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MERRILL LYNCH & CO.
North Tower, 21st Floor, New York, New York
(September 18, 1997) METALS: PRECIOUS METALS–The bear market in gold continues to develop slowly but steadily with the spot price having touched $318 an ounce early in the morning of September 17. Most dealers look for a modest shortcovering rally over a three- or four-day period. The upside to the shortcovering rally, according to most of the traders we have spoken to, is probably around $322 or $323 basis spot. That will probably become the upper end of the trading range with $318 a bottom for the time being. But the downside target over the next few weeks looks to be $315 basis spot while an end-of-year objective of $300 is looked for by many observers including ourselves.
There is undoubtedly some central bank selling going on in the London market at present. Who the bank is and what tonnages are being done remain unknowns at this stage. But the market has been featured with a considerable be tightening in the gold forwards market. The high level of borrowing could not be purely producer related, dealers reason, given the good producer selling already seen and the producers' general desire to go out several years.
In the past we have often seen a bullion house borrowing gold from the market as it continues to sell for a central bank. Only when the sale has been completed does the central bank actually deliver the gold to the bullion house. The other piece of evidence pointing to some central bank activity is that one house usually associated with central bank selling in the past remains a very steady seller now.
We think it pointless to speculate as to which central bank is doing the selling. Frankly, it doesn't matter in our opinion. What counts from a market sentiment point of view is that there is still more evidence that central bank sales are no longer “one offs” but are a permanent supply feature to the market. Until quite recently, the market did not view central banks as a permanent supply source. But now central banks are perceived, correctly in our view, as a supply source that will be growing in volume over time.
Some observers like Gold Fields Minerals Services think the recent central bank sales may add up to some 200 tonnes. Total central bank sales so far this year, but excluding the current central bank seller, were estimated earlier this month by Crosswords Research and Consulting service to be at least 482 tonnes. If so, we could be looking at total central bank sales this year of over 600 tonnes.
Physical demand for gold has been very good until recently. But now there are signs of demand falling away rapidly in large parts of Asia. Indeed, we have seen consignment stocks sales coming out of some parts of Asia over the last few weeks. India is holding up well by all accounts. But overall, physical demand for gold seems to be slowing. So more refined gold should start to build up again at the refineries around the world.
This stocks build up at the refineries will start to exert more gradual downward pressure as well. The refiners obviously hedge all their stocks so their net short position should grow over time. Some big European refiners have been known to “actively” hedge their stocks from time to time to generate some revenue. They are more likely to be active sellers than they are buyers. They have a vested interest in selling physical metal, not holding it in their vaults!
Silver continues to struggle to break through the $4.80 level basis spot. Indeed, at present the market seems to be locked within a range of $4.80 to $4.50 basis spot. Virtually everybody in the market from bullion dealers to smelters and by-product producers now view silver as a raging forward sell when prices are above $5.00 an ounce basis spot. But the downside still remains quite limited with very strong Indian demand still a feature.
Platinum and palladium remain very steady markets with the Russians still remaining very modest suppliers after their six-months absence from the market. We know of several leading pgm traders who are now confidently talking about $300 an ounce palladium prices during 1998. We can't fault their logic. The Russians supply 60 percent of the world's palladium needs and some 25 percent of its platinum needs. But the Russians have now cut back their supply so sharply that prices are far more likely to rise further than they are to fall.
BASE METALS–We think the economic weakness in Asia will have a much more bearish impact on base metal price prospects than many observers currently think. The last week or two has seen pessimism grow about growth prospects in the Asian region for the rest of this year and for all of 1998. This pessimism is fully justified, in our view, for a number of reasons. The Japanese second-quarter GDP numbers showed the largest quarter-on-quarter fall for 23 years (down 2.9 percent quarter-on- quarter and up only 0.6 percent year-on-year.)
Lombard Street Research, a leading UK economic research firm, concluded from the figures that “the Japanese recovery has aborted again as it did in 1995.” LSR goes on to note that “...chaos in the South East Asian markets herald slower growth there, lower imports from Japan and tougher competition for Japanese exports. The U.S. will also be unhappy to see Japan's current account surplus back at 2.5 percent of GDP.”
