Are high commodity prices really a risk for global growth?

In this week’s contribution, we will comment on an article on the rise of commodity prices and global growth, which had been published in the January 22 edition of “The Economist”. From our point of view, even the Economist lacks some basic economic understandings.

The article creates the impression that the second round of quantitative easing by the Fed was the main driver of rising commodity prices. This is not the case. First, commodities are not a homogeneous asset class, but each commodity has its own supply and demand fundamentals, even as there are some common factors. Large financial institutions, in particular the hedge funds and CTAs buy commodities not only because of the available liquidity but that fundamentals point to a trend of rising prices. If fundamentals are bearish, these institutions sell commodities despite low US interest rates and quantitative easing. This explains that some base metals posted strong gains in 2010 while zinc even declined.

Second, when talking about commodities in general, we need to look at an index, like the CRB Index. According to the CRB index, commodity prices declined during the first five months of last year and found a bottom in late May. The CRB pared the loss in June and July. However, at this time, the discussion in financial markets was whether a double dip recession of the US economy was avoidable. This recovery could not reflect a reduced concern about global economic prospects. In the eurozone, the rescue package for Greece has been approved, but markets feared still the result of stress tests for the banking system.

Third, the major push in commodity prices was triggered by rising prices of agricultural commodities. The wildfires in Russia and the drought in the Black Sea region caused a slump in grain harvests. In addition, the USDA had also revised lower the forecasts for grain harvests in the US. Floods in India and Pakistan had an impact on sugar prices. The La Nina weather phenomenon is responsible for the flood in Australia’s grain belt (Queensland) and also for the poor harvest outlook for Latin-America. Mr. Bernanke is certainly a powerful central banker, but it would be new that he is that mighty to make rain or sunshine by buying US Treasury paper.

We fully agree that Mr. Bernanke’s speech at the Jackson Hole meeting in late August marked a turning point for the US stock market. And increasing equity prices are a sign of an economic improvement, which has been reflected in higher GDP growth rates in the US. However, as already explained in earlier contributions, QE2 was not a necessary requirement for a weaker US dollar. Capital flows out of the US dollar and in to other economies where higher returns are achievable would have driven the US dollar lower even without QE2. Thus, the Fed monetary policy has supported a rise of commodity prices, but it was not the main driver.

Some economists compare rising commodity prices with a tax hike. The writer of the article in The Economist at least referred to a consumption tax. However, this comparison shows another lack of understanding basic economic principles. A hike of a direct tax, like the income tax, would leave relative prices unchanged initially. It would reduce the disposable income of private households. But if the government spends higher tax revenues and keeps the fiscal balance unchanged, then aggregate demand could even increase according to the multiplier effects. Also in the case of a general consumption tax with a single tax rate, the relative prices of goods would not be altered initially. However, due to higher prices, private consumption would be lower in real terms. But the overall impact on aggregate real demand depends again on the use of tax revenues by the government. In both cases, redistributive impacts of the fiscal policy and the preferences of the individuals affected by the tax are likely to lead to adjustments in the demand patterns, which result in changes of relative prices at the end of the process. But a specific indirect tax on a good would alter relative prices immediately. Depending on the price elasticity, the result is most likely that the demand for all goods will decline. Economists usually consider in textbooks the case of two goods. However, for aggregate nominal demand and thus for GDP growth, it is again decisive how the government spends the tax revenues. In the case of a tax rate hike, the tax policy is the cause for adjustments of the supply and demand curves for various goods. However, aggregate demand is not necessarily declining as long as the government spends the tax revenues again. By contrast, the current fiscal policy in the UK, where the hike of VAT is used to reduce the budget deficit is having a negative impact on aggregate demand.

The rise of commodity prices is not the result of tax rate hikes. Rather it reflects the adjustments to fundamental changes in the supply and demand for commodities. In the agricultural sector, the growing world population and higher incomes in many emerging markets leads to a trend of growing demand. The weather conditions around the globe have caused a drop of world supply of many agricultural commodities. As a result, prices have risen to match supply and demand. For base metals, the demand has risen due to the strong economic recovery in emerging countries in Asia and Latin-America. However, the supply situation was different. Tin production was also affected by weather conditions, which led to lower mining output in Indonesia. The copper production also could not keep pace with demand as the ore contains less copper and demand has jumped not only due to economic growth but also due to the demand for physically backed ETFs. Thus, the rise of commodity prices reflects either a stronger increase of demand or supply shocks caused by external factors. The rising demand by consumers is more a reflection of solid global economic growth and not a risk for growth going forward.

