The darkening economic outlook this month has sent investors out of the palladium market in droves, but the coming months of uncertainty are likely to be more of a cooling-off period than an end to their romance with last year's star performer.

Palladium, which is mainly used in catalytic converters for gasoline-powered vehicle engines, has been one of the weakest commodities this year, falling about 5 percent to around $750 an ounce, after having virtually doubled in 2010.

Last week marked the largest decline in speculative holdings of U.S. palladium futures on record, while exchange-traded funds lost more metal in that one week than in the preceding eight weeks together.

The overarching concern among money managers and policymakers over the economic impact of vast U.S. and euro zone debts has sent speculators scurrying out of any assets that depend on growth.

Palladium is one of the best gauges of investor sentiment toward the global economy, because the auto sector relies on demand from both the developed and emerging worlds.

It's all about industrial production, and at the moment it's not a happy story, said Sharps Pixley Chief Executive Ross Norman. Fundamentally, I think it remains an attractive buy, but that depends on your view of how the economy plays out.

Palladium will get hit further if the economic situation worsens significantly, he said, but ultimately investors will seek to buy hard assets of all classes, and it will be a case of a rising tide lifting all boats in the commodities world.

Societe Generale metals strategist David Wilson described the supply picture for palladium as fairly positive for prices. Without sales of Russian state stocks of the metal, the palladium market would have been in deficit since 2007.

Russian government stockpiles have dwindled, we think sales are going to be considerably lower than they have been in the past, and there is unlikely to be any expansion from (world number one producer) Norilsk (Nickel) over the next few years either, he said.

The fall-off in palladium might be a good buying point, Wilson said.

HOLDINGS DOWN

Speculative holdings of palladium, as reflected by open interest held by net non-commercial traders on NYMEX, have fallen by nearly 20 percent so far this year, or 286,300 ounces, their largest decline since a record 6.85 million ounce exodus in 2006.

While it is possible to dismiss the rush for the exits on NYMEX as little more than an expression of frustration among short-term speculators, the bleed of metal from exchange-traded funds reflects a more worrying trend among players with longer-term investment horizons.

ETFs backed by physical metal, which helped fuel the 73 percent rise in investment demand for palladium last year -- thanks to the U.S. listing of ETF Securities' palladium fund
-- have seen unrelenting outflows this year.

Global ETF holdings of palladium haven fallen by nearly 20 percent in 2011, mirroring the decline in speculative interest in palladium futures, which together equate to about 550,000 ounces, or 50 percent of last year's total of 1.085 million ounces of investment demand.

One of the principal drivers for investment in palladium over the prior two years was the explosion in demand for cars in China, which last year overtook the United States as the world's largest auto market.

But curbs on vehicle registrations and the end of a series of subsidies for new car purchases have slowed year-on-year sales growth in China to less than 6 percent in the first half of the year from 48 percent in the same period of 2010.

In the United States, car sales are up modestly so far this year, yet economists are attaching ever-rising chances of the world's largest economy tipping back into recession, which would almost certainly bite into consumer spending power.

Sharps Pixley's Norman noted the average age of a car today is 11 years, compared with 8.5 years in 1995, indicating that consumers invest in new vehicles less frequently.

Wherever you look, those macro issues that are very supportive for gold are obviously not supportive for palladium, said Societe Generale's Wilson said.

In contrast to palladium, gold, perceived by many to be the safest of safe-havens has risen by over 30 percent to record highs this year.

At times like these, palladium tends to suffer as the industrial tag has been out of vogue in the last month or so, said Saxo Bank senior manager Ole Hansen. Cyclicals will have their day in the sun again, but just not now.

(editing by Jane Baird)