Increasing risk aversion hits precious metals

As pointed out over the last few weeks, the risk on and risk off trades of investors not only move stock and the safe haven government bond, but also the metals markets. Given the movements of the major fundamental drivers over the last week, gold and silver held quite well, while the PGMs and other industrial metals have been hit hard. However, is the pessimism among investors and traders really justified?

Economic data released during the course the week in the two major economies came in stronger than expected. In China, the flash estimate of the HSBC manufacturing PMI increased from 47.9 to 49.1. While this reading is still below the threshold of 50, it is the turn-around that matters. Also the recent Chinese data on Q3 GDP growth showed a strong 9% annualized quarter-on-quarter growth, which also points to a rebound. These figures are good indications that the slow-down of the Chinese economy has come to an end. Also US economic data surprised positively. The GDP growth increased from 1.3% in the second quarter to 2.0% in Q3 according to the first estimate. Durable goods orders rose 9.9% on the month, while the consensus was looking for a smaller rebound. Also the core durable goods orders rose stronger than predicted by 2.0% while the consensus expected only an increase of 0.8%. Nevertheless, the US stock market ended the week lower.

We pointed out over the last two weeks, that many corporate companies give a very cautious outlook for their business going forward. To some extent, this is part of a strategy to dampen expectations of analysts, which then makes it easier to beat earnings estimates in the next quarter. However, to some extent, it also reflects the uncertainty by business leaders. Again, the Fed did not provide a positive guidance. The assumption that business leaders base their decisions on rational expectations had been falsified by reality again and again. Akerlof and Shiller were right in pointing out that animal spirits, a term coined by Keynes, have a strong influence on decisions. Thus, part of any economic policy should be to influence the psychology of decision makers. The FOMC statements of the latest two meetings appear more as a self-defense for the implementation of QE3 instead of providing an encouraging outlook now that QE3 has started. Therefore, it appears that investors’ sentiment is worse than justified by the economic data and outlook of the two major economies.

In Europe, the United Kingdom surprised with reporting GDP growth in the third quarter. However, the major problem is still the eurozone. It gets more and more obvious that the German narrative that fiscal austerity would lead the eurozone out of the crisis is absolutely wrong. The mercantilistic German economic system is now feeling the result of describing the wrong medicine. Germany’s economy relies on exports and car sales. But with pushing Southern Europe into a recession, the demand for German export goods declines. Also car sales in Europe plunged. Business leaders postpone or even cancel big ticket orders, which have a negative impact on new orders of the German manufacturing industry. Therefore, it is not surprising that the German manufacturing PMI flash estimate showed another drop and the ifo-index was dragged down by a fall of the current situation assessment.

The automotive sector had been hit hard. Car sales in the eurozone plunge. France intends to provide financial support for its car companies. Ford considers closing three plants in Europe. The German manufacturer Daimler had to revise down the earnings forecast. All these factors had negative impacts on stock prices of European automotive companies. Therefore, platinum and palladium were under stronger pressure this week. But also the easing of the strike situation in South Africa contributed to the decline of PGM prices.

“Those fundamental things apply as time goes by”. This line from the lyrics of the famous song of the movie Casablanca also describes quite well the behavior at financial and commodity markets. At the end, the fundamentals are the major factors driving prices. As some major economies like the US, China and the UK show signs of an economic improvement, the outlook for gold and silver remain positive. However, the PGMs might continue to underperform as long as political leaders in the eurozone do not find a solution to solve the crisis quickly. 

“Get greedy when others are fearful …”

“… and fearful when others are greedy”. This quote from Warren Buffet applies not only to stock markets but also for precious metals. Precious metals dropped on the first and the last trading day of this week. However, the economic outlook is better than the markets are currently pricing in. Thus, we regard the current weakness as a buying opportunity and not as a reason to sell.

