Economic Divergence is Back

From the August 24, 2014 HRA Journal: Issue 218-219

As we move through the third quarter of 2014 we are seeing a trend in the world economy that everyone hoped had been left behind in 2011; major divergence in growth rates across the world’s large trading blocks.

The US posted the best quarterly growth in years in Q2.  I noted just after that release that inventory build accounted for almost half the growth but it was still a big positive surprise.   It freaked out traders that read the number as an indication that rate increases in the US would come sooner than expected.  That may be true though it still doesn’t seem to faze bond traders.

The 10 year T Bond yield index below is now plumbing one year lows, with 10 year yields sitting just about where they were a year ago when the US Fed started to hint it would unwind QE3.  That’s pretty impressive when you think about how many fiscal hawks are screaming for the Fed to raise rates, including a number of Fed governors.

Janet Yellen’s headline speech at this year’s Jackson Hole conference spoke to those hardliners.  As she has for several months now she pointed out that not all the employment indicators are rosy.    I agree with her on that.   Wage gains are very unimpressive for an economy that is reporting an unemployment rate just above 6%.  There hasn’t been a lot of “trickling down” going on in the US.

Other members of the Fed committee may ultimately win the argument and push for a start to rate increases this year but the Chairperson tends to win those fights.  I see no reason to assume Yellen won’t get her way.

Some of the support for bond yields is market internals unrelated to what the Fed might do.  A falling budget deficit means the US Treasury does smaller auctions and provides less supply.   Recent changes to rules governing money-market accounts are expected to generate several hundred billion in demand at the short end of the yield curve which might also be pushing yields down.

Bond traders clearly don’t fear an incipient return to inflation and are still unmoved by the fear of near term increases in US interest rates.

The bond market’s strength helps explain stock traders confidence when so many are talking about rate increases.   Stock traders are taking their cues from the bond market, not from hawkish Fed committee members.   That helps explain why the S&P is at all-time highs.

I think Yellen’s case is bolstered by the small uptick in the unemployment rate in the July payroll report.  That indicates some of the army of discouraged workers is back hunting for jobs.  We’ve expected this pattern to emerge for some time now.  It’s a good thing if it continues because, again, it’s a sign of increased confidence moving from Wall St. to Main St.  If the US economy is ever going to get on a higher growth track it will happen because the middle class starts spending in earnest.  Plutocrats amassing another hundred million each off stock options won’t make as much difference to the US economy as Republican fundraisers would have you believe.

If the trend that began in July continues it may spell the end of falling unemployment rates for a while. That is a very good thing as long as returning workers are getting jobs and the labour force participation rate starts to climb.  As a bonus it also gives Yellen a bit more ammunition to hold off rate increases if she chooses to use it.

By and large the economic readings out of the US have been good but there continue to be conflicting numbers to keep inflation hawks at bay.  While the numbers are improving and both the Q2 GDP growth and payroll numbers are good the economy still hasn’t hit an inflection point and moved up to the next gear in terms of growth rate.  That is more than a little weird five years into an expansion.  It’s uncharted territory in many ways so the conservatism of the Fed board and many macroeconomists is totally understandable.

The real problem the Fed faces is that they have already pulled out all the stops.   If they move too soon and the economy isn’t ready for higher rates there is no fallback position.   There is a growing chorus screaming for a rate increase but the Fed really can’t afford to get the timing wrong.   Better to increase the odds of inflation than to move too soon and have the economy stall out with no monetary levers with which to “pull up the flaps”.

Whether the US economy has finally reached “escape velocity” remains to be seen.  I’m a little skeptical, though I’d rather not be.  The size of the inventory growth contribution leads me to suspect we could see downward revisions to that 4 percent annualized growth number.  The fact that several important June component numbers (released after the advance GDP number) were on the weak side doesn’t help.

One reason the US will have trouble accelerating is that it’s not getting any help at all from offshore.   Q2 growth numbers for the Eurozone were lousy.   Germany, the only economy with any hope of powering the Euro zone stalled out and both France and Italy posted negative growth rates.  The EU has never recovered from the financial crisis, in part thanks to the widespread denial of the people running it.

No, it wasn’t just Wall St.  A lot of the dumbest buying and most clueless deals were engineered by European banks.  By and large this sector is still in much weaker shape than its US counterpart.  That matters a lot since bank lending is more important to investment and business formation in Europe than it is in North America.  If banks aren’t lending in the EU it’s a big problem.

Of course, part of the current problem is Ukraine which has created a much bigger chill in Europe than anywhere else.   As that mess drags on and the scope of sanctions increases the impact is much more direct in places like Germany that have significant exports to Eastern Europe and Russia.  It’s starting to look like that situation will be resolved by force in coming weeks.  The Ukraine government forces seem to be in the driver’s seat and the rebel held area is shrinking rapidly.  Short of Russian intervention this civil war could be over soon.  In fairness one has to appreciate the fact that Euro area countries are getting much tougher with Russia even when there is a very direct cost to their economies for doing it.