In economic theory, inflation is defined as an increase of the overall price level and a clear distinction is made to changes in relative prices. However, the way inflation is measured, a change of relative prices in one segment could lead to the perception of rising inflation. And this is the main risk for global growth as central banks have the duty to prevent inflation. Theoretically, central bankers should look through a one-off increase in commodity prices. Most likely, we could expect that the Fed would be smart enough to act accordingly. The Fed focuses on core inflation, excluding the rather volatile Food and Energy sector. China has already raised interest rate twice in the final quarter of 2010. In the eurozone, ECB president Trichet stated recently that the governing council should focus on headline inflation. The harmonized CPI surprisingly increased to 2.2% reflecting not only rising commodity prices but also tax hikes in some countries to reduce the budget deficits. The ECB expects that the inflation rate would remain above the 2% target for a few more months, but would decline again in the medium-term. Nevertheless, they left no doubt to tighten monetary policy if needed to keep expectations of headline inflation anchored at 2%. In the UK, the Monetary Policy Council of the BoE already discussed a rate hike in January as the inflation rate is above the upper target ceiling, again largely driven by increasing Food and Energy costs as well as a hike of the VAT rate from 17.5 to 20%. As long as central bankers believe that higher interest rates could have an impact on weather conditions, they pose a risk to global growth.   

Gold has reversed trend

One basic assumption of technical analysis is that history is repeating. If you regard this assumption as wrong, just have a look at the chart of spot gold. Last week, gold traded slightly higher during the first three trading sessions but came under massive selling pressure the last two trading days. This is exactly the same trading pattern as in the preceding week. We pointed out last week, that gold had found some support at the trend line, which connected the November lows. As gold initially moved slightly higher, it appeared that this support would hold. However, the plunge on Thursday lead to a close far below this upward trend line and confirmed that the trend in the gold market has reversed definitively, as other indicators already pointed to a downward trend in gold.

On Thursday, the CME announced that the margin requirements for the metals contracts have been increased. While some longs might have liquidated their holdings following the announcement, we don’t regard the rise of margin requirements by the futures exchange as the trigger of the sell-off in gold and silver. The market was already under pressure during the European morning hours, when the CME had not yet released its statement. In addition, the decision of the CME was merely a reaction to the increased volatility and it is not uncommon that margin requirements rise with higher volatility and are lowered following falling volatility. Variations in margin requirements are the result and not the cause of changes in volatility.

There were three factors, which are mainly responsible for the plunge of gold and silver last Thursday. The day before, the Chinese CPI inflation figure had been leaked and the decline to 4.6% had reduced the fears in financial markets that the PBoC would hike interest rates or minimum reserve requirements again. However, together with the official release of the CPI figures, also the data for the producer prices were released and the PPI inflation came in higher than expected. Furthermore, the GDP growth in the final quarter of 2010 accelerated to 9.8% and the industrial production rose by 13.5%, beating expectations slightly. Therefore, the fear of another PBoC rate hike returned and stock markets sold off.

In the eurozone, there was a lot of talk about a restructuring of the Greek national debt. A newly appointed member of the economic advisors in Germany, the five wise men, gave an interview stating it would be unavoidable that Greece restructures its debt and Germany should be prepared to pay according to the guarantees given in May last year. Normally, this would have been positive for gold. However, the head of the EFSF (the European Financial Stability Funds) came up with a proposal for a voluntarily restructuring. The EFSF should borrow Greece funds, which it would use to buy back outstanding bonds at the current deep discounts between 40 – 50 % of face value. This plan led to an improvement of sentiment and sent yield spreads of peripheral government bonds over German bunds lower. The Euro strengthened versus the US dollar. The stronger euro was not favorable for gold as the flight out of the safe havens dominated.

In the US, existing home sales surprised by rising far stronger than the market consensus expected. This had a negative impact on the US Treasury market. The rising yields of bonds and notes make investments in gold and silver less attractive. Thus, on Thursday, there was a rare event of falling stock, bond and metals markets.