The drop on Monday, where gold fell more than 1% while silver and palladium dropped around 1.7% and platinum plunged 2.2%, was attributed to selling by funds, which took profits. This view is supported by the statistics on holdings of the underlying metal by the biggest ETF for gold and silver. The SPDR Gold Trust ETF recorded a decline of gold holdings by almost 7 tons on Monday to 1,333.9 tons on Monday. Silver holdings in the iShare Silver Trust ETF fell by around 9 tons to 9,885.5 tons. Also the CFTC report on the “commitment of traders” showed a strong drop of long positions in gold futures held by the large speculators. They fell by 14,413 to 232,988 contracts in the week ending October 16. As the non-commercials also increased the short positions, the net long position declined even stronger by 17,329 to 194,020 contracts. In silver, the large speculators reduced the long position only slightly, nevertheless, the net-long position even increased by 303 to 40,128 contracts as closing short-positions was stronger.  

The drop of precious metals prices on Friday was triggered by the fall of stock prices on Wall Street. While the S&P 500 index manage to post a small gain in the comparison with the close of the week before, the index lost almost 1.7% from the previous day. It was not the 25^th anniversary of the crash in 1987, which drove prices lower, but disappointment about earning reports. Even if a company met earnings expectations, analysts wrote negative comments based on some figures being lower than estimated. Also the cautious outlook given by the companies weighed on sentiment. Investors feared the economic outlook would darken and uncertainties would rise.

However, this pessimism is not justified by the economic data released during the week. US retail sales in September rose 1.1% from the previous month while the consensus expected an increase of 0.7% only. Industrial production increased by 0.4%, twice as fast as the consensus predicted. Headline CPI inflation rose 0.6% compared with a forecast of 0.4% and core inflation was a modest 0.1%. This should be negative for US Treasury notes, but positive for precious metals. Furthermore, data from the housing sector also surprised on the upside with housing starts and permits coming in stronger than expected. Also the Philly Fed manufacturing Index rose far stronger than the consensus forecast. Beside positive data in the US, also the ZEW sentiment index for Germany and for the eurozone increased further.

Thus, the economic data indicates that the economic situation is improving and not worsening. As pointed out already in the article last week, companies provide often a more cautious outlook to lower earnings expectations. If analysts then revise down their earnings estimates, it would be easier for the companies to beat the lower earnings estimate. Therefore, we put more emphasis on the economic data, which is pointing towards stronger growth. This should be positive for the risky assets and negative for the so-called safe havens of US Treasuries and German Bunds, which offer yields below the headline inflation rates. These negative real yields are another argument to prefer real assets like precious metals as the opportunity costs are rather low. Also the risk/reward perspectives are more promising for precious metals than for safe government bonds. Thus, we regard the current weakness as a buying opportunity.  

Give Greece and growth a chance

Many commodity analysts currently recommend gold based on the argument that quantitative easing by central banks in industrialized countries would lead rather sooner than later to accelerating inflation. Only a few days ago, commodity analysts from Germany’s number two bank, Commerzbank, gave such a recommendation. But how is this compatible with the development of last Friday? Gold lost 0.76% on the day and ended the week near the low. Silver and platinum lost around 1.75% and palladium even plunged by almost 3.5% on the day. This all happened on the same day the US Department of Labor released the producer price index of finished goods for September jumped by 1.1% mom, which was far above the consensus forecast of 0.8%. This divergence could not be explained by a buy the rumor sell the fact behavior as precious metals weakened already during the whole last week. However, it underlines that inflation fears are currently not the main factor behind the demand for precious metals. It is still more the swings between risk aversion and risk appetite of investors, which move the price of precious metals.

