Physical gold to keep on outperforming, less optimistic on metals --BMO

BMO Research suggests commodity markets may be re-energized soon after the G7 economies start to emerge from their slump in the latter part of 2009.

Author: Dorothy Kosich
Posted: Thursday , 11 Dec 2008

RENO, NV -

Noting that physical gold has outperformed "virtually every other asset class on a relative basis," BMO Capital Markets Bart Melek advises the trend will "likely stretch well into 2009."

Nonetheless, BMO Global Commodity Strategist Melek counseled that the relatively strong U.S. dollar and the prospect of global disinflation "have made BMO Research somewhat less optimistic about the prospects of the metal in the first half of 2009."

"A modest turnaround in valuations should begin once markets start seeing better economic times ahead. The change in market outlook should yield better metals and gold prices as well," he said. Investors should look for signs of an economic bottom, slowing inventory growth and rising long-bond yields (an end to aggregate price declines) as signals for better times to come for metals, gold, bulks and material-based equities."

"Investors' eventual emergence out of the current panic mode (which is driving capital into treasuries and the U.S. dollar) and the end to the central bank interest rate cutting phase should see the greenback weakening," Melek suggested. "This should help propel gold to an expected $900/oz by the end of 2010."

"Other supportive factors include the possible monetization of the U.S.'s massive public debt obligations and the deficiencies present on the balance sheets of American banks, and rising physical demand coming from the developing world," he added.

COMMODITIES

"Deteriorating economic conditions across the world are expected to keep commodities under considerable selling pressure into 2009 due to poor demand prospects, with only a modest turnaround occurring in the later part of the year," Melek advised. As a result, "BMO's short and medium-term commodity price forecasts were recently lowered, as were expectations for the underlying equities."

Melek called "this latest brutal base metals price correction has been the deepest and swiftest in the post-WWII era, 25% more severe than the peak-to-trough low reached 20 months into the 1974 recession. Mining equity valuations have also posted the sharpest and fastest decline in the last five cycles,"

Meanwhile, he noted "the lack of trade financing owing to the credit crisis is exacerbating the impact of a slower global economy on commodity demand."

Nevertheless, Melek asserted there is light at the end of the recession tunnel. "Fundamental strength on the demand side (China, the developing world), elevated cost structures, shortages of equipment and skilled labour, and the credit crunch reinforce the BMO Research thesis that metal prices are not likely to stay depressed for a prolonged period."

"BMO Research expects that commodity markets may be re-energized soon after the G7 economies start to emerge from their slump in the latter part of 2009. The end of consumption declines in the U.S. and Europe will no doubt start tightening supply/demand balances that will have likely formed during the recession."

Melek asserted the "correction for many commodities seems overdone. The prices of many metals are materially below the marginal costs of production, with more than estimated 80% of nickel and zinc, 60% of aluminum and 30% of copper producers currently underwater. "

"Furthermore, this effect is not limited to the base metals and can be seen in the case of platinum as well," he suggested. "This implies a considerable rebound once the global economy turns, as it is not possible to operate in an environment where prices are below the cost of production over the long term."

"Extreme conditions in capital markets, strategic behavior ...political risks, logistics, electricity constraints around the world and other supply-side rigidities could mean that many currently proposed projects may never materialize," Melek advised.

However, he added, "The market for many bulk and metal commodities could operate in an ‘auction pricing' mode (bringing prices back near cyclical highs), as opposed to a ‘marginal cost' mode under a balanced market situation once the global economy moves toward potential growth again-yielding significantly higher prices than the base scenario dictates."

Nonetheless, Melek said the outlook carries considerable risks.

"There are credible concerns that the current G7 slump may deepen and that recent government (and central bank) attempts to recapitalize banks along with sharp interest rate cuts will do little to reverse the negative trend in the short term, leading to materially lower growth in China and an even grimmer demand outlook for everything ranging from copper, to metallurgical coal, to oil," he concluded