Investors’ sentiment might be the key whether gold will fall further or will find support at the reaction lows of October last year. According to the latest CFTC report on the Commitment of Traders, the large speculators have increased long positions for the first time in four weeks. However, they also have opened far more new short positions. Thus, the net long position dropped again by 12,379 to 164,993 contracts. Also the holdings of the biggest Gold ETF, the SPDR Gold Trust, declined initially further. However, after the plunge of gold on Thursday, bargain hunting set in and the holdings rose to 1,271.8 tons, which implies also a gain in the week over week comparison.

As we don’t expect that Chinese monetary policy would lead to a dramatic fall of GDP growth in China, we regard the fears in the markets as overdone. We also expect that a stronger Euro would be positive for gold in the medium-term. Thus, we would currently look more for support in the gold market for buying at lower levels.

Is gold losing its shine?

Gold closed slightly above 1,360$/oz last week, the lowest close in 2011 and in almost two months. At the start of the year, gold traded above 1,420$/oz. This raises the question whether gold has entered a new down-ward trend while most forecasts for gold in this year are bullish.

From the perspective of a technical analyst, the answer is not a clear “yes, the trend has changed”. Based on closing prices, the trend has reversed according to the Dow Theory, as last Friday’s close was the lowest since mid-November and it was below preceding reaction lows. If the analysis is based on the whole trading range of the day, the trend also has clearly changed according to the Dow Theory. However, gold found support at the upward trend line, which connects the lows made in November. Therefore, gold would still be in an upward trend. The highs, which gold made since November, are in close vicinity. The upper Bollinger band line is also moving sideways with only little fluctuations. The lower band line moved higher, but lately indicates that gold is caught in a trading range. In addition, gold found support last Friday at the lower Bollinger band line. Therefore, all in all, we would regard gold being in a correction within a sideways trading range as the most likely scenario.

And a sideways consolidation of gold after the strong increase since August 2010 should not come as a surprise. If a market is overbought, it takes some time to digest the gains. The timing of the recent correction is also not a big surprise. Some accounts are market to market and unrealized gains are treated as a profit. For managers of those accounts, there is little reason to sell gold based on accounting reasons. However, some accounts value gold at book-entry levels. Managers of those accounts have an incentive to realize gains at the start of a new fiscal year to lock in already a profit. Such a behavior has also been observed in other markets in the past. Unless, the expectations of those account managers have not changed, they will repurchase gold again at a lower level, which should provide some support for gold.

Last week, we already pointed out that gold suffered from a firmer US dollar based on some stronger than expected economic figures, which had triggered expectations the Fed might hike interest rates later this year. During the course of the previous week, it was more the debt crisis and the ECB which moved gold. At bond markets, the fear was widespread that the auctions of new debt from Portugal, Spain and Italy would attract insufficient bids from investors. As a result, the euro was weak, but gold rose due to safe haven buying. However, as after Portugal also Spain could sell new bonds without problems, the euro firmed but investors sold gold as they sought more risky assets. Despite the countries of the eurozone periphery could place new bonds, the debt crisis is far from over. Market pundits still point out that these countries are not out of the woods. Therefore, a renewed flight to the safe haven of gold could set in anytime.

However, what is likely to have a stronger impact on gold over the medium-term horizon is the recent ECB press conference. The ECB attributes the rise of the eurozone inflation rate, which came in at 2.2%, above the target rate to higher food and energy prices. The ECB also expects that inflation would remain above 2% over the next few months without expecting that inflation would deviate from the target over the medium-term horizon. Nevertheless, ECB president Trichet sounded more hawkish than the market consensus expected by stating the ECB would not be pre-committed and would be ready to act when needed. Mr. Trichet also referred to 2008, where the ECB hiked interest rates while other central banks already eased monetary policy. This is a clear message to markets that the ECB is likely to lift interest rates ahead of the Fed. This would be supportive for the euro against the US dollar and would probably also push gold prices higher.

One development over the recent weeks presents a short-term risk for gold, but could also be the catalyst for the next rally in gold. Financial investors have reduced their exposure in gold. According to the weekly “Commitment of Traders” report compiled by the CFTC, large speculative accounts have reduced long positions further by 15,972 to 234,333 contracts and have increased the short positions by 8,974 to 56,961 contracts. Thus, the net long position dropped by 24,946 to 177,372 contracts, the lowest net long position since the end of May last year. Also the gold holdings in the biggest ETF, the SPDR Gold Trust, declined further to 1,259.3 tons, again the lowest value since May 2010. Against the backdrop of these huge position liquidations, the price of gold held rather well. However, further position liquidations by large investors could be the straw that breaks the camel’s neck. But in the case that gold could remain in a sideways trading range, financial investors might return as buyers in the gold market and could set the stage for another major push higher. Thus, it is far too early to conclude that gold has lost its shine.