The current situation in Japan is worse than in 1995. “The financial mess caused when the bubble economy burst has not been cleaned up.” LSR says. “While big banks are in better shape, smaller banks are struggling. Life companies and construction companies are in deepening difficulties. The `big bang' in fiscal 1998 will make matters worse. Time bought by the boost given to growth in 1996 from the large fiscal package has been wasted. The fiscal stimulus was withdrawn prematurely–and like stopping mortgage repayments before a house purchase is complete leading to repossession–has made a mess of public sector finances without clearing up the mess in private sector finances.”
“The government,” LSR concludes, “has few options left. It can't ease monetary policy further. It could cut corporation and income tax again, but is hardly likely to do so on the scale necessary with the budget already 5.4 percent of GDP in fiscal 1997. Its only hope is a further sharp fall in the yen, with American acquiescence in that the alternative could be a Japanese melt down.”
As the table shows, the importance of Japan and the rest of Asia in Western world metal consumption cannot be stressed enough.
|Share Of Asia In W. World Metals' Consumption In 1996 (%)
Japan Other Asia Total Asia Copper 13.8 19.8 33.6 Aluminum 14.4 15.7 30.1 Nickel 22.2 15.3 37.5 Zinc 11.6 20.1 31.7 Lead 6.5 18.4 24.9 Stainless Steel 18.2 21.7 39.9
The importance of Asia and particularly Japan speaks for itself in the numbers in the table.
In our view, China (their consumption figures are excluded from the table) is most unlikely to save the metal markets by buying up all the surplus metal created by slowing consumption in the rest of Asia.
The Chinese economy is rather slow this year and there are a number of signs suggesting that domestic supply of most metals is ample. Chinese imports of copper and aluminum are well down this year. Chinese copper consumption, for example, is estimated by CNIEC as being down 3.8 percent for the first four months of 1997 at 275,800 tonnes. Even more bearish is the CNIEC forecast that second-half refined copper imports from the West would be only 70,000 tonnes. Chinese imports of aluminum were down 86,000 tonnes for the first seven months of 1997 at only 92,000 tonnes.
Economists are worried about China's bulging inventories which are now running at about 6-7 percent of GDP. As a World Bank study reported recently: “China's economy over the past two years has undergone a sharp deceleration in aggregate demand, which has been accompanied by massive inventory growth, roughly 40 percent in real terms, four times GDP growth.”
Europe is unlikely to save the day either with vigorous growth. Germany and France will do well to maintain growth next year at this year's levels. American GDP growth is widely expected to slow next year as well with 2.5 to 2.8 percent being forecast versus recent annualized levels of nearly 4 percent.
In our opinion, the strongest period for base metal demand is now behind us. Demand will fall in Asia as growth slows. Demand in the U.S. and Europe should also slow next year. So it is very difficult to make out a strong bullish case for base metal prices. The momentum of economic growth has finally begun to slow for the world. So sideways to modestly lower prices are likely for most base metals next year, in our view.
But how low can copper prices go on this scenario? Cash LME copper prices are currently around 93.4 cents a pound. Prices could fall to below 85 cents a pound for a time. But we doubt that such low price levels would be sustainable for very long. Scrap sales would dry up rapidly at prices below 85 cents a pound and as scrap accounts for some 30 percent of total copper supply this would soon begin to stabilize the market.
In the short term, we rather doubt if prices will move much below the 90-cents-a- pound level. The Chinese tend to be scale down buyers from around 95 cents right down to 90 cents. There has been some light Chinese buying interest reported. But nothing very exciting. The Chinese are said to be making inquiries, we understand, with some integrated producers to buy refined copper directly from them. There are also reports that the Chinese are looking to buy more concentrate directly from producers.
Both of these moves would make sense for Beijing as Chinese buying practices on the Western world spot market in the past often pushed prices up against themselves because it was so high profile. Most of the copper buying we have seen recently has been North American or European.
The crunch time for copper prices should be in October. Will we see LME copper stocks start to fall again or will they continue to rise? If they start to fall, as many observers expect, then copper prices should stabilize in and around current levels. They might even rise towards the $1.00 a pound level for a time. But we doubt if demand will be strong enough to push prices much higher than $1.00 for any length of time. If, on the other hand, LME copper stocks go on rising throughout October and beyond, then we could be looking for 85 cents!
(Reprinted by permission. Copyright © 1997 Merrill Lynch, Pierce, Fenner & Smith Incorporated.)
Ted Arnold
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