First, the Bad News
From the October 18, 2016 HRA Journal: Issue 259
Gold had another big leg down in October and that has the naysayers out in force. I’m not that surprised or dismayed. Scepticism is a feature of young bull markets. We should use it to our advantage rather than agonizing about it.
I think we’re about to start trending higher immanently, for both the gold price and the resource sector. We may actually see a pattern similar to last year if the Fed makes good on its promise to raise rates in December.
Even if you think there is a bit more potential downside lots of stocks are on sale so you should be at least choosing your favourites and putting in bids. Strong companies with good projects should see higher prices later even if they don’t sooner.
Expect gold and equity markets to keep getting buffeted by Fed rumours. No one expects a strong earnings season in New York and this could weigh on things too. Last but not least is the US election. At this stage it doesn't look like the presidential race is in much doubt but politics is a game that punishes complacency and this is the weirdest election in recent memory so I’m not second guessing it. The least likely winner would be the most gold positive so if there is a surprise winner it would definitely strengthen the case for gold and gold stocks. Thanks to all of you that came out for the Subscriber Investment Summit and I hope to see you at the Metals Investor Forum next month.
OK, first the bad news, if you’re a resource stock investor. Gold got smacked down, with most of the move coming in a huge selloff that lasted literally minutes. That selloff in particular brought the price below several important technical levels, which generated more selling.
The good news? Traders are freaking out across the space. My inbox is stuffed with “learned analysis” from a bevy of “gold experts” I’ve never heard of before. They’re all assuring me that the gold price is going much lower, because reasons.
I’ll grant you, the gold chart below isn’t a pretty sight. If you’re a short term trader or trade purely on charts (those two often go hand in hand) it does look scary.
As you know, or should by now, I take a more fundamental view and base my predictions on macro factors and, in the case of gold at least, view it as both a commodity and a currency. Like anyone who’s been involved in the resource sector for any length of time I also have a contrarian streak. I’m just laying those biases out in advance.
Gold stocks, junior and senior, were the hottest sector in the market in the first half of 2016. That generated a lot of attention and drew in some outside money. I think two types of money started flowing into the sector this year; short term speculative and hedge fund money and longer term generalist investors.
It’s the first group that is driving the short term charts but, in my opinion at least, the second group is far more important to gauging the longer term direction of the sector. My views on the major trends haven’t changed. I still think we’re in the early stages of a bull market for the gold sector. In that scenario, large pullbacks should be viewed as buying opportunities, not reasons to panic. We can all say “shoulda, woulda, coulda” about selling some specific stock at its recent peak price but it’s a long way from that sentiment to declaring a bull market over.
So what happened since the last issue to suddenly turn the market against gold and stocks? The short and oversimplified answer is the US Dollar. Oversimplified because saying “the USD went up” doesn’t tell us much about why or what happens next.
The “why” has two main parts. Currency trades, as you know, are always two sided. Traders buying the USD are selling something else as part of the trade.
This month currency traders have been selling the British Pound, big time. British PM May set a tentative schedule for Brexit negotiations and also let it be known she would go with a “hard Brexit” if that got things done faster.
Traders have been assuming (I don’t know why) that this would be a very amicable parting. Things could get nasty if its not. That realization has led to the Pound getting sold down from $1.32 to under $1.22 in the past two weeks. That explains a good chunk of the USD strength.
The rest of it is easily explained by traders that are being convinced (this time) that the Fed is serious about raising rates in December. There have been some, but only some, better metrics out of the US economy. The real reason bond traders are taking this more seriously is serial warnings from usually dovish members of the FOMC that they are worried about an inflation overshoot and need to pre-empt that with a rate increase.
Does this make sense? Depends on how you look at the data. Let’s start with an updated version of the GDPNow chart that appeared in the last issue. I noted then that the estimate had dropped just below Wall St consensus and I expected to go lower.
It has since dropped a lot more, with the latest reading at 1.9% estimated Q3 GDP growth. This is an improvement over the first half of the year but implies a growth rate for 2016 as a whole well below 2%. That doesn’t seem like a growth rate that should have anyone on the FOMC worrying about acceleration.
So what are the suddenly hawkish FOMC members worried about? The answer may lie in the lower chart on the next page. It depicts four different US Consumer Price Index measures. The best known is the “core CPI” which is the black line showing a recent reading just above 2.25%.
That is above the Fed’s stated inflation target of 2%, but the FOMC is reported to prefer the Personal Consumption Expenditure deflator that is used in GDP calculations. That is currently running at 1.7%, still below the Fed’s target.