Forecast Season

At the beginning of a new year, it is the time to provide new forecasts for the year just started and to review the forecasts made one year ago. We participated in two surveys in January 2010. Last week, we were informed that we had the most accurate forecast for silver in the annual survey of the London Bullion Market Association (LBMA) and the best forecast for the average cash copper price at the LME in the ThomsonReuters survey.

The 2011 ThomsonReuters survey is not yet completed and published. However, we gave ThomsonReuters an interview, which could be found on their web-site (click here for the interview) about the outlook for copper. The LBMA has already released a summary of the 2011 survey on its web-site (click here for the pdf-document), but a more detailed report will be published later this month in their publication “The Alchemist”. There you will also find the arguments for the forecasts of the various participants in the poll.

All in all, we expect that precious and base metal prices will be higher at the end of 2011 compared to the start of this year. However, in now almost 25 years of professional forecasting market developments, we have seen many occasions that the short-term move were opposite to the longer-term forecast. But by the end of the forecast period, markets often came close to the level forecasted. Thus, we are not worried by the correction in metal markets last week. Nevertheless, we are very well aware that many recipients of longer-term forecasts expect that a market has to move in the right direction immediately after the forecast has been made to regard it as a useful forecast.

After the rally in the second half of 2010, many commodity markets were already heavily overbought and thus, they were susceptible for a correction. Two factors triggered this correction last week by leading to a stronger US dollar. First, the US manufacturing index came in at 57.0, which was above the market consensus of economists looking for only a marginal increase to 56.7. This improvement of the ISM manufacturing index has been viewed as an indication that the expansion of the US economy would accelerate. There was again talk in the markets that the Fed might abandon QE2 earlier than scheduled. Second, the ADP private sector employment estimate sent shock waves through markets. The actual figure of 297K came in almost three times as high as the market consensus. Thus, market participants revised up expectations for the non-farm payroll report. The combination of stronger expansion in the manufacturing sector and a considerably higher job creation lead to speculations that the Fed might hike interest rates already in H2 of 2011.

The market should have been aware that the accuracy of the ADP estimate is very poor. Even taking into account that the official non-farm payroll report appears to underestimate the development of the labor market somewhat lately as preceding months were revised up considerably, the ADP estimate was too good to be true. The labor market report confirmed this, as just 103K new jobs were created in December compared to the consensus estimate of 159K, which moved to around 195K after the ADP report. While the statement of the Bernanke testimony was written without knowing the labor market data, the figures confirmed his assessment. Thus, there is currently no reason to expect that the Fed would change its monetary policy. The purchases of US Treasury paper will proceed as planed. A hike of the Fed Funds target rate is not on the agenda for 2011. This implies that the US dollar would not be supported by higher interest rates. In addition, money market rates as an opportunity cost for holding metals will not provide a reason to sell metals over the medium-term horizon. Therefore, we regard the current correction as an opportunity for investors and consumers to buy metals.

2011 in Metal Markets – a brief outlook

First of all, we wish all readers of this blog a very Happy New Year and that 2011 will be a successful year.

Since following financial and commodity markets, no year was just a repetition of the preceding one. This made the job of a professional market analyst and strategist interesting as change was the only constant. Therefore, the year 2011 is most likely different than the year, which just ended two days ago. Nevertheless, some factors having a strong impact on metal markets last year are likely to play a crucial role at least in the first half of this year.  

At the November FOMC meeting, the Fed started to implement QE2, the second round of quantitative easing. The Fed intends to buy US Treasury paper until the end of June 2011. However, whether this program will be terminated ahead of schedule or even extended beyond the end of H2 2011 will depend on the economic development of the US economy, in particular the core PCE inflation and the unemployment rate. However, QE2 is not undisputed, not only outside the USA – some politicians even regarded it as a weapon in a currency war – but also within the Federal Reserve System. The rotation of the voting members leads to a situation that the number of opposing voting members increases this year. Nevertheless, Fed chairman Bernanke is likely to have a majority for his policy. But more no votes among the FOMC members could have a negative impact in markets. However, the long end of the US Treasury curve might be more affected and the curve could get steeper. This would also have a negative impact on commodity markets as the opportunity costs for investors or the funding costs for consumers could increase.

