Product Flash - March 23, 2020 -

Coronavirus: impact on the precious metals market

The markets are feeling very nervous and equities are taking a battering, so some investors are looking to protect their savings by turning to "safe haven" assets.
Gold may appear to have been a disappointment in recent weeks, with its year-to-date performance now lying in negative territory. The same goes for silver and platinum-group metals, which have tumbled.
What are the factors driving prices down? How have they affected the OFI Financial Investment - Precious Metals fund? What can we expect in the coming weeks and months? Here we offer some insight.

Precious metals performances and impact on OFI Financial Investment - Precious Metals

The OFI Financial Investment - Precious Metals fund is 35% exposed to gold, 20% to silver, 20% to platinum and 20% to palladium. At 19/03/2020, on a year-to-date basis, gold was down -3.26%, silver -32.60%, platinum -39.12% and palladium -19.77%.
There are technical reasons for the slump which might continue to apply for a few more days. First of all, the end-February expiration of gold options in the USA appears to have led to sales of forward contracts aimed at pulling gold prices down below the threshold of $1,650/ounce at which large positions had been opened. At the end of trading on Monday 24 February, we saw a sell order for 3 billion dollars placed on the market.
Market mechanisms then kept yellow metal prices under pressure. The CME (the clearing house for precious metals futures trading) announced increases in security deposits for the gold and silver markets, first on February 27 and then again the following week. This is a routine measure as higher volatility in recent days has raised the level of risk. The clearing house has factored this in and is calling for larger deposit amounts to guarantee that the trades it registers are completed successfully.
This decision has major consequences. All leveraged speculators are having to downsize their positions. And with each contract requiring a larger deposit for a given amount, the number of contracts that any one investor can hold is lower.
In addition, falling oil prices have had an indirect impact on precious metals prices. The long-standing dispute between Saudi Arabia and Russia about potentially reducing output to stabilise oil prices has dragged the price of black gold down very rapidly. With oil prices plummeting, lots of investors exposed to commodities through the big diversified commodity indices (the most well-known being the GSCI - Goldman Sachs Commodity Index and the BCOMM - Bloomberg Commodity Index) have liquidated their allocations. The big indices are also exposed to precious metals, triggering another drop in precious metals prices.
Today’s situation closely resembles that of 2008. When the equity markets first started to drop (in October 2008), clearing houses issued margin calls for all asset classes in order to cover their positions, forcing investors to liquidate some of their portfolios. Naturally, investors first of all liquidated their satellite positions, beginning with those that still offered capital gains, in order to pay for these calls for additional deposits. This is typical of what is happening to gold today.
In addition, the correction has been more brutal in the equity and fixed income markets, so asset allocation managers have found themselves with precious metals accounting for a larger share of their portfolios. Some have decided to sell part of their precious metals positions in order to maintain the same allocation weightings in their portfolios.
The Financial Times asserts that some wealth management clients have had to sell gold and silver positions in order to pay for margin calls on so-called Lombard loans (loans secured against equity portfolios).
The consequence of all these technical factors combined is that gold has dropped, as it did during the first phase of the equity slump in 2008. Back in October 2008, gold futures slid by more than 18%. But the price of gold then began to recover very rapidly, gaining around 30% between end-October 2008 and end-January 2009. All in all, gold delivered a performance of over 10% in full-year 2008 whereas equities ended the year down by more than 42%.

The same mechanism may apply this time around. So the question is where all of this will take us. In an attempt to work this out, we can refer to the weekly Commitment of Traders (COT) report published by the Commodity Futures Trading Commission. This report is published at the end of each week and shows the trend in positions held by futures traders up until the previous Tuesday. In the most recent report published at the weekend, the figures (at March 17) showed that speculative positions had decreased sharply for silver (-66% versus the highest net position of the last 52 weeks, down 20% over the week), platinum (-78%) and palladium (-94%). On the other hand, gold positions remained high (-31% versus the highest net position of the last 52 weeks), which might suggest that there is still significant potential for liquidation. However, the historical data appear to indicate that a support level for the number of open positions on gold, of at least 100,000 lots, has applied since 2015. So, even for gold, the downside potential now seems limited.