None of these are scary numbers to anyone who lived through the 70’s and 80’s but that history probably explains why some FOMC members are worried about getting further behind the curve. There’s little doubt from the graph below that the trend for all four inflation measures is “up” recenty. The question is whether they should worry in the first place.
An argument can be made that we could see more acceleration in the CPI in coming months, in particular because of rising oil prices.
After many false starts, OPEC reached an agreement with Russia to cut production by half a million barrels. That has led to a lift in oil prices but, so far, only back to prices seen during the early summer. Oil may have an impact on inflation but the price will need to move $10-20/bbl higher and stay there for it to be meaningful. I’m not an oil bull personally. The jury is definitely out still on whether we see lasting oil price increases that large. Probably someday, but I’m not convinced its immanent.
The recent strength of the USD will moderate inflation by keeping import costs down. It will also moderate the economy and be a drag on earnings for the multinational corporations that make up a large chunk of the S&P 500.
We went through these issues late last year. Back then, most in the market were calling for the USD to continue surging higher. I thought it would top out because you could see it was starting the damage the US economy. Long Dollar was also a very “crowded” trade. It’s getting crowded again and these things have a way of unwinding when there are too many traders on one side of the market.
We may still see a bit more upward movement in the US Dollar but probably not much. The Dollar has been the “bogeyman” for gold bugs forever but I think the top on the USD is again near. This will have a positive impact on gold prices irrespective of other issues.
So why is the Fed still talking about raising rates? Based on recent speeches it seems there is something of a civil war going on in the FOMC. On the one hand we have several members that are worried, or at least claim to be worried, about inflation or an accelerating US economy.
Keep in mind when you look at the GDPNow chart on the previous page that the bulk of the downward movement happened after the last Fed meeting. That doesn’t discount the views of those on the FOMC that want to raise rates but it calls into question their true motives.
Before I start wrapping this up I want to touch on one more economic stat that still generates far more impact in US markets than I think it should; weekly unemployment claims. They get cited constantly by both Wall St analysts and FOMC members and its become something of a pet peeve for me.
Unemployment claims trended lower through 2015 and have stayed low for much of this year. They get trotted out by bulls week after week as evidence of how strong the US job market is.
Apparently these bullish types on Wall St don’t understand how the unemployment insurance system in the US works. The chart on the bottom of this page displays the percentage of unemployed workers who receive unemployment insurance over time.
After most recessions, especially the last one, Federal programs were added to allow long term unemployed to receive benefits longer. This is done for humanitarian reasons as its well known the average length of unemployment increases during and after recessions. Those programs are temporary and phase out over time.
As the chart below shows the percentage of unemployed workers in the US getting unemployment benefits has dropped by about 60% since just after the Great Recession. Understand what this figure means. It does NOT mean 60% less people need or want the coverage. It means, in most cases, they have exhausted the benefits available and can no longer claim them.
Keep that ratio in mind when you hear analysts crowing about low jobless claim numbers on CNBC. They haven’t fallen so fast because everything is awesome in the US economy. They have fallen because workers who are long term unemployed no longer qualify for the benefits. That is a very different thing an not a sign of economic strength.
Several FOMC members talk about the strength of hiring though the latest non-farm payroll report was below consensus and the three month average that is a more reliable measure is still declining.
Wages ticked up last month, though year-over-year, we’re still not seeing much increase in wage gains. When you think of the competition for jobs in the context of the unemployment benefits discussion above, its not that mystifying that there isn't wage pressure.
Does that mean I’m taking the gold bug tack and arguing there will be no rate hike in December? No, I think the bond market has it right as its pricing in 70% odds of a hike in December. Not because I think that the economic backdrop argues for a hike but because its not really about macroeconomics at all.
I think recent speeches by Fed Chair Yellen and Vice Chari Fisher give us the best explanation of what is really motivating the Fed. In a word, its credibility.
I’ve touched on this before but its only recently we’ve seen senior FOMC members openly admit it. Fisher in particular seems worried that the Fed is losing credibility and can’t afford to “cry wolf” again. I’ve noted already that I think its too late to worry about that but it at lease explains motives.
Fisher clearly thinks the Fed has to raise rates rather than engaging in bait and switch for the umpteenth time. I don’t think that is the smartest reason but I at least understand it.