A second impact has to be expected on the US dollar. It is not only the spread of money market rates, they are a crucial factor for carry trades, but also yield spreads for 10yr government bonds, which have an influence on exchange rates. We do not expect the Fed to hike the Fed Funds target rate this year. This would still be an argument that carry trades could weigh on the US dollar. However, an underperformance of the medium to long end of the US Treasury curve relative to other major government bond markets could dampen US dollar weakness or even lead to a stronger US dollar. This case would be negative for metals markets.

The crisis of European government debt is also likely to play a major role still in 2011. After the rating agencies downgraded some countries of the eurozone periphery or put them on credit watch for a downgrade before Christmas, the rise of CDS rates is likely to keep the speculation alive that Portugal might have to get bailed out by the European Financial Stability Fund and that other countries could follow. Also the decision taken by the head of states at the recent EU summit have not convinced the markets. Thus, in the short run, the fear of a contagion of the eurozone debt crisis could weigh on the euro in early 2011.

All countries have adopted more restrictive budgets for 2011. Especially the countries of the eurozone periphery voted for severe austerity measures. Currently, financial markets are skeptical whether expenditure cuts and tax hikes would improve the fiscal situation of those countries. They fear that the impact of restrictive fiscal policy on GDP might be more harmful than the governments estimate. Only time will tell if the medicine prescribed by the EU and the IMF as well as by pressure in bond markets will lead to an improvement. In this case, the tensions in financial markets could ease and CDS rates decrease again. This would be a positive factor for the euro and most likely also for metal markets. However, in the case that GDP would shrink stronger than markets priced in, the euro might weaken against the US dollar. But this case does not necessarily imply that precious metals would suffer. Gold and silver might even advance further on safe haven buying. But the impact on base metals could be negative.

A rate hike in China was expected for quite some time, however, the People’s Bank of China surprised the markets by the timing of this move. Over Christmas, the PBoC increased interest rates to cool inflationary pressures. Given the still strong pace of economic growth in China, further rate hikes have to be expected during 2011. This might have a negative impact on Chinese gold demand as fighting inflation would reduce the appeal of gold as an inflation hedge. However, the crucial question for base metals, in particular copper, is how far a restrictive monetary policy in China would dampen GDP growth and thus the demand for base metals.  Our base case scenario is that China’s GDP growth would slow from above 10% to close but below 10%. However, the construction sector might slow down stronger. Therefore, we expect that China would make a positive contribution to increasing demand for base metals, but that price increases are likely to be lower than in 2010. Also the demand from other “BRIC” countries should support base metal prices.

However, Chinese policy might have a negative impact on two precious metals. Also over the Christmas weekend, Beijing announced to reduce car registrations by 50% due to the congestion in the city. So far, it is only a measure taken by the administration in Beijing. But given the traffic and environmental pollution in other metropolitan areas, one has to expect that other cities like Shanghai would follow soon. The Chinese market contributed strongly to the growth of the automotive industry in 2010. The outlook for a drop of car registrations in China is a negative factor not only for the stock prices of car manufactures, but also for the demand for catalytic convertors. Thus, platinum and palladium might underperform gold and silver this year.

Two other factors play an important role in our quantitative fair value models, the year-over-year percentage change of crude oil and the S & P 500 index. OPEC shows no signs to increase the output quota any time soon. The demand for crude oil is rising in emerging markets. Thus, WTI could surpass the 100$/bbl mark in 2011. This would be a positive factor for metal prices, especially for gold and silver, which serve as a hedge against inflation fears. Many US companies also profit from operations in emerging markets or exports to those countries. As the Fed is likely to keep interest rates stable in 2011, the S & P 500 index might trend further up in the first half of this year. This would imply, that yoy %-change would be positive and would also argue for rising metal prices.

 All in all, we expect still a positive performance of metals, in particular in the first half of 2011. However, whether metal prices will also rise in H2 depends on a pick-up in US GDP growth and that Chinese GDP growth would not slow down too strongly. Thus, market timing instead of buy and hold might be more important this year than it was in 2010.