Trading on global risk sentiment

AS IS the case across all asset classes, sentiment in the commodity markets hinges upon the belief, or lack thereof, in the ability of politicians and policy makers to find a solution to the European debt crisis. With no sign of a meaningful, long-term cure for Europe’s ills on the cards, cyclical commodities, like industrial metals and energy, suffered a broad downturn over the last quarter, while safe haven flows have driven a bullish trend in precious metals.

As the denominating currency of commodities, dollar strength has taken the edge off commodity gains. With the Swiss National Bank defending its currency and the constant threat of a major yen intervention by the Bank of Japan, haven flows into the dollar should drive its bullish run through 2012.

The short-term outlook for industrial metals rests upon the question of whether Chinese and other emerging market demand will be sufficient to negate the slowdown triggered by European economic woes. The market sentiment in the third quarter seemed to be that the fallout from the European crisis would lead to a global slowdown in infrastructure and industrial demand, triggering a broad sell off across the industrial metals. But as the GSCI index shows (above, right), we have seen commodities bounce back somewhat.

Through the fourth quarter, it is expected that China will make up for a European downturn – its inflation dropped in October to 5.5 per cent year-on-year, a 5-month low. Coupled with this, it is anticipated that we will see a program of easing from the Chinese government, boosting domestic industry and its commodity demand.

Copper is seen as a particularly correlated proxy for world infrastructure growth. With a tightness of supply, traders should look for strong and sustained gains in the red metal as supply lags increasing emerging market demand.

As long as there is market perception that China can mop up a drop in Eurozone demand, industrial commodity prices will be supported. However, a downturn in Chinese macro data will knock this confidence.

While industrial commodities are at the mercy of supply-side troubles, precious metals should be seen as a judgement of whether you think that we will see an end to global economic uncertainty. Over the last quarter, we have seen a closing correlation across risk assets, as well as currency devaluation through the inflationary policies of central banks, disincentivising investors from holding cash. Despite downgrading its outlook for other commodities, Goldman Sachs has upgraded its outlook for gold. And it doesn’t look like a difficult call to make. Gold is closely correlated with volatility as market uncertainty drives haven flows into the yellow metal. As Italian and Spanish 10-year bonds head above the 7 per cent mark and ECB open market bond purchases fail to gain any real, long-term traction, market volatility is unlikely to be tamed in the short to mid-term.

Driven by Fed manipulation of its fiat currency pushing down real rates – combined with European contagion worries – gold reached $1,800 earlier this month. According to Michael van Dulken, head of research for Accendo Markets, should the gold price break this point again, we may be heading for a serious bounce. However, he points out that in the short term, with the markets in such a nervous state, any macro headlines have the potential to cause a big price move.

Traders should bear in mind that gold benefits as a speculative position on market fear thanks to its scarcity and its lack of large-scale industrial demand. However, this benefit on the up side means that it does not have strong support on the down side – if the carpet is pulled out from under it, the down swing will be big and it will be fast. However, as long as there is market uncertainty and central bank manipulation of domestic money supplies, gold will be in demand.