However, also the reaction in the US Treasury market appears as not being rational. The core PPI remained unchanged in September. We have pointed out several times in this blog that there is a difference between inflation and change in relative prices. Thus, the core PPI figure indicates that there is no inflationary pressure in the pipeline. But this is not an argument for buying instruments with a fixed nominal coupon. In order to preserve the purchasing power of the capital invested, the return should be sufficient to buy the same basket of goods in the future. This is currently not the case in the US Treasury market. Yields on conventional 10yr T-Notes are even below the core inflation rate. Investments in US Treasury paper produce losses in real terms for a broad range of maturities. That investors buy T-Notes indicates that investors’ risk aversion is increasing currently.

Two factors contribute currently to the higher risk aversion. First, the World Bank presented its forecasts for global growth, which had been revised down surprisingly more than expected. Also the IMF lowered its forecast for GDP growth in its Global Economic Outlook ahead of the IMF autumn summit, which took place this weekend in Tokyo. The track record of official forecasts from the two Washington twin-institutions is not the best one. Quite the opposite, they usually are ranked in the lower quarter. Political considerations seem to have an influence on the forecasts. Currently, the IMF recommendation is to reduce deficits further, but not at a pace that strangles economic growth. This is also reflected in the recommendation of the Tokyo summit to the US and Europe.

In this context also Greece is back in the spotlight. Last week, the German economic research institutes presented their semi-annual expert report. Beside lowering the GDP forecast for this and next year, they also commented on Greece. Several members voiced the opinion that Greece would not manage to solve its problems and would have to leave the eurozone. Also Sweden’s finance minister Anders Borg talked about a Greek exit on Saturday. However, already last Tuesday at a visit in Athens, German chancellor Merkel affirmed that Greece would be kept in the eurozone. This Sunday, also German finance minister Schaeuble rebuffed speculations on Greece leaving the eurozone. Furthermore, he stated there would not be a Greek default on government debt.

The recent comments indicate that Germany softens its stance on Greece. The German government appears now determined to provide further support to prevent a Greek exit. Thus, Germany might follow the advice from IMF head, Christine Lagarde, to give Greece the time of two more years for reaching the budget target. However, this would also require that the IMF delegate of the troika softens the demands for further austerity measures. Contrary to statements of former ECB chief economist Stark, fiscal austerity in a recession is not leading to a recovery. This has been demonstrated by the development in the eurozone periphery. It has also been shown with empirical evidence in a recent IMF working paper. It is time that finance ministers recognize this fact. Giving Greece more time would be an important step to solve the debt crisis. At the IMF summit, there was also talk that Spain would apply for help from the ESM in November, which would pave the way for the ECB to buy Spanish debt in the secondary market.

Another interesting proposal came from ECB council member Asmussen. He recommended Greece to borrow fresh money and to buy back old outstanding debt. This proposal is not new and had been made already last year by the head of the ESM, Mr Regling. If official holders of Greek government debt would sell the bonds back to Greece at current market prices or even book entry levels, Greece could reduce its outstanding debt significantly. A volunteer sell back at book entry values could hardly be classified as illegal government financing by the ECB.

The second factor has been the start of the earnings season. Alcoa usually kicks the reporting season off and beat earnings expectations after adjusting for one-off items. However, the outlook, which Alcoa gave for the aluminum market, weighed on market sentiment. This also explains the pressure on aluminum prices at the LME and the Shanghai Futures Exchange. But not only Alcoa, also other companies provided a more cautious outlook for the current and future quarters. This lead to a series of losing days at Wall Street and also other major international stock markets. Also that Apple lost a trial against Samsung on patent violations dragged stock prices lower.

Stock markets have ignored positive economic data released in the US but also in other economies since the start of this month. It is also a traditional behavior of companies in uncertain times to paint a more cautious outlook. However, the recent economic data indicates that the economic situation is improving, not only in the US but also in several European countries as rising industrial production figures in Italy, Greece and France underline.

The comments from the German government on Greece avoiding a government default and remaining in the eurozone are positive. It could be expected that the EU will provide further support to Greece. Also the hints that Spain would ask for help from the ESM should be positive for risky assets. And the recent economic figures indicate that economic activity might get traction again, just at a time when institutes revise growth forecasts lower. Thus, we expect that investors risk appetite will increase soon again. This would be also positive for the precious metals. The current consolidation is probably a buying opportunity and not the start of a trend reversal.

