Material Matters: Base Metals, Gold, And Commodity Currencies

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 – Is the current base metal rally sustainable?
 – RBS offers preferred exposures for 2012
 – ANZ updates its gold market view
 – Link between euro and commodity markets weakening

By Chris Shaw

As Barclays Capital points out, base metal prices have started 2012 very strongly. Prices are up an average of 11% so far this month, enough for the base metals sector to be the best performed among commodity markets year to date.

Barclays suggests some of the increase in base metal prices is simply an adjustment to weak performance in the latter months of 2011. Also contributing to gains has been better than expected macro data in the early weeks of this year, which has allowed for a slight softening with respect to concerns over a global recession.

Also supportive to prices have been falls in LME inventories, especially in the copper, tin and lead markets. As well, forward indicators are suggesting a slowdown in global metals demand growth should soon stabilise.

This has been enough to prompt some short-covering in the market and the strength in prices this month leads Barclays to suggest if global growth momentum continues to improve across the course of 2012, industrial metals could be major beneficiaries. 

But without enough appetite for new longs to enter the market, Barclays cautions the current rally could run out of steam. To reflect this Barclays remains of the view current optimism remains dependent on event risks, leaving markets vulnerable to any negative shocks that may emerge. 

Macquarie is similarly questioning the sustainability of the recent rally in base metal prices, taking the view the price gains are not fundamentally warranted. This is especially true for aluminium, zinc and lead.

Anecdotal evidence suggests to Macquarie the rally has largely been driven by fund flows, representing a positioning rally that began with short covering in a number of markets. There has been evidence of some new longs entering the market, but for Macquarie the key to any sustained rally remains China.

This makes the return to the market next week of the Chinese after New Year celebrations of much significance, with Macquarie intending to closely watch physical premiums for any indications of the level of activity of Chinese buyers.

In copper specifically Macquarie notes there are some fundamentals supportive of higher prices, such as a strong rise in imports into China in the final quarter of 2011 and a recent rise in cancellations of copper stocks from warehouses in the US.

But Macquarie argues these positives have become exaggerated as some of the imports into China are understood to have gone to stocks and not consumption, while not all LME stock cancellations have been due to higher end market demand.

In contrast, Macquarie takes the view the rally in nickel prices has been more reasonable on a fundamental basis. This is because Chinese nickel pig iron production fell sharply late last year and stainless steel production is typically the strongest in seasonal terms in the first half of any calendar year. 

Tin price gains also appear more fundamentally reasonable in the view of Macquarie, as the market for this metal continues to run in deficit and LME stocks are now around three-year lows. Monsoons make Indonesian supply vulnerable at this time of year, while tin demand also tends to be seasonally stronger in the first quarter of the calendar year.

For RBS, the key point in commodity markets is the issues from 2011 of slowing Chinese growth and the EU debt crisis have not yet gone away. This means investors still need exercise some caution in terms of any exposure to the resource sector.

This is based on the expectation global economic growth will come in at around 3.4% in 2012. This estimate factors in a recovery in US growth from 1.8% in 2011 to 2.6% in 2012 and in Japan to 1.8% from minus 0.8% last year. Recessionary growth in the Eurozone of around minus 0.4% is expected in 2012, while growth in China is forecast to slow modestly to 8.5% this year from 9.1% in 2011.

Under such a scenario, RBS favours exposure to copper for the metal's ongoing supply shortfall and to aluminium given current cost curve support. While all precious metals appear attractive at present, RBS is particularly attracted to platinum and palladium.

Bulk commodity prices should remain elevated relative to historical levels in coming years, but RBS doesn't expect any near-term return of the pricing tensions seen in 2010/11.

Key picks for RBS for 2012 are those quality miners with cheap valuations, strong balance sheets, production growth and an attractive position on the cost curve. Such stocks allow for some hedging on the part of investors, as such stocks should benefit in any recovery while remaining somewhat protected in the case of any further downturn.

From a sector perspective RBS suggests remaining overweight gold and the diversified plays in the shorter-term, while looking to increase exposure to pure plays somewhere around the middle of this year.

Among the diversifieds, BHP Billiton ((BHP)) and Rio Tinto ((RIO)) are regarded as cheap and both are rated as Buy by RBS. While BHP is seen as more defensive, Rio Tinto offers greater upside potential over the longer-term.

Among the pure plays, RBS prefers those offering leverage to a recovery, which means Fortescue Metals ((FMG)), Atlas Iron ((AGO)), Alumina Ltd ((AWC)), Lynas Corp ((LYC)) and Iluka ((ILU)). All are rated as Buy with the exception of Iluka, where RBS has downgraded its rating to Hold from Buy given recent share price gains. Medusa Mining ((MML)) is RBS's preferred pick among mid-cap gold exposures.

Among resource stocks under RBS's coverage Buy ratings are also ascribed to Alkane Resources ((ALK)), Gindalbie Metals ((GBG)), Grange Resources ((GRR)), Independence Group ((IGO)), Iron Road ((IRD)), Kingsgate Consolidated ((KCN)), Mount Gibson ((MGX)), Newcrest Mining ((NCM)) and OceanaGold ((OGC)).

In gold, the US Federal Reserve's guidance that monetary policy would remain highly accommodative through to at least late in 2014 and of a willingness to embark on QE3 if needed has been a positive for the price of the metal, as gold has rallied by more than 10% in less than a month.

In ANZ Banking Group's view the combination of low rates, the chance of quantitative easing and a weaker tone for currencies including the US dollar is a positive one for gold. Also supportive is any easing in monetary policy in China and India, as this will reduce the opportunity cost of holding gold.

As a result, ANZ suggests there is now the risk of upside revisions to a current gold price target for 1Q13 of US$1,900 per ounce. As gold trading in recent sessions has cemented a more positive outlook, ANZ sees potential for any continuation of the retreat-rally pattern seen over the past two quarters to push the gold price to US$1,780 per ounce by early in March.

One risk is quarter-end selling from hedge fund redemptions. To account for this risk ANZ continues to forecast a gold price at the end of 1Q12 of US$1,650 per ounce. 

In terms of the links between currency and commodity markets, Macquarie notes the euro was the major driver of metal markets in the latter stages of 2011. But in more recent sessions while there has been a large increase in speculative short interest in the euro, positioning in metals has not been as definitive as the shift in views on the currency would suggest.

This implies either a significant divergence of expectations between commodity and currency traders, or that a view on the euro is no longer as important to investors. The latter implies the problems in Europe may prove to be less significant for commodity prices going forward.

Supportive of this view is that commodity currencies such as the Brazilian real, the South African rand and the Australian dollar have recently shown more positive momentum despite a lack of any direction from the euro. To Macquarie this is another important sign the problems in European-driven currency risks are a diminishing concern for those interested in commodity markets and emerging market currencies.

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