Why base metals may likely outperform gold in 2011

In its Q3 Metals Review, Natixis says gold and silver are likely to underperform next year while base metals should regain some of their lustre

GRONINGEN - 

After rising rapidly to record highs in April, base metal prices fell heavily in the second quarter. This was largely a result of the looming sovereign debt crisis in Europe, concerns that Chinese growth was slowing and, exacerbated by emerging fears that the US might be heading toward a double dip recession.

At the same time that base metals were declining so gold was rising strongly for many of the same reasons, and in late June hit a new all-record of $1,265 an ounce.

However, in its Q3 Metals, Review, Natixis argues that during the course of July, many of these concerns have ameliorated or been priced into the market, which during July has seen base metals trending higher, from the depressed levels of early June.

Gold, however, has been declining in June, and the Bank writes, "We believe there is the potential for further weakness. With the increase in supply and suppression of fabrication demand at current high prices, this requires a constant stream of investment inflows to balance the market.

"Critically, we feel that the arguments supporting investment are steadily being eroded.  The sovereign debt problem is slowly becoming less of an issue, or is already priced into the market, and as such the need to hold gold as an alternative safe haven asset is being progressively reduced.  Another bearish factor is producer de-hedging, which having averaged around 350 tonnes a year for the period 2006-09 is set to fall to trivial levels due to the much reduced scale of the outstanding hedge book," it says.

 On the base metals side, however, says Natixis, the recovery in demand has been stronger-than-expected and is largely the result of three factors: "fiscal and monetary stimuli, growth in demand from developing countries, and capital spending by a strengthening corporate sector".

The first of these factors the bank writes, is likely to diminish in importance as the second half of 2010 unfolds. But, it adds, "Although many developed countries maintain that monetary policy will remain abnormally loose for a protracted period, the extremely expansionary fiscal policies enjoyed over the past year will progressively move into reverse, especially in those European countries that left themselves in the least sustainable fiscal positions. Consumers, particularly those dependent upon the state for some or all of their income, will be forced to retrench, meaning that household spending will remain a drag on growth in the immediate, if not foreseeable future."

In terms of the second stimulus factor, the group says that developing market growth these days is no longer just coming from China, "In 2010, the developing country growth story has broadened to the point at which "BRICs" seems an unnecessarily narrow description, in that it leaves out fast growing economies such as Indonesia and Turkey," it writes. However, it does acknowledge the importance of the Chinese market and adds that the revaluation of the Yuan, even though it has resulted in only a minimal appreciation in the value of the currency so far, is unambiguously positive for the global economy and also good news for "productive" commodity prices.

It writes, "In the run up to the revaluation, Chinese investors had an incentive to hold store of value assets such as gold instead of dollars. Now that revaluation is underway, the gradually increasing purchasing power of Chinese users of commodities will slowly boost the dollar denominated prices of the more productive commodities such as energy and base metals".

The third factor, Natixis says, is becoming increasingly important because, "Thanks to the largesse of governments and the sustained spending by households during a period of corporate cost-cutting, both company profits and cashflow are currently in excellent condition. This places the corporate sector in an ideal position to lead the economic recovery through investment in restocking inventories and renewal or replacement of the economy's capital stock."

However, while the group believes that there is a strong bullish case for the base metals complex, it does acknowledge that there are some risks to such a forecast. As it points out, "There is a great deal of economic uncertainty in all the major metal consuming regions, and given the interdependence of these economies, it may only take a downturn in one region to start off a "domino effect". Europe is probably still top of the list given the possible contagion from the sovereign debt crisis, although the resultant weakness of the Euro has also provided a substantial boost to Europe's manufacturers.

"Going forward, a new risk toward lower demand is the potentially excessive fiscal tightening as governments belatedly try to address their huge budget deficits. Similar arguments can be applied to the US economy as the fiscal stimuli gradually expire, with the potential for dollar strength against the euro to have a negative impact on US growth. These outcomes could easily result in a "double-dip" recession among western economies."

While such a scenario, would also be good for gold, the group admits, it adds, "Although there is the possibility of a sharp correction from current levels, one of the lessons of this cycle has been that periods of price weakness tend to be much shorter than in previous cycles. This reflects the more price elastic supply response, the greater willingness of fiscal and monetary authorities to contemplate unorthodox policies to sustain economic growth, and the massive influence of investment activity from long term investors (pension funds) and more speculative investors (hedge funds)."

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