Silver: Managed Money Position

The liquidation of precious metals positions may therefore peter out soon, since speculators now have only limited exposure.

What the physical market tells us

If the downturn is essentially due to technical and financial factors, then the physical market ought to send out different signals. And this is indeed the case today.
As far as silver is concerned, the U.S. Mint announced a few days ago that it had sold out of American Eagle silver coins owing to a surge (+300%) in demand in March relative to the previous month (click here).
We can see some encouraging signs on the gold market. First of all, coins and bullion are currently trading at premiums above the price of gold, which is what happens during periods of strong demand. Moreover, these premiums are getting wider and wider. A Swiss refinery informed all its clients yesterday that it would raise premiums on ingots of 100 grams and 1 kilogram by 20%. This now corresponds to a premium of $1.80 per ounce for such trades (click here). Refiners have thus had to step up their production rates and increase their staff in recent weeks to keep up with demand.
In addition, a rumour had been bandied about in Switzerland in recent days suggesting that Swiss refineries (among the biggest in the world) might decide to shut on account of the coronavirus. This was confirmed yesterday, with several Swiss refineries announcing their closure as from this week. In these circumstances, premiums on physical gold could widen further.
On the other side of the pond, the Royal Canadian Mint also announced that it was halting production. But, without any doubt, the biggest news from the physical gold market last week was that trading of Napoléon was being suspended in France for the first time since this market was created, the reason being insufficient supply! (click here)
Last of all, gold ETF trading levels also look rather reassuring. Despite recent events, gold holdings by ETFs are at a historical high on a monthly basis and less than 2% below their historical high on a daily basis.

Total Gold ETF Holdings

So positions are not being liquidated on the physical market, in contrast to what we are seeing on the financial market. This suggests that sooner or later, once liquidations have petered out, gold and silver prices will begin to pick up ahead of futures.

What to expect now?

If these technical factors are indeed responsible for the slight dip in precious metal prices, they do not undermine the market’s fundamentals which are getting steadily stronger. The concern caused by the current health crisis is boosting demand for bonds, which are considered less risky, thereby putting downward pressure on interest rates. It is worth noting that lower interest rates offer the best support for gold, which is a yield-less asset. The US Federal Reserve’s decision to lower interest rates twice by a total of 150 base points, outside of its usual meetings, has led to a steep drop in nominal interest rates. Real interest rates, meanwhile, have so far decreased relatively little as inflation expectations have been slashed.
But monetary easing, quantitative easing, fiscal stimulus plans (which are bound to be announced) and even the use of helicopter money (whereby money is distributed to individuals directly) are measures capable of pushing real interest rates even lower.

These favourable conditions have prompted three major banks to revise their gold forecasts in recent days. Goldman Sachs sees gold climbing to $1,800/ounce within the next 12 months, while Citi and Deutsche Bank say gold might possibly reach $2,000 within the next 18 to 24 months.
Bear in mind that, in previous crises, gold has generally been among the first markets to recover, along with gold-mining companies.
It is also worth noting that emergency interest rate cuts by the US Federal Reserve in the past have led to the price of gold rising by an average of 26.1% in the 2 years that followed. Based on current prices, this would push gold up to $1,900/ounce.

Gold performance after historic emergency cuts

Fundamentals of the platinum and palladium markets

Platinum-group metals, meanwhile, have fallen steeply. Platinum has been penalised by its purely industrial role and no doubt by the liquidation of positions taken up on the cheap in the second half of last year.

