Weekly Fundamentals - Gold Still Looks Cheap in Inflation-Adjusted Term

Commodities moved with great volatility in the past week, driven by intensifying concerns of US double-dip recession, spreading of sovereign crisis from the European periphery to core economies, speculations of Fed's easing measures and somehow supportive macroeconomic data. During the week, the front-month contract for WTI crude oil plummeted below 80 for the first time since October 2010 while the equivalent Brent crude broke below 100 first the first time since February 2011. Both benchmarks recovered later in the week in tandem with the rebound in equities. Gold remained the best performer as investors fled to the yellow metal for safe-haven investments. The benchmark Comex contract gained +5.54% during the week with price surging to a new record high of 1817.6 Thursday before retreating after the SME announced margin increases. While further correction in likely in the near-term, gold will still be the biggest beneficiary of low interest rates, rising economic uncertainties and a new round of central bank easing.

Earlier in the week, the Group of Seven Nation issued a joint statement, pledging to 'take all necessary measures to support financial stability and growth'. However, this failed to restore confidence and financial market tumbled in response to S&P's downgrades of US' debt ratings. After trimming the credit rating of US debts' from AAA to AA+ on August 4, the rating agency also lowered the AAA ratings of a number of US-backed bonds, including Fannie Mae and Freddie Mac, by a notch to AA+ on August 8. The agency said the downgrade was due to their 'direct reliance on the US government. In a statement in the midday, S&P also warned about the Asia-Pacific outlook, citing 'uncertainties in the global financial market and weakened prospects in the developed economies have further undermined confidence. The potential longer-term consequences of a weaker financing environment, slower growth, and higher risk aversion are negative factors for Asia-Pacific sovereign ratings '.

The market was in a 'risk-off' mode until the Fed announced to keep interest rates low at exceptionally low levels at least until mid-2013 at the FOMC meeting. The central bank also decided to maintain its existing policy of reinvesting principal payments from its securities holdings and will regularly 'review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate'. Although the Fed did not explicitly signal it will adopt QE3, the change of language in the 'extended period' phrase, maintenance of the reinvestment program, inflation expectations and discussion of 'the range of policy tools available to promote a stronger economic recovery in a context of price stability' indicated that the Fed will resume outright asset purchases, should economic outlook deteriorate further. The next key event would be Fed Chairman Ben Bernanke's speech at Jackson Hole on August 26 The market has been speculating that the Chairman will announce further easing policy on that day.

In the coming week, US' data including CPI and industrial production will be in focus as the outcomes will be deterministic of Fed's monetary policy. The BOE and the RBA will also release minutes for the August meeting. We expect both central banks to show worries over rising downside risks on global economic outlook.

Energies: EIA, OPEC and IEA released their latest oil demand forecasts last week. In light of economic slowdown and heightening global uncertainties, oil agencies revised modestly their outlooks for oil demand growth. The OPEC lowered the demand estimates for both 2011 and 2012, the IEA trimmed this year's outlook but raised next year's and the EIA raised demand from 2010-2012 but the size of growth in 2011 was lowered as a result. All 3 agencies warned of the great uncertainty in global economic outlook. The IEA stated that 'concerns over debt levels in Europe and the US, and signs of slowing economic growth in China and India have spooked the market and raised fears in some quarters of a double-dip recession'. The OPEC cited 'dark clouds over the economy are already impacting the market's direction...The potential for a consequent deterioration in market stability requires higher vigilance and close monitoring of developments over the coming months'. Together with reduction of the price forecasts, the DOE/EIA said that 'there is significant downside risk for oil prices if economic and financial market concerns become more widespread or take hold'.

Notwithstanding weaker headline growth forecasts, demand in non-OECD countries remains resilient and its share of total global demand is indeed revised higher. For instance, the EIA's estimate of non-OECD as a percentage of total oil demand was upgraded to 48.02% in 2011 and 48.48% in 2012, compared with 47.91% and 48.78% respectively in July's projections. The OPEc also forecast non-OECD as a percentage of total oil demand to increase to 47.67% in 2011 and 48.43% in 2012, compared with July's projections of 47.62% and 48.38% respectively. China will continue to be the biggest oil consumer in the emerging market. Therefore, the economic developments in China and emerging markets will be more determinative for oil prices in coming year despite short-term volatility.

Nymex natural gas price rose +3.02% last week as inventory increased less than expected. Storage climbed +25 bcf to 2783 bcf in the week ended August 5, compared with consensus of a +37 bcf gain. Stocks were -197 bcf below the same period last year and -80 bcf, or -2.8% below the 5-year average of 2863 bcf.

In the Short-Term Energy Report, the EIA forecast that total natural gas consumption will increase +1.8% to 67.4 bcf/day in 2011, driven by industrial and electric power demands, and then to 67.8 bcf/day in 2012. Gas production is expected to increase +5.9% y/y to 65.5 bcf/day this year and then by +0.9% to 66.1 bcf/day in 2012. Domestic production has been so strong that it contributed to net exports.

During the week, the Baker Hughes also reported the number of gas rigs increased +3 units to 896 units.

Precious Metals: Gold extended its rally last week, recording the biggest weekly gain since 1Q09, amid global economic uncertainty and speculations of Fed's QE3.The metal surged to a new all-time high of 1817.6 Thursday before sliding after the CME Group announced margin increases. The CME raised the initial margin requirement to 7425 per contract from 6075 and the margin for hedging to 5500, up +22.2% from 4500.

While gold's correction may continue next week, CME's margin adjustment would not reverse the metal's uptrend. Indeed, the market only used that as an excuse to take profit from gold's recent exponential rally. Gold's accelerated rise might have been a bit overextended in the near-term. The chart below shows that the metal's close on Friday has already exceeded the upper 3 standard deviation. It's reasonable for the metal to have a correction before resuming the rally.

The market has been talking about gold price bubble as the metal has risen more than +26% since the beginning of the year and almost 80% of the gain was made over the past 6 weeks. Nominal gold price has indeed risen to a record high and exceeded levels in 1980. However, after inflation is adjusted, gold price remained -20% below those levels. While many people also compare the current economic situation with the one in 2008 when Lehman Brothers collapsed, the current pattern of gold price is more similar to the period from 3Q07 to 1Q08. If gold is to resemble the movement at that time, price will need to rise +20% more as the metal soared +50% back then.