The Euro chart on the previous page gives you a pretty good reflection of the sentiment shifts.  After topping out at $1.40 in mid-May the Euro has been beaten down as economic readings and news from the Ukraine worsened sentiment.

It’s a very ugly looking chart.  The good news is that if the Euro falls far enough it might actually generate a bit of inflation.  Euroland is now perilously close to tipping into a deflationary spiral.  It’s mindboggling to me the ECB is still dithering about QE and tightening its balance sheet.  The recent steepening of the Euro’s fall came from comments at Jackson Hole by ECB chief Draghi that he would maybe probably do something.  Its way past time.

Currency movements and belief by some that US rates are about to rise haven’t done the gold market any favors.  Gold struggled at the $1300 level before giving that up and dropping to the $1280 level.  The fight is ongoing there and it’s too early to tell if the bulls or bears will come out on top.   That’s a more impressive performance than it looks.  I subscribe to the theory that physical demand in the gold market will ultimately determine price levels.  The short term is a different matter. There are lots of traders that play gold as primarily a currency bet.   Look at the Euro and USD charts that bookend the gold chart.  It’s not hard to understand why gold weakened recently in US Dollar terms.

Not surprisingly, the US Dollar chart looks almost like a mirror image of the Euro chart. The USD has undergone a huge rally since May, moving from 79 to the current 82.5 range.  For most of the rally gold has moved with not against the Dollar or has been uncorrelated.  This is important to remember.  It’s almost a truism among gold bugs that gold will rise when the USD “collapses”.  Except that it often doesn’t.   Markets are rarely as simple as traders want them to be and there are always multiple conflicting factors at work.  A falling dollar would help underpin the gold price but it’s not a necessity to a higher gold price.

Both the USD and Wall St are rallying thanks to positive divergence in US growth rates.  Both could still go higher.  Markets are forward looking however so traders are already pricing in a rate increase in the near future.  Both stock and currency markets tend to have their steepest moves prior to a change in interest rate policy.    The geopolitical risks that currently abound should just add to the upward pressure on the USD though they will hurt the equity markets if things get out of hand.   Nasty geopolitical surprises are good for gold short term but can’t be trusted.

Most of the recent periods of weakness for gold have arisen either due to apparently calming in political tensions or strong US economic readings.   The first factor is something I have voiced uneasiness about before.  I am no fan of geopolitical price runs since they usually end quickly and badly (if you’re long).

Drops after better US readings or comments by a US Fed board member that sound hawkish have been common.   A strongly growing US economy (if that happens) with rising cost pressure is a positive environment for gold.  Most traders forget that or never knew it.  There isn’t much we can do about kneejerk selling when the US reports good numbers.  We’ll have to live with the volatility but don’t assume stronger US economy is a death knell for gold.

It’s frustrating to see gold knocked back below the $1300 level yet again but, given the backdrop, its performing well.  None of the events that were expected to provide a tailwind have come to pass but bullion has held its trading range.  We are about to enter the strongest period of physical demand in the year.  India will officially be no help but smuggled gold will still cross the borders.  Chinese demand will be ever harder to gauge now that additional (and uncounted) entry points exist.

I think physical demand will hold up but it will be hard to measure.  Expect to see headlines about weaker physical demand but I think they will be based on essentially useless statistics.  Unfortunately, I know of no way we’ll be able to get accurate reading of Indian and Chinese demand going forward.   At the end of the day the only measure that will matter to us speculators is market price.  I still expect a return to the normal pattern of rising gold prices through autumn.

The chart above shows how well the Venture Index has held up through the summer doldrums.  It has climbed back above 1000 again and trading volumes are improving.  This is a good performance given how both the gold price and oil price have fared recently (there are a lot of oil and gas juniors on the Venture).  The index certainly isn’t where I want it and is a long way from the gain I still expect for 2104.  The best months of the year for juniors are still ahead of us though.

Similar comments can be made about GDX and GDXJ.  Those charts don’t look wonderful but there is an impressive amount of support, all things considered.  The GDX is a couple of points lower than its March high but that is pretty good considering gold is trading $100/oz below its March peak. I’d be happier if volumes were higher but the resilience has been impressive.   Clearly, there are traders that expect better days ahead for miners who are willing to buy on even slight weakness.  Let’s hope they are right.  I think they are.

I added a company in the copper space this issue.  My expectation for at least slightly weaker copper prices hasn’t changed. Neither has my belief that the “best in breed” will find the backing to be developed.  I think this company has the economics to attract funding and higher prices. The above market financing just announced speaks to the attractiveness of the project.  More new names will be added to the HRA list shortly.

By now you have received an invitation to the next Subscriber Investment Summit in Vancouver on October 9th. As I expected registrations are running well ahead of recent summits.  Do not wait to register if you want to attend.  Please use this link to do it: http://vancouversis2014.eventbrite.com/?aff=HRA

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