Against the Fundamentals, but not the Flows of Funds

Last week, precious metals closed higher than the Friday before. However, all fundamental drivers included in our fair value models were negative. But investors have rediscovered commodities and the rise of some base metals also supports the precious metals.

Among the economic data, the focus was on the purchasing manager indices for many countries. The Markit flash estimates prepared the markets already for weaker PMIs for many countries in the Eurozone. Thus, it was not a surprise for the market that the final index confirmed the trend, especially as also the EU data on business confidence come in lower. In the US, the ISM manufacturing PMI also edged lower while the consensus of Wall Street economists expected a small increase. However, the lower ISM did not harm the recovery of the US stock market as some components of the ISM manufacturing PMI pointed to better index readings next month.

But not each decrease of a purchasing manager index translates into weaker economic activity. The first misunderstanding is the threshold level of 50. The PMIs are so-called diffusion indices based on surveys. The percentage of negative responses is subtracted from the positive ones. If the number of positive and negative replies is the same, the raw index is zero and the value of 50 is added to obtain an index oscillating around a positive number. However, the responses are not weighted by the size of the company. Regression analysis between economic activity and manufacturing PMIs show that the critical value is in most cases below the 50 threshold.

Furthermore, the time series properties of the PMI are different from those of financial assets. The vast majority of assets in financial markets follow a random walk, which could be described by a geometric Brownian motion. However, oscillating indicators like the PMIs are mean-reverting and their behavior could be described by an Ornstein-Uhlenbeck process. Even with a slow speed of adjustment to the mean, declines during the phase of economic expansion occur and are not necessarily already a harbinger of a slowdown.

In China, the official manufacturing PMI remained above the 50 threshold. However, the more widely followed HSBC manufacturing PMI fell below the 50 threshold in January and now rose again above 50 in June. This surprise already provided support for copper after the release of the flash estimate and lifted copper further up this week.

The US labor market data came in far stronger than predicted by even many optimistic forecasters. The number of new jobs created rose to 288,000 and also the figure for the preceding month was revised higher by 7K to 224,000. The unemployment rate was expected to remain unchanged at 6.3% but dropped to 6.1%. And average hourly earnings increased again by 0.2% on the month. Thus, the labor market report points to an acceleration of the US recovery after the GDP drop due to the weather in the first quarter. This has lifted the US stock market to new highs for the S&P and Dow Jones indices. Also the US dollar appreciated against the major currencies and the US dollar index rose. Furthermore, the US bond market declined and yields on the 10yr US Treasury note rose by to 2.64%. All these factors are usually negative for precious metals.

Stronger economic data is normally supportive for the price of crude oil as it indicates a rising demand. However, demand is only one side of the equation. It was developments at the supply side, which lead to falling oil prices. In particular the news that the Libyan government reached an agreement with rebels, who handed over ports with oil terminals, send the price of crude oil lower.

In 2013 and also in some parts of this year, a stronger US stock market was negative for precious metals. The rise of the PGMs could be well explained with a stronger economy, translating into higher demand from car makers, and the supply loss due to the strike in South Africa. But why does gold and silver now rise when the major fundamental drivers are negative?

First, correlations are not causations and many factors can have an impact on the relationship between two variables. This explains well, why correlations fluctuate widely if correlation is measured over a shorter time period like 20 or 30 days. There were also periods when the stock markets and gold moved in the same direction before.

Second, the behavior of investors is not constant. Their assessment of future performance perspectives changes. Also the perception of risk is variable. In 2013, investors were convinced that stock markets offer a better return outlook and they shifted funds massively out of commodities into stock markets. The precious and base metal prices declined from the levels prevailing at the start of last year. However, now, two developments have changed the outlook. Many investors get more cautious towards equities. The valuations do not look as attractive compared to last year. Volatility has dropped. This is often regarded as a sign of complacency by investors. However, fund managers are now aware that low volatility spells danger.

Analysts at the end of last year were predicting that supply of many metals would rise and would shift the supply-demand balance towards lower prices on average in 2014. In this blog, we pointed out for copper that the development of warehouse inventories were not compatible with the narrative told by analysts but also official organizations. Indonesia impost export regulations, which had a strong impact on the supply of some metals. Nickel was the first base metal reacting with rising prices. But also lead and zinc prices recovered during the first half. Now also copper recovered and is trading again above the 7,000$/t level.

Therefore, we conclude that an increasing risk-awareness towards equities and the improved outlook for commodities has induced investors to allocate again more funds into commodity markets. Unfortunately, the LME has delayed further the publication of data comparable to the “Commitment of Traders” report compiled for US exchanges by the CFTC. Thus, there is only data for copper traded at the CME available for base metals. At the start of the year, speculative investors were net long 10,363 futures contracts and by the end of the first quarter, this turned into a net short position of 32,975 contracts. But during the second quarter, the net short position was reduced significantly to 1,764 contracts as of July 1^st. In gold, the non-commercials were net long just 766 Comex gold futures at the start of June. Within one month, the net long position rose to 40,299 contracts, the highest level since early December 2012. Also the gold holdings of the SPDR Gold Trust ETF rose by almost 20 tons after hitting a low of 776 tons in late May.

If our conclusion about the behavior of large investors is correct, it has two implications for precious metals. First, firmer equities are not a reason to sell gold as some investors also buy gold as a hedge against the case that equities might reverse direction. Second, the improved economic outlook for the US and China leads to more funds flowing back into commodities. This is the kind of tight that lifts all boats. But as piano player Sam sung in the famous movie Casablanca: “Those fundamental things apply, as time goes by”. Thus, the stronger US recovery should lead to the first Fed rate hike in the middle of 2015 and rising yields will support the US dollar and weaken US Treasury paper. Both should weigh on precious metals and other commodities in the medium-term.