Yellen’s most recent speech was even more illuminating. She was coming out as a dove again, clearly agonizing about the fact near zero bound rates just aren’t having the impact hoped for. Unlike Fishers however she seems to be saying she’ll again vote against a rate hike.
Yellen is concerned that something fundamental has changed and that there may be no acceleration in US growth. Unlike most of her peers on the FOMC she at least acknowledges what’s been obvious to most all along. She appears to be quite unconcerned about the inflation rate. Indeed, in her speech, she was wondering out loud about letting the economy “overheat” and letting inflation run past the 2% Fed target rate.
Strangely, the market reacted to this speech as if Yellen was applauding a strong economy. The USD rose and gold fell during and after the speech with gold bouncing off the $1250 level. I found that reaction mind boggling given the contents of the speech.
I read a completely different message into it. Yellen clearly seemed to be lamenting the fact that a zero bound interest rates haven't accelerated growth and there is little reason to think that will change. Yellen appears to be coming to the conclusion that the only way to pull the US and, by extension, world economy out of a low growth track is to intentionally allow it to “overheat”. Yellen appears to be hoping that doing this will generate some inflationary pressure that will cause consumers to pull consumption forward and drive up growth rates.
It’s not remotely clear whether this would work since it’s also not clear what mechanism not already in place would lead consumers to suddenly up their game. For the time being however that’s not the point. The point is that Yellen’s speech sounded like a central banker intent on doubling down on stimulus (again) not one trying to decide the best time to tighten.
To bring this discussion full circle, recall that my thesis since the start of this year is that gold is in a new bull market. I think it’s a bull market primarily because we can expect to see negative real interest rates persist for an extended period.
Importantly, holding to this thesis does not require me to pick sides in this FOMC fight. Either the hawks are right, in which case we see inflation move up and the Fed remaining behind the curve, even if they raise rates once or twice.
Alternatively, Yellen wins the argument and the Fed allows inflation to run longer and higher (assuming that even happens) in the hope that that prods consumers into increasing their spending more rapidly. In this scenario, if inflation does accelerate, the Fed will be left even farther behind the curve.
Either way, the backdrop hasn’t changed and I think the market will come around to accepting that. When it does, we’ll again see the US Dollar roll over and gold rise. I believe we’re on the cusp of that realization.
Indeed, the remainder of this year for the broader market looks a lot like last year. That should have alarm bells ringing on Wall St. Even though the market is pricing in a rate increase I don’t think it would react well to one. One of the few sectors that may come out of one unscathed, like last year, is the gold sector.
One of the strangest parts of the recent gold market reaction is the apparent complete lack of memory about what happened less than a year ago. The Fed raised rates and the gold price took off. There are good reasons to think that could happen again. In other words, I don’t see many scenarios playing out over the next few months that don’t lead to higher bullion prices.
So why isn’t the gold price flying already? I think you can blame it on the same traders that are now driving up the Dollar. When gold got hot this year, hedge funds and speculators that are chiefly momentum traders jumped on the bandwagon. Like the USD late last year the long gold trade got very crowded. Those traders, who tend to be late and wrong, have to be cleared out for the gold price to stabilize and move higher. The good news is that this is starting to happen.
We’ve seen a 100,000 contract reduction in speculative long positions in the gold market over the past two weeks. That’s the fastest drop since records started being kept. It goes a long way to explaining recent gold price movements.
Interestingly, bullion ETFs have not shown outflows over the same period. I think those are the purview of longer term holders and that its significant they are not bailing.
Predictably, mainstream finance publications are citing the falling speculative long position as a reason gold prices will drop. I’d like to see those positions cut more but have the opposite read on the situation. This drop means the market is coming back into balance.
Technical damage has been done to the gold price. Maybe that generates more selling as so many traders are chartists but I think the interim low is close, if not already behind us.
Times like this call for a bit of bravery, not panic. Even of some prices go lower we’ve seen enough of a drop to make many active companies far better buys than they were a couple of months ago. The update section highlights several companies that still have news coming or soon will. The introduction page to the update lists the most likely beneficiaries of stabilized gold prices. I wouldn’t wait much longer if you’re a buyer.
The next Metals Investor Forum is coming!
November 12th and 13th
Rosewood Hotel Georgia, Vancouver
Join me, Joe Mazumdar, Gwen Preston, John Kaiser, Jay Taylor and Jordan Roy-Byrne for two days of great investment discussions, great companies and great food.
The May MIF got rave reviews and the next one is sure to fill quickly. Why not register now and make sure your seat is secured?
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