This analysis is by Bloomberg Intelligence analysts Mike McGlone and Andrew Cosgrove. It appeared first on the Bloomberg Terminal.
Steady metal prices to start 2018 should translate to further gains by year-end. They needed to pause after gaining 21% last year, as measured by the Bloomberg All Metals Total Return. With a strong history of backing up into Federal Reserve rate hikes and recovering thereafter, the inevitability of a 25-bp hike in March is a primary suppressant. Yet it will be past tense by the end of the month, and favorable fundamental and technical drivers should prevail.
Neck-and-neck with the stock market in this rate-hike cycle, metals have a firmer foundation than equities. Some back-and-fill in the primary industrial metals — copper and aluminum — should eventually resume the bull trend, following nickel and zinc. Gold is about as trend-ready as it gets, with limited directional options other than higher.
Recovery from VIX lull favors metals
Metals are neck-and-neck with the stock market in this tightening cycle, but should gain in relative value. The Bloomberg Industrial Metals and S&P 500 Total Return indexes are both up more than 40% since the first Federal Reserve rate hike in late 2015. Metals are still down about a third from the 2011 peak, with primary drivers pointing positive — global PMI, a weakening dollar and demand exceeding supply. A primary risk to broad metals is some mean reversion in historically low stock-market volatility.
Continued recovery from the longest-ever lull in the CBOE SPX Volatility Index (VIX) favors the metals, notably precious. 2018 may mark the transition year to physical from financial assets as inflation recovers.
Metals’ primary pillars are pointing positive
Leading metals companions — the dollar and China’s purchasing managers’ index — remain supportive. The latter is hovering at seven-year highs. With a 20-year annual positive correlation of 0.77 to the Bloomberg All Metals Total Return Index, China’s PMI is about the inverse of the trade-weighted broad dollar (negative 0.7). A declining greenback vs. an accelerated pace of interest-rate hikes is indicative of a longer-term peak.
The rest of the world catching up to increasing U.S. rates signals a weaker dollar and stronger global economy — notably positive for industrial metals. We find the most favorable industrial-metals demand vs. supply conditions in 12 years. It’s similar for precious metals, where the dollar is the primary driver.
Nickel, zinc and gold let copper, aluminum rest
A resting bull is the 2018 metals takeaway as strength in minor industrials offsets weakness in the major types. Aluminum and copper, down about 4% this year, reflect consolidating bull markets. Favorable demand vs. supply, improving global PMI and GDP and the weakening dollar indicate the Bloomberg Industrial Metals Subindex Total Return is likely to add to its 29% gain of 2017, but after resting a bit. Gold up vs. copper and silver down is a negative indicator that gains credibility with mean reversion in stock-market volatility.
Indicating some supply constraints and improving industrial demand, nickel and zinc remain the stalwarts. Nickel appears to have greater relative appreciation potential vs. its corrosion-resisting cousin, reflecting its substantial price discount and favorable demand vs. supply balance.
Shades of 2004 for industrial metals foundation
Industrial metals’ situation is similar to 2004, just before a substantial rally and with technical and fundamental indicators almost a mirror image. Our analysis of World Bureau of Metal Statistics (WBMS) demand vs. supply data shows that the ratio is its highest in 12 years. The trade-weighted broad dollar’s peak last year almost matched the high of 15 years ago. Similar to the end of 2003, the Bloomberg Industrial Metals Spot Subindex in 2H17 broke above its 100-month moving average, followed by the 12-month mean this February.
Consolidating at the 2H12 price peak, 2011’s highs (more than 20% above the end-of-February levels) appear in play. What it might take to reverse these bullish trends is the greater quandary. The 12-month average, about 10% lower, is initial support.
Gold primed for upside, breakout spark
The primary positive drivers ripen gold for a breakout higher since the metal bottomed with the December 2015 start of the rate-hike cycle. The dollar then peaked at the end of 2016, and the VIX appears to have scraped bottom. At the same price vs. June 2013, gold’s 52-week Bollinger Bands have compressed to the narrowest range in 13 years, giving it fuel for an extended increase. September 2005 was the last time the market was as tightly coiled.
That consolidation period preceded the previous VIX trough (2007), culminating in a 340% gold rally to the historical peak of $1,900 an ounce in 2011. The VIX’s (started in 1990) historical correlation to gold isn’t very strong, but there is no precedent for recovering from the lowest-for-longest ever.
Continued role reversal favors gold vs. Bitcoin
Gold is about as ripe to break above its 52-week mean as Bitcoin is to rejoin its own. Fed interest-rate hikes have been consistent catalysts for gold bottoms and Bitcoin peaks. The most recent in December has resulted in the most extreme post-hike decline for Bitcoin, 59% to the Feb. 5 low. It likely marked a longer-term peak with the launch of futures and frenzied activity. On the other hand, gold has been locked on its 52-week mean for the longest run and narrowest range in over a decade.
Tightening, the opposite of quantitative easing, which is a mantra of cryptocurrencies, is a legitimate reason for their decline. Inflation is a primary reason for tightening and a valid cause for gold to rally. The breakneck crypto supply should continue to favor gold.
Gold vs. silver indicates VIX bottom
If the VIX has bottomed, gold is favored vs. most assets, notably copper and silver. The potential for mean reversion in the world’s benchmark for stock-market volatility, likely recovering from its lowest-for-longest level in almost three decades, should be a primary determinant of gold’s performance relative to most other assets. Still below the previous trough from 2007, a bottom in the VIX 52-week mean would validate similar from June for the gold-to-silver ratio.
Gold has more potential to gain vs. copper on a bottoming VIX. Since 1990, the annual VIX correlation is 0.62 for the gold-to-copper ratio vs. 0.50 for gold-to-silver. With copper halting at the halfway mark of the 2011-16 bear market, gold is poised to take the rally baton. A bottoming VIX would be a primary catalyst.
Crude oil is back at key levels favoring gold
Gold relative to crude oil has backed up into the key support zone, favoring the metal. It takes almost 21 barrels of crude oil to buy an ounce of gold, just below 2016’s low and slightly above the 2015 trough. Hampered by steep contango the past few years, United States Oil Fund (USO, the largest ETF) is now supported by backwardation. Yet WTI crude above $60 a barrel is quite extended. SPDR Gold Shares (GLD) vs. USO is near the key 2016 low support level.
Reflecting the inverse nature of energy ETFs vs. prices, 2018 outflows at $1.3 billion about match all of 2017’s. When including money that has flowed out of long and leveraged natural gas and oil ETFs or into shorts (the delta exposure), outflows are closer to $2.8 billion.
More from the Bloomberg Commodity Outlook: March 2018