- Weak start of the year followed by stunning rally…
- …because of improvement in demand outlook…
- …and general supportive environment for precious metals
- We think that the upside is limited though…
- …because fundamentals may not be that strong…
- …and investors could lose interest
Sharp price rally since mid-June
Last year, palladium prices dropped by almost 30% from just below USD 800 per ounce to USD 562 per ounce. This coincided with investors aggressively liquidating positions in palladium (futures and ETFs). This year, palladium prices had a weak start, but since mid-June prices have rallied by more than 30% to above USD 700 per ounce (our year-end 2017 target). There are several reasons for this strong rally. First, the general trend in precious metal prices is positive. Second, investor sentiment has improved, supporting the more cyclical precious metals. The doom-and-gloom mood of just after the Brexit referendum has completely faded. Third, the outlook for the global car sector has improved compared to last year (when the emission scandal hit). Last but not least, wage negotiations in the mining sector in South Africa have fuelled expectations of possible strikes. In this note we answer the following question. Is the sharp rally justified or has it gone too far?
Increasing role for investors
Of all the precious metals, palladium is the one which is driven mostly by cyclical factors such as demand for autocatalysts and industrial demand. Demand for palladium is high if the global economy grows strongly resulting in a substantial rise in industrial and autocatalyst demand. Meanwhile, if supply does not rise as sharply as demand, palladium prices could rally sharply. Over the recent years, investor demand has become increasingly important. Investor demand is driven by different dynamics than industrial and autocatalyst demand and it is far more volatile. Investors also take into account central bank policies, the US dollar and the attractiveness of other cyclical assets. The most positive scenario for palladium would be if:
– global growth is strong (boosting autacatalyst and industrial demand),
– demand is larger than supply,
– central banks have accommodative policies
– the US dollar does not rally sharply
If expectations about the global economy and car sales in particular deteriorate, investors are the first to react negatively by reducing speculative positions in palladium even if actual demand does not fall that steeply. Moreover, if investor sentiment is constructive and other cyclical assets offer greater return, palladium investor demand will likely be low. Meanwhile, if investor demand deteriorates, gold and to a lesser extent silver are more popular. In short, palladium as investment is highly leveraged to the outlook for the global economy but it doesn’t offer income in the form of a yield or a coupon. As the graphs below show, investor demand has been the swinging factor for the palladium market, making price behaviour much more erratic.
Palladium price rally has run its course
Demand for palladium has been larger than supply since 2010, if we exclude flows into futures and ETFs. Because of these favourable fundamentals, investors were bullish for a long time. However, they abruptly changed their minds in 2015. This resulted in a sharp sell-off in prices. So weakness in palladium prices in 2015 was partly due to a less favourable fundamental environment (larger mine supply and the emission scandal) while investors also turned their back on palladium, creating indirect supply as well (via the selling of investor positions).
What are our expectations for the remainder of 2016 and 2017? We take into account the following:
1. Outlook for car sales
2. Outlook for industrial demand
3. Expectations of lower supply because of, for example, strikes at major mines
4. Absolute and relative price levels
5. Overall outlook for precious metal prices
6. Outlook for other cyclical assets
7. US dollar outlook and easy monetary policy
For a start, we expect a mixed picture for car sales for the coming months and years. In case of the US and Japan, car sales will likely stay around current levels but we don’t expect a substantial increase. The outlook for Europe is deteriorating with the expected slowdown in the UK economy. In Emerging markets such as China, India, Brazil and Russia car sales could improve though. Moreover, industrial demand will be subdued due to the modest unconvincing growth levels in the major economies. This is not an environment that would justify a sharp increase in industrial and autocatalyst demand expectations.
In contrast, palladium jewellery demand will likely pick up from a very low level as higher gold and platinum prices could trigger substitution into palladium. Investor demand will be a crucial driver again. The main question we need to ask ourselves is if investors will continue to invest in palladium as we have seen so far this year. We think that if economic data confirm the picture on unconvincing global growth, they will likely be less inclined to buy. They may even start to sell/take profit on positions bought earlier in the year. In addition, palladium prices have done quite a catch-up so it is not cheap anymore.
This year, we expect the Fed to keep interest rates unchanged, which will likely support precious metal prices in the coming weeks and months. However, towards the end of the year expectations of Fed rate hikes could resurface in financial markets, supporting the US dollar and weighing on precious metal prices (we expect the next rate hike in Q1 2017). This will likely trigger a liquidation of net-long investor positions, resulting in lower precious metal prices including palladium. In Q2 2017 we expect the environment in precious metals to improve again and prices to rally.
Currently, the investor climate is supportive for palladium prices but this could change quite quickly. If supply uncertainty starts to fade and economic data in Europe disappoint, sentiment could change for the worse. In short, we think that the upside in prices is limited. In contrast, a sharp sell-off is more likely than a continuation of this amazing rally. We have adjusted our palladium forecasts to reflect this new reality.