Platinum is an essentially industrial metal used in jewellery and in the manufacture of catalytic converters for diesel engines. Prices have been languishing for some time now because of the economic slowdown and the shrinking diesel market. But producers have now decided to limit their output (one of the biggest South African producers announced in late 2018 that it would shut down 5 of its 11 mines and lay off 13,000 of its 40,000 workers over a period of 2 years), and new environmental standards require an increasing amount of platinum content in each catalytic converter. For instance, China’s new China 6 standard requires more platinum content in each converter. Next year, it will be India’s turn to tighten up its environmental standards and Europe will adopt the Euro 6d standard which consists in measuring real driving emissions (we can thus expect the consumption of platinum to increase).
The coronavirus has put a sharp brake on car sales (e.g. -80% in February in China), so demand for platinum has temporarily fallen. But it should catch up again when the health crisis is over. Moreover, the world’s largest platinum producer, Anglo American Platinum, announced this week that there had been an explosion at one of its sites and it had had to declare a force majeure. As a result, worldwide production of platinum is set to fall by 6% this year. So the market, which was expected to show a small surplus, could slide into deficit. Platinum is the precious metal that is struggling the most, but this news should enable it to begin trending upwards again.

Palladium, meanwhile, proved resilient for some time but has since plummeted from a historical high of +40% since the start of the year to about -20% on 19/03/2020.
If this market was able to resist, it is for a simple reason: the deficit is such that no industrial group wanted to risk postponing its purchases for fear of not being able to find the goods when the coronavirus crisis ended. The market is expected to end this year in deficit yet again, for the ninth year running.
There is so much tension that this market has had a backwardation structure for a long time, i.e. with futures prices below spot prices. As a result, carrying such a position delivers a yield. In today’s world, this is rare enough for speculators to take an interest, especially as the market boasts extremely solid fundamentals. More and more countries around the world are imposing lockdowns, with the economic repercussions this entails, so this price structure has ultimately disintegrated, and we have seen liquidations on a massive scale. However, one thing worth noting is that this inverted price curve applies only to short maturities while the rest of the curve still offers positive carry. In short, the market is feeling the effects of today’s economic difficulties but is still convinced that the tension will return when the health crisis ends.

The global supply of palladium amounts to around 320 tonnes while consumption stands at 350 tonnes. Palladium is used primarily (about 80% to 85% of global demand) in the manufacture of catalytic converters for petrol engines. It is increasingly difficult to find enough stock to balance out the market. Even Johnson Matthey (JM), the world’s biggest manufacturer of catalytic converters, said in its market outlook report published in February 2020 that the deficit was likely to widen further this year.
This imbalance is prompting the industry to consider substitute solutions. JM mentioned some of them and is in the process of examining them. It even presented one of them (substitution with platinum) but it will not be operational until 2023 at the earliest, and the substitution will only cover about ten tonnes, which will not enable the market to move back into surplus.
Shorter term, an incident was recently reported at Anglo American Platinum, the world’s biggest producer of platinum but also a major producer of palladium. The incident meant it had to declare a force majeure for some of its facilities, which will reduce global palladium output by 3% this year.

So the market could once again surge significantly. The economic slowdown is currently triggering a wave of profit taking. But palladium, which is used in the manufacture of catalytic converters, will benefit from increasingly stringent environmental standards being introduced in China followed by India and Europe. For instance, the new standards in China will require car makers to use an additional 25% of palladium in their catalytic converters this year. Palladium prices could therefore bounce back strongly when the health crisis eases off. Various analysts even suggest that palladium could rise above $3,000/ounce this year, which is twice as high as it is currently!

All this therefore suggests that our fund’s portfolio is poised to rebound strongly. Once financial positions have stopped being liquidated, gold and silver stand to benefit from the economic and monetary environment that this health crisis will have created. Because of their status as industrial metals, platinum and palladium might have to wait until the end of the coronavirus epidemic is in sight before recovering, but they offer a great deal of catch-up potential. Palladium, in particular, could move back up to its previous highs rapidly.

Benjamin LOUVET
Commodity Fund Manager at OFI AM

This analysis does not constitute a recommendation to buy or sell.

Document completed on 23/03/2020

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