Why the selloff in precious metals may be premature

Political uncertainty

The results of the EU referendum and the US Presidential Election may have passed but that doesnt mean the political uncertainty has evaporated. There are still many questions left unanswered about the UK’s relationship with the EU and Trump’s economic policies are likley to remain a source of guesswork for many months.

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Even more concerning are series of elections coming up in Europe. From the Italian referendum on the country’s constitution in early December to the French Presidential elections in April next year to the Dutch general election a month before. As WSJ highlight the biggest risk could come from a little known referendum law in the Netherlands that requires the government to hold a referendum on any law if 300,000 citizens request it. Dutch Eurosceptic parties now believe they have the means to block any further integration. They have already taken advantage of this law to secure a vote that rejected the EU’s proposed trade and economic pact with Ukraine, which Brussels saw as a vital step in supporting a strategically important neighbour.

Although you should be wary of the “law of small number” and the “gamblers fallacy” in drawing too much significance from a series of events there does seem to be an underlying trend towards populist uprisings in developed countries in the west just as perhaps the Arab Spring was the equivalent in the Middle East and North Africa.

At least one hedge fund manager is betting on the break-up of the EU. Hugh Hendry, founder and chief investment officer of Eclectica Asset Management said European politics posed the biggest market risk of 2017, with an impending French election the most likely trigger of fresh market ructions. Hendry said a parallel could be drawn with Britain’s withdrawal from the gold standard in 1931, when one key member leaving prompted others to follow. “Just one member leaves and it becomes extremely vulnerable.”

Market ahead of itself on inflation

Trump’s win has sparked speculation of a surge in inflation on the back of a big boost to infrastructure spending and protectionism, through higher demand in an economy already near full employment and the negative shock to supply that trade barriers would present.

Higher inflation expectations could prompt a more rapid increase in interest rates – hence gold’s surprise slump in recent sessions.

The markets may well be disappointed with the rate of increase in infrastructure spending in the US while for Trumps rhetoric over a war on global trade it appears much more likely that once in office he just limits his intentions to reducing the impact of the status quo rather than ‘building walls’.

There is a question mark over whether inflation may remain ahead of the yield curve – that is to say, whether it will rise faster than interest rates. If it does, real interest rates would be negative. This would trigger sell-offs of assets like bonds that are already in widespread retreat. Gold would thereby benefit.

The recent strengthening in US bond yields and the US dollar may be enough to slow the economy naturally to bring inflation expectations back in track. While the prospect of higher US interest rates may provoke another “Taper tantrum” in emerging markets that scares the Fed into delaying or smoothing the rate of interest rate hikes.

War on cash

Markets are likely to see support in the form of physical buying of precious metals. India’s crackdown on corruption resulted in 86% of the notes in circulation turning into worthless paper overnight. Although this may reduce the capacity of normal Indian’s to turn to gold it will be a warning sign to other countries citizens that their governments can and will resort to all measures to crackdown on corruption and to prop up their financial systems.

The risk: A sharp rise in bond yields

The main risk on the downside to this outlook is that global bond markets suffer a sharp selloff resulting in a spike in bond yields. According to SocGen “there is to our minds significant risk of a more disorderly repricing of global bond yields. Such a scenario could have very negative spillover, not least to emerging markets.”

 

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OPEC and the price of oil: Who will hold all the cards in the final game of Top Trumps?

The battle for market share in today’s oil market and the internal battle within OPEC is much like the 1970’s card game Top Trumps in which the aim of the game was to compare the numerical values on your opponents cards and then to try and trump and win their cards. The winner eventually declared when he or she had taken all the other players cards (more on that later).

But first, perhaps it shouldn’t have been a surprise.

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Just as the drop in oil prices completely wiped out all the gains since mid-August headlines reported that the cartel-like organisation was embarking on one final diplomatic push to secure a cut in oil production. Just two weeks before the group’s meeting in Vienna, Saudi Arabia, Iraq and Iran are still at odds over how to share production cuts.

It was back on 11th August that Saudi’s Energy Minister first suggested that the group would meet to discuss possible actions to stabilise the oil market. Ever since then whenever oil prices fell sharply on fears that the group would not live up to their promises and short positions in the futures market were at their most extreme, one or another OPEC representative would intervene to help buoy the market. And yesterday was no different.

See this analysis from Morgan Stanley prior to the latest round of verbal intervention.

