Metals reflect highs and lows of global activity

James Steel, the chief commodities analyst at HSBC in New York, talks to Vanessa Drucker about metal.

Q: What has been driving the price of gold and the other precious metals?


About a dozen factors influence the gold price alone. Some of them are complementary, some offsetting and some contradictory. Since June, we have had substantial declines in energy, grains and base metals. One reason is a revision in growth prospects, particularly in OECD [Organisation for Economic Cooperation and Development] countries. But in China, the marginal rate of commodity consumption is also moderating. In this atmosphere, gold and metals were hit by a general move out of commodities and back into equities – more a flow of funds than anything else – which was all the more pronounced because it occurred against a fall in the dollar.

Q: Has the dollar’s rise had a significant impact?


Yes. Our FX [foreign exchange] analysts say that the dollar’s recent rally is predicated not so much on the strength of the US economy, but rather the fact that other OECD economies are playing catch-up to the US in terms of economic data. So, more than a recovery in the US, we are experiencing deterioration in the other countries. The clouds have begun to gather over Japan and Europe. Our analysts are still supportive of dollar, for the rest of this year, especially against euro, and are even looking for a few further gains. We are predicting $1.45 to the euro for the fourth quarter of 2008, and into the first half of next year.

Q: Is revived jewellery demand propping up the price?


When gold got over $1,000 [£560] an ounce, and platinum over $1,800, jewellery demand contracted and gold bumped up against a ceiling. However, with gold back below $800, and silver and platinum also retreating, demand has bounced back up. The $800 level is enough to reinstill interest in price-sensitive jewellery buyers.

The jewellery market typically suffers an initial sticker shock. Then, gradually, the industry adapts to a new price structure. The market would remain sensitive to any price rise back over $900. In the emerging world, in addition to high prices, volatility restrains purchases. For instance, Indian housewives and merchants do not want to buy at high prices – but the real consumer backlash comes when they see they could have bought for Rs100 [£1.26] less. When price rises gradually, demand does not fall off as much.

Jewellery data for platinum is not as handy to come by. The platinum jewellery market functions as a safety valve. When the price goes up, usually because of supply disruption or increased demand from auto manufacturers, jewellery demand drops off. The converse happens if, as we are seeing now, an unexpected drop in auto demand occurs. The platinum price drops, jewellery demand recovers and absorbs the excess. Although jewellery is not the principal demand agent, it displays a higher degree of elasticity than automobile or industrial use (which is mandated by law).

Q: You mention the falloff in demand for catalytic converters.


Platinum and palladium fell even harder over the summer than gold. In addition to the negative effects from the general deleveraging out of commodities and the dollar rally, those metals have been hammered by a pronounced slump in the US for SUVs [sport utility vehicles]. The amount of platinum needed in catalytic converters varies dramatically among vehicle models, but the SUVs and the heavier sedans (with poorer gas mileage) have borne the brunt, as they use a disproportionate amount of platinum. Demand outside the US remains pretty good, though recent Chinese auto production figures have slowed, to only 8-10%, versus 15-20% forecast from the beginning of the year.

Q: Does inflation play a role?


Inflation by itself is positive for metals, but the story is more complicated than that. Gold reacts not so much to inflation as to anticipated monetary response. If inflation goes up in a slow growth environment – while, say, house prices are crashing, or unemployment is rising – the central bank may not be able to tighten.

That would be a positive case for gold. If inflation rises in a well performing economy, investors can be sure the monetary authorities will move to nip it, so you can expect gold to weaken.

Q: How low is low?


Commodities usually do not fall below the marginal cost of production, which in the case of gold is just over $700. Once it broke $800, I considered further declines would be limited. Mining has become expensive for a range of reasons, and marginal costs are rising fast.

Q: How do all the precious metals correlate?


Gold remains the driver of the whole complex. In a pronounced bull or bear market, silver and platinum move faster than gold because they are more thinly traded. Silver was becoming expensive for industrial processes. It is interesting that a lot of new applications for silver are being studied, such as in telecommunications and bioscience, which relies on its antibacterial properties.

For example, they have been using it in flackjackets for Iraq, since silver has properties that prevent infections from wounds. Until recently, the high prices had been deterring further investigation. The pullback will make it easier for industrial buyers to keep up demand.

Q: What are metals telling us?


The decline mainly reflects moderating economic activity. In the first half of the year, metals reacted violently to the upside in what appears to have been a bubble-like move. Commodities have lost their first bloom. The drop-off since March indicates that real assets do not always keep trading higher, even in the face of bad news.

We still have not seen a real recovery in credit, but the situation appears to be getting less volatile, if not exactly improving. So we expect the metals to remain at elevated levels, but not as high as we saw them. It has been a raucous year so far. One used to be able to count on a relaxed summer, but that has not been true.

We are putting a floor on the gold market now, somewhere well over $700. For the rest of this year, I foresee a gradual rally in gold, based on jewellery demand and a continued firming in commodity prices.

JAMES STEEL is HSBC’s chief commodities analyst with responsibilities for precious metals. Steel joined HSBC in May 2006. Steel also ran the New York research department for Refco, an American commodities brokerage house. He also worked for The Economist in the Economist Intelligence Unit covering commodity producing nations.