Under pressure from the strengthening dollar, the metals sector stands as the potential stalwart as stock-market volatility normalizes. Gold has the most upside if equities continue to decline, particularly if U.S. stocks give back more vs. the world. In this scenario, the dollar should decline and metals and broad commodities would benefit. Gold’s appreciation potential remains disconcerting, given the macroeconomic implications as the market becomes increasingly coiled.

Industrial metals have provided a discount in a bull market. The implications of sustained declines should increase risks for equity markets. Downtrodden copper appears to have priced closer to a worst-case macroeconomic scenario, making it ripe to benefit in most outcomes.

Bears seem low on fuel for a metals decline
It will take continued dollar strength or weakness in EM equities to appease metals-sector bears, in our view. Mean reversion potential is elevated. Up about 7% in 2018 through Oct. 30, the trade-weighted broad dollar is a primary metal-price suppressant. It’s similar for the MSCI Emerging Markets Index, which is down about 20% and has among the strongest positive correlations to the Bloomberg All Metals Total Return Index. On pace for its worst year since 2008, EM equities have limited downside.

Meanwhile, dollar strength has limited room. Near the 2002 and 2016 peaks, the greenback’s rally appears to be pushing on a string, notably on the back of the outperforming U.S. stock market. The annual correlations of the metals index since 1997 are minus 0.7 vs. the dollar and plus 0.82 relative to EM stocks.

Gold lonely at top generally not a good sign
It’s typically not a good sign when gold is up and most others are down, as happened in October. The S&P 500 index’s decline (almost 10% at its worst in the month) is the primary pressure factor on the Bloomberg Industrial Metals Subindex. Gold stands to benefit if stock-market volatility continues to recover, yet all metals would be supported by a weaker dollar that has gained on the back of outperforming U.S. equities.

The near-20% year-to-date decline in copper, the worst-performing major commodity, is generally unsustainable in an expanding global economy, particularly when priced at a significant discount to its historical apex only seven years ago. Contrarily, equity prices are well-ahead of similar period peaks.

Industrial metals should have less to fear
Copper and the industrial metals have provided a sufficient drawdown under the weight of falling equity prices, in our view. Sustaining much lower would have adverse macroeconomic implications, notably for equities. It’s the stock market that appears to be a bit offside. While equity volatility is normalizing, copper is likely providing a dip in a nascent bear market. Industrial metals are a potential bullish stalwart vs. equities, adjusting to mean reversion in the CBOE SPX Volatility Index (VIX) from its lowest average (250) ever less than a year ago.

Measured by the World Bureau of Metal Statistics, demand vs. supply indicators remain above par, barely budging since the bull market began in 2016.

Metals showing bullish divergence vs. greenback
For the first time since the bear-market bottom in 2015, the Bloomberg All Metals Total Return Index has revisited its lower 52-week Bollinger Band, signaling that the sector is poised to recover from this support level. Despite the trade-weighted broad dollar rallying to within 2% of its 14-year high from 2016, the all-metals gauge has remained more than 20% above the similar low. It’s unlikely the dollar can sustain itself above the 14-year high. Risk vs. reward appears to favor metals’ longs at current levels.

If metals remain below 3Q levels, it could indicate an end to the bull market, with broader negative macroeconomic implications. In the history of the metals index since 1997, the annual correlation to the dollar is negative 0.70.

Stocks and gold ripe for trading places
Aligning the means in this rate-hike cycle, gold appears more likely to revisit its average vs. the S&P 500. Getting back toward $1,260 an ounce is only 5% above the Oct. 5 price for the metal vs. a 17% decline for the stock market. This wide dispersion appears to have reached an inflection point this month, with the 10-year Treasury yield sustaining above 3.1%. The last yield-resistance breach was in January, above 2.6%. Stocks peaked later that month as gold prospered. The sharp dollar rebound halted gold’s climb in April, but is less likely now.

The metal’s preemptive recovery absent dollar weakness is a bottom indication. The dollar has less room to rally this time. The Bloomberg Dollar Spot Index is 7% above the 2018 low. The broad trade-weighted index is 2% below the 2016 multiyear peak.

Gold’s upside potential outweighs downside risk
Up 13% in this Federal Reserve tightening cycle to Sept. 7, gold is closer to support, which should prevail. A combination of sustained strength in the dollar and the stock market is likely needed for gold to decline below good support near $1,120 an ounce a year from now. It may benefit most portfolios, which is supporting the diversifier, notably via exchange-traded funds. Total known ETF holdings are up 47% since the first rate hike.

Good initial resistance for gold is near $1,375, the high in this tightening cycle. Trading the past few years within the most compressed range in decades increases the chance of a breakout higher, typically the case in such coiled markets. If the greenback resumes the mean-reversion process of 2017, gold should head toward $1,400.

Higher plateau in silver vs. gold is unlikely
Silver is set to embrace a leadership role in a metals-sector rally. The amount of ounces of silver equal to gold has reached the highest level in 23 years, with net silver positions the shortest in 12 years as a percentage of open interest. A higher plateau in this relationship is unlikely, while the potential and extent of some mean reversion weighs heavily on greater short-covering risks. A primary spark would be a pullback in the trade-weighted broad dollar, which should be approaching the point of diminishing returns near 2016’s peak.

February 1995 was the last time the gold-to-silver ratio was at current levels. It hasn’t sustained higher since 1993. Commodities will find demand when prices are low, and vice versa when they’re relatively high.