Trend remains up for precious metals

It was a positive week for precious metals on balance. The PGMs performed especially well while silver, which rose strongly in the weeks before, just managed to post a small gain. However, all four precious metals ended down on Friday. This already led to questions whether the upward trend in precious metals would be over. From our point of view, it is not and precious metals have further upside potential in the weeks and months to come.

Last week, the focus had been again on Spain and the question when the government will ask for a full rescue by the EFSF/ESM. Reports Spain could already apply for a bail-out as early as this weekend had been rejected by the prime minister and later also by the finance minister. But the statements by ECB president Draghi during the press conference led to a recovery of the euro, which was also positive for the precious metals.

The first Friday of a new month is usually the day where US labor market data will be released. Trading activity in many financial and commodity markets remains often range-bound ahead of the data release. But it was the reaction of precious metals after the numbers of new jobs created and the unemployment rate had been published, which was rather strange. The non-farm payroll figure came in just as expected by the consensus of Wall Street economists, but the previous months had been revised up. The surprise was the development of the unemployment rate. The consensus among economists predicted an increase from 8.0 to 8.2%. However, the unemployment rate declined 7.8%, the lowest rate since January 2009 when president Obama took office.

One reaction in commodity markets, especially in the crude oil pits, was that traders stated they do not believe the numbers were true. Also the comment by former CEO of GE, Jack Welch, on twitter that the numbers were manipulated by the administration to help the re-election of incumbent president Obama increased the disbelief in financial and commodity markets. The decline of the unemployment rate had been the result of people leaving the workforce. We pointed out some weeks before, that this is the normal behavior if jobs are hard to get. However, when the conditions in the labor market improve again, some workers return to the workforce and apply again for jobs. Thus, there is no rational reason to believe the allegations that the labor market report was faked.

Reuters wrote in a market report, that gold had been sold as the labor market report dimmed the safe haven demand. This statement does not make much sense as an increase of the unemployment rate is usually not a reason to buy gold. One factor behind the recent rally of precious metals had been the third round of quantitative easing by the Fed. The FOMC decided in mid-September to buy $40bn of mortgage backed securities per month until the unemployment rate had reached the target of the FOMC. Some fund managers voiced at TV stations like Bloomberg that this would be QE indefinite. As also the consensus forecast indicates, markets had priced in that the Fed would buy MBS for quite some time. However, if the unemployment rate continues to decline at the pace of the last two months, the target of the FOMC might be reached far quicker than assumed. Thus, some traders might fear that the Fed would provide much less liquidity through QE3 than assumed and therefore also less capital would flow into precious metals.

From our point of view, it is rather unlikely that the unemployment rate in the US will decline to full employment level only due to workers leaving the workforce. Also an increase of the pace of new job creation per month would be required. This will only be the case, if also economic activity accelerates stronger. At the recent GDP growth, the Fed is not expected to end the expansionary monetary policy anytime soon. Thus, the reaction in precious metals markets on the labor market report is overdone. A pick-up of economic activity would also be positive for precious metals. Stronger GDP growth should be positive for stock markets and should lead to higher equity prices. An increase of investors’ risk appetite is normally also positive for the demand for precious metals. Furthermore, stronger growth would also be supportive for crude oil prices, which are another fundamental factor for the price development for precious metals.

In our base line scenario, we expect the situation in the eurozone to stabilize. Furthermore, we expect that there will be a last minute compromise to prevent the US economy falling from a fiscal cliff. Thus, US GDP growth is assumed to increase again, which would be positive for stock markets and the oil price. Also in China, we expect further stimulus measures. This all should contribute to a decline of risk aversion by investors, which would be positive for precious metals. The rally is just taking a breather and is far from being over already.