OPEC can still spook markets. Although OPEC’s actions have not matched its words (i.e. promoting the need for production restraint while quietly growing production), the cartel has become adept at talking up declining markets. The group has repeatedly made bullish announcements about OPEC intervention during periods of low liquidity (e.g. US holidays), and whenever short positions become large. Despite the fact that many investors are skeptical of OPEC’s ability to change the outlook, prices still move on these headlines. Investors have proven that they are not willing to press short positions against OPEC, even if the odds of intervention are low. In essence, this is similar to the old adage of “Don’t Fight the Fed.”

We’ve highlighted before that you can only cry wolf so many times before the market loses interest. Surely they are going to have to follow through on their promises now or face losing all credibility while oil prices plunge?

Related article: Crying wolf: For OPEC talk is cheap

Earlier this week BMI published a note estimating a 45% probability of a “wait and see” stance and no deal on output cuts. This seems much too high.

First, OPEC would not have factored in Trumps’ victory in the US elections.

The short term impact thus far has been a strengthening in the US dollar which has also contributed to the fall in the price of oil, which if as many expect the dollar bull run has much further to run then the headwind to oil prices will intensify.

Trump’s victory puts Iran in a much weaker position now. If Trump tears up the agreement to remove sanctions from Iran then the ability of Iran to increase exports is weakened considerably.

Trump has also indicated that he wants the US to wean itself off Middle East oil completely. Although this is always likely to be completely impractical (many refineries are built to use just the type of crude oil that Saudi’s and others supplies) it presents a much more confrontational edge to the relationship.

Secondly, all OPEC members badly need higher oil prices to help reduce funding costs – from food shortages in Venezuela to an increase in the cost of insuring debt in Saudi Arabia.

According to PIRA failure to implement a deal could see prices fall as low as $35 per barrel, while $60 per barrel could be seen if the group is successful. BP, speaking before the latest verbal intervention were less pessimistic saying “You see that in the price,” he said. If the talks fail, prices “will stay around the level we’re at [~$43 per barrel].”

Finally, and most importantly they have to cut. Since first noting the groups attempts to try to stabilise prices OPEC has embarked on doing exactly the opposite, increasing output as much as possible so that when they do have to cut they are the ones holding all the cards. OPEC can’t keep playing this game of Top Trumps forever. If they don’t stop, their credibility will be shot and the game will just not be worth playing anymore.

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What does a Trump Presidency mean for commodities?

In a line – Risk off in the short term, but potential tailwind for commodities developing (particularly base metals and silver).

As Trump appears to have won the US Presidential race what next for commodities? Not surprisingly gold and silver have been the main beneficiaries, while crude oil and lead prices are the biggest losers thus far.

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Despite the shock, precious metal prices are still some way below the highs they achieved back in July. And perhaps here market participants have learned from the aftermath of the Brexit vote. After the initial shock its possible that Trump’s bellicose rhetoric is toned down and that the perceived negative impact on US growth and trade policy is not as bad as feared.

Remember that a drop in the US dollar is positive for commodities in general. Metal prices, particularly lead, nickel, copper and silver benefit from a fall in the dollar.

What are the medium to longer term impacts?

Oil / Natural gas: Oil prices have dropped sharply on the news. Attention will now turn to OPEC who will be under a lot more pressure now to deliver something meaningful at their late November meeting. Longer term, although keen energy independence Trump may take a much stronger tone with Iran and other parts of the Middle East.

As Trump expands support for the USA’s coal industry the switch towards higher gas consumption is likely to stall, while an increased focus on energy independence could see higher natural gas supply.

Industrial metals: If growth in the US slows it will be negative for industrial metals like copper and aluminium as demand from construction and automotive sectors slows. However, calls for more infrastructure spending could be a boon for metal demand as the country’s aging infrastructure is updated.

Energy metals: Trump has surrounded himself with advocates for traditional energy sources and climate change skeptics. This may lead to reduced investment in renewable energy sources in the US and electric cars. Together this may reduce demand growth for ‘energy’ metals such as lithium, cobalt etc.

Agricultural: Commodities like sugar, coffee and soybeans are likely to fair the worst as emerging market currencies like Brazil’s fall against the US dollar. A fall in their currencies increases the incentive to export.

Although the uncertainty over Trump’s Presidency is likely to mean the prospect of an interest rate hike is off the table in December, interest rates may have to go up much further than people realise in the longer term. The drop in the US dollar combined with expansionary fiscal policies could mean that inflation jumps much higher. Again, Brexit provides a snapshot of where the US could be with rising input pressures.

Worth remembering also that longer term most commodities typically do worse on average under Republican presidents, grains including corn, wheat and soybeans tend to do better under Republican presidencies.

One final observation. Market attention will now turn to the Italian referendum on 4th December. The populist movement may not be done just yet.

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