinese government measures to slow growth are a sell signal and will be quizzing Chinese market players about when this will happen.

“In addition to stimulating real consumption growth, ‘the Chinese’ also did two really clever things. Firstly, they (almost) instantly shut their high-cost marginal supply and replaced it with cheaper imports (aluminium, zinc and nickel stand out in this regard). This gave lie to the myth that except for a handful of state-owned enterprise (which are in the minority of production these days), the Chinese government does not let capacity shut for social and employment reasons.

“Secondly, they decided to take advantage of the fact that for a while they were the only buyers and decided to build inventories of base metals for future use at what turned out to be bargain prices. This was both government-sponsored buying and also private speculative buyers (often by cash buyers rather than that using cheap and readily available bank credit). In addition, a good part of the extra buying was normal consumer restocking in an economic recovery.

“The subsequent recovery in base metal prices has been spectacular, with most prices doubling since the early part of 2009. As prices recovered, the bargain hunting has mostly stopped and some of the high-cost production has reopened (in zinc, aluminium and nickel), sharply reducing the imports.

“What everyone will want to know now is what Chinese buyers plan to do with their accumulated stocks – particularly large in nickel (100,000 t plus, equal to a quarter of a year’s use) and modestly higher in copper, zinc and aluminium (equal to a few weeks of Chinese demand). So far there are no signs of these stocks being sold (in fact, we suspect the holders are looking for higher prices, are willing to wait a long while for that to happen and may well buy more into any price weakness).

“Faced with slowing Chinese import demand (but not consumption) and rising Chinese and rest-of-world production (certainly in aluminium, zinc and nickel, but not so certainly in lead and copper at the moment), the real focus for the market during the next week will be to assess the strength of the nascent demand recovery in the rest of the world.

“Non-Chinese world demand has experienced one of the largest slowdowns of the past century from the fourth quarter of 2009. There have been signs of a recovery in recent months and most economic lead indicators are pointing upwards, but the magnitude and duration of the recovery is still highly uncertain.

“Will the recovery be enough to outweigh rising supply and falling Chinese demand in the next quarter? This is the big question of the week. Certainly the signals are still very mixed. Nickel demand looks likely to fall in the short run (following strong quarter-on-quarter rises in the second and third quarters of this year) as orders have fallen in its main end-use (the stainless steel market). However, the nickel market was in large deficit in 3Q09 and may remain that way in 4Q even with a demand slowdown.

“Zinc demand has recovered as general steel producers ramp up production and automakers are planning to rise output following extensive destocking. However, in zinc, over 1 Mt of Chinese mine production has reopened since the middle of the year – prices have rocketed for zinc in recent months – can it continue?

“Copper and aluminium orders are still anaemic in Europe and the US, but have recovered strongly in Japan recently. Aluminium physical premiums have risen, indicating physical tightness – how real is this? Certainly the massive destocking cycle among consumers appears to be ending and we expect the call on production will rise even if real consumption remains flat. The question is, will this be enough? Our sense is that the demand recovery outside China will be slow and could disappoint in the short run (within the next month or so), but then may well surprise on the upside in late-2009 and early 2010 (history suggest this is likely from the lead indicator information we currently have).

“Will the market look through this weak period (which has been widely anticipated in copper, but has had little negative pricing impact so far)?

“The other questions will involve the pace and level of the supply response. In copper, where the market remains tight, a considerable number of labour contracts have to be renewed between now and the end of the year, and the supply risks remain to the downside. How real are the copper mine expansions in 2010 and 2011, and will we be surprised on the downside or the upside? (This question has been asked every year around this time for the past five years and the answer has always been downside…but is it different this time? We suspect not.).

“In previous years, LME week has led to many supply surprises from discussions with producers – almost always that projects are delayed or that production problems are more prevalent than has previously been assumed.

“The final set of questions relates to the financial sector. Will the hedge funds see any short-term weakness as a buy opportunity or are they going to go away from LME week as sellers, convinced that demand is not going to recover enough?

“In aluminium, the statement that “75% of stocks are not available to the market” due to financing agreements will be subject to a lot of scrutiny and debate – certainly, if price are driven up by nonavailability of material, plenty more idle capacity would become ‘available’ if producers decided to reopen idle capacity and sell forward to lock in a profit.

“There is also a lot of talk about new ETFs (exchange traded funds) in base metals, to allow investors to get exposure to metals without upsetting the US regulatory authorities who are fretting about speculators in futures needing to be reigned in. Index funds have allowed investors to gain access to commodity prices by buying futures with no physical backing.

“The new ETF products involve no futures exposure, but require the investments to be backed by physical holdings – so a regulatory measure that tries to prevent something could feasibly end up doing more damage that the alleged risk. In this case, prices might potentially be driven higher by ETFs than by index funds.