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JP Morgan Bullish On Gold, Bearish On Base Metals

Commodities | Jun 26 2006

By Chris Shaw

Do increased global interest rate expectations spell bad news for demand for (and thus prices of) commodities?

According to JP Morgan the answer depends on what commodity you are referring to, as in the broker’s view the outlook for gold remains very positive. The broker believes, however, the story for base metals is different.

Its negative view on the base metals is based on the likelihood of slowing demand growth, thanks to a combination of weaker US growth and the impact of demand destruction thanks to higher commodity prices.

Supporting the broker’s view is the recent downturn in its Global Purchasing Managers Index (PMI), which historically has provided a good guide for Global Industrial Production, which in turn has provided a good guide to the direction of metal prices.

The broker notes while growth in China continues to be strong it is not being supported by other regions, as G3 growth appears to be slowing in response to ongoing central bank tightening. The US economy is also giving an early indication base metal demand may fall, as the broker notes both the auto and housing sectors, which require large amounts of various metals, are showing signs of turning down.

Not helping is the emergence of inflation, as while an inflationary environment is good for metal prices, the move to higher interest rates to counter the trend is likely to slow economic growth globally, in turn reducing demand for the metals themselves.

Believers in the "Supercycle" thesis can point to low inventory levels as supportive for prices going forward, but the broker is not convinced of such an argument. Nickel provides an example, as the broker notes the price has moved lower in recent weeks even though LME stockpiles have also fallen.

JP Morgan explains this by noting the lower official stockpiles are simply a reflection of re-stocking by stainless steel producers, meaning supply is not as tight as official figures make it appear. The broker expects supply to increase by 4-5% as new projects come on stream, an amount enough to match demand growth and so reduce the potential for price increases thanks to a tightening in the market.

Leading nickel producer Inco last week issued a bullish outlook on the sector, but the company’s assessments have met sheer skepticism in the market, including from the likes of Citigroup analysts Alan Heap, a proud promoter of the Super Cycle thesis.

Inco said its revised global market balances feature a 30kt supply deficit for 2006. Heap’s forecast is for a 30kt surplus for 2006, to be followed by a 8kt deficit in 2007.

However, Citigroup’s resources expert also believes the primary driver of the nickel price is not its fundamentals, but the nature of ongoing aggressive speculative activity.

In contrast to the (potentially) worsening demand environment for the base metals, JP Morgan believes the gold market outlook continues to improve. Demand continues to strengthen (even if only for one-off events such as the establishment of gold Exchange Traded Funds or ETFs), but this stronger demand is not being met by higher supply thanks to declining production from South Africa in particular. This means central bank selling is required to meet the shortfall, but the quantity of this selling is limited under agreements in place between the banks.

At the same time, the broker takes the view demand could increase further if there continues to be concerns over the future direction of the US dollar, as a weaker greenback is often associated with higher gold buying as investors chase a safe haven. There has also been significant talk over the past year or so of holders of substantial amounts of US dollar foreign reserves looking to diversify their holdings, with gold given as a possible alternative.

The final point in gold’s favour is the market is characterised by less significant swings in inventory than occur in the base metal markets, particularly as gold is generally very widely held. This contrasts with the base metal markets, where speculators have been regarded as responsible not only for pushing prices higher but in accentuating the recent falls as they reduce their positions.

Commodity specialists at Barclays Capital flagged over the weekend they were likely to reduce price forecasts for base metals following the decision by Barclays economists to increase their US interest rate forecasts.

Barclays remains confident regarding its price forecasts for energy and agricultural resources.

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