Metals on the decline, but for how long

Base metals and precious metals posted losses this week with the exception of gold, which managed to end the week marginally higher due to a rebound on Friday. While the US dollar on balance was a supportive factor for metals, the two other major drivers were not. After investors preferred risky assets in the week before, safe haven government bonds were in demand again since the middle of the week. The reason for the increased risk aversion is a renewed fear about global growth.

A well received auction of 2yr German government notes (Schatz) was the trigger for a rebound of safe haven buying. This move accelerated with the presentation of the UK budget. Furthermore, fears about Spanish public finances flared up again, which drove yields on Spanish government bonds up and the prices of safe haven German Bunds rallied. This recovery of bond markets had already a negative impact on stock markets and also on metal markets. This reaction in bond markets demonstrates again that financial markets are not always rational as academic theory postulates. The new Spanish government has made a wise decision. The austerity measures already implemented and the eurozone debt crisis cause a slower nominal GDP growth than previously expected. This has of cause an impact on the budget deficit, which would not decrease in per cent of the GDP as much as intended. Instead of imposing further austerity measures, the new government of PM Rajoy decided to accept a lower decline of the deficit/GDP ratio. Another round of spending cuts or tax hikes would have a much more severe impact on GDP growth and could be even counter-productive as the case of Greece shows. The bond vigilantes also overlook that Spain has already included rules of balancing the budget in the constitution. Spain also pledged to reduce the budget deficit further, but will not take measures, which could deepen the recessionary developments.

Metals markets came under stronger selling pressure on Thursday after the release of flash PMI surveys. In China, the HSBC manufacturing PMI dropped from 49.6 to 48.1. The official Chinese PMI is currently above the 50 mark. Furthermore, it is not always moving in the same direction as the HSBC PMI. However, also in the eurozone, the manufacturing and the service sector PMIs surprisingly declined and even Germany was not immune against a weaker economic outlook in other eurozone countries.

There is a widespread believe that a reading of the PMI below 50 would imply that economic activity is contracting and that a reading over 50 would imply expanding activity. This also explains that journalists at a business TV station stated that China would be in a contraction for the fifth months in a row. However, this 50 mark is not a sharp threshold. Quantitative analysis shows that even with a PMI at 48 the industrial production might increase compared to the same month of the preceding year.

A further point to keep in mind, when interfering from the PMI level to economic activity, is the construction of this index. The PMI is a diffusion index. A sample of purchasing managers is surveyed and the percentage of negative replies is subtracted from the percentage of positive responses. This balance fluctuates around zero. In order to keep the values of the PMI positive, 50 is added to the balance of positive vs. negative replies. However, not all companies included in the sample have the same size and the same contribution to industrial activity. Larger sized companies usually contribute more to industrial production than smaller ones. Thus, the distribution of responses over various classes of company sizes also plays a crucial role. Consider the following scenario where there might be more negative replies from small companies than from large companies. This would be negative for the PMI and could lead to a reading below 50. However, the production increase at large companies could over-compensate the shortfall at smaller companies and thus, overall industrial production could increase.

Chinese recent economic data is sending some conflicting signals. According to the latest figures from the customs office, Chinese copper imports reached the third highest level last month. Rising copper imports don’t argue for a massive slow-down or even contraction of economic activity in China. Some analysts argued that copper was only imported to serve as collateral for short-term funding. This argument is rubbish because it does not make any economic sense to buy copper solely for the purpose of using it as collateral. Of course, companies use copper inventories as collateral for short-term funding. However, importing copper serves the primary purpose of maintaining a certain level of inventories. If companies import more copper then they expect a pick-up of future domestic copper consumption. Furthermore, copper inventories at LME warehouses are declining.

All in all, we expect that metal markets are likely to remain in a consolidation and trading range market for the time being. Growth concerns bias the risk to the downside. However, monetary policy is expansionary in the US and Europe. Also the Chinese central bank started to loosen monetary policy. This should prevent a hard landing. We expect therefore that metal prices would be higher, in particular in the second half of this year.