London, 1 November 2010

Ahead of us lies a very big macro week. It kicks of with PMI manufacturing indices data for all the major economies. While PMI manufacturing indices have been indicating that manufacturing globally is still expanding, there was a general slowdown in the pace of expansion in manufacturing in the US and Europe since June. In contrast, China’s PMI manufacturing index gained strength over this period.

This morning, China PMI manufacturing index for October came in higher than expected (actual 54.7; exp. 53.8). We view this is bullish for base metals especially, but also palladium. Even more significant (and bullish) is the fact that October’s data print was higher than the September data print (which came in at 53.8). Seasonally, October manufacturing tends to be lower than activity in September — the main reason would be holidays at the start of October. This year, it was not the case. Base metal prices should remain well supported by China's manufacturing activity into year-end — driven by a bullish reading in October, a bullish reading in September and a bullish reading in August.

When isolating the relationship between China’s PMI manufacturing index and base metals, we find a strong relationship between the base metals and China’s PMI manufacturing index. Aluminium, followed by copper, has the strongest (positive) relationship with the current the PMI manufacturing index (or rather with the underlying market conditions represented by the PMI index). Zinc, nickel and lead also have a positive relationship with the Chinese PMI manufacturing index, but much less than aluminium and copper.

Furthermore, we find that the influence of the PMI manufacturing index (or rather the conditions represented by the index) builds in importance, with the strongest impact felt with a three-month lag (after which the impact diminishes). So looking at China’s manufacturing conditions, we expect base metal prices to find good support from China's manufacturing activity in Q4:10.

Base metals

The base metals have started the week on a positive footing, boosted by better than expected Chinese PMI data and stronger equity markets. The dollar has been fairly static however, with the lack of movement in the currency markets seeing the metals also start to drift sideways heading into the afternoon. Copper turnover has been fairly solid, with good two way interest, however the rest of the complex is pretty subdued.

This week is a busy one in terms of macroeconomic data, the key announcement being the FOMC rate decision on Wednesday evening and the scale of the next round of QE. As a result, the base metals market is currently in the process of trying to second guess the wider market’s likely reaction to the FOMC decision on QE2. In our view, the Fed is unlikely to intentionally disappoint the market, however the next couple of days will likely remain choppy.

In terms of other key data this week, both measures of Chinese PMI increased more than expected on Monday, giving the metals a boost during overnight trade. The unexpected improvement in both the official PMI, and the HSBC measure are bullish signals in terms of China’s economic health, with the data helping provide solid background support for metal prices. Looking further ahead, this afternoon’s US ISM data is likely to be overshadowed by the FOMC announcement, however the October Nonfarm Payrolls and unemployment rate, released on Friday, may have some bearing particularly if unemployment is referenced by the Fed in its statement.

Nickel inventories have continued to pick up, with on-warrant LME stocks climbing 1,170 mt this morning - all of it as full plate cathodes into Rotterdam. Rising inventories appear to have weighed on nickel prices of late, which prices underperforming the rest of the complex over recent weeks. Its worth noting however that, although LME stocks have been rising steadily since the middle of October, the inflow of material since August has nevertheless still been well below seasonal norms.

Precious metals

Palladium has reached our initial target of $650, while our target for platinum remains at $1,800 (Commodities Daily 14 Jun’10 and 27 Oct’10). For palladium, we now target $700. Given that China’s auto market is heavily weighted in favour of palladium, we view today’s China PMI manufacturing Index data as bullish for palladium (refer to Focus section). On Wednesday, US auto sales for October are due. While October data may show a m/m decline in US auto sales, we expect auto sales to pick up (on seasonality) from November through to March.

Platinum support is at $1,690 and resistance is at $1,721. Palladium support is at $633 and $654.

Our estimate remains that the gold market (and by extension many other commodities) are pricing $500bn of QEII already. We will interpret the impact on commodity prices of any QE announcement relative to this $500bn. As highlighted on Friday last week, our Standard Bank Gold Physical Flow index (GPFI) shows the gold physical market is now providing support rather than resistance. Overall we believe that (1) the physical market should provide support for gold on pull-backs until the end of January. (2) However, post-Diwali (5 November), this support may be situated at a lower price level — possibly below $1,300 (depending on FOMC actions on Wednesday (3) We believe that resistance in the physical market may grow stronger post-China New Year and run well into 2011.

Gold support is at $1,344 and $1,330. Resistance is at $1,367 and $1,375.

Positive sentiment towards manufacturing, combined with strong investor demand, continues to support silver. Resistance for the metal is at $25.00 and $25.40. Price support is at $24.15 and $23.40.

Energy

Oil continues to oscillate in a narrow range. Last week, net for the week, front-month Brent edged up 19 cents per barrel to settle at $83.15, while front month WTI ended 26cents per barrel lower at $81.43. Product cracks and refining margins took a double whammy from the ending of French strikes and the ending of the refining maintenance season in Europe and the US. The return of the idle refining capacity may add additional downward pressure on the time structure of the oil products.

Oil traded higher this morning on the back of a weakening dollar and strong China PMI data. For the rest of the week, there will be plenty data releases. However, it is most likely the Fed’s FOMC announcement regarding  QEII on Wednesday will determine the directions of the market.

The weekly CFTC report showed net speculative length in crude push higher last week while net speculative length in products continue to decline. The CFTC also released on Friday the index investment data for September, which reported total money flows into index investments for commodity was up 13.4% in September over August. Money into oil was up 9.1% m/m.

We note that the current level of the speculative length in oil could cause oil prices to pull back very sharply if the Fed disappoints on Wednesday. To highlight this point, we have seen two previous big drops in oil prices when net spec length reached current levels. One was in Jan/Feb, another was April/May. The difference this time is the Fed will be the trigger on whether the price, as well as the net spec length, will break out on the upside or take a sharp correct downwards.

Technically, front month Brent holds resistance at $84.09 and support at 82.07 in the short-term.

Ends --

By Walter de Wet and Leon Westgate: This e-mail address is being protected from spambots. You need JavaScript enabled to view it