Leading and Lagging
From the November 24, 2016 HRA Journal: Issue 261
Things DIDN’T go as expected, with Trump winning the US election and markets embracing the change rather than fearing it. That has led to a serious breakdown in the gold price. The next big items are the November payroll report and December Fed meeting. We’ll have to see how markets react to those events but the odds of a lower for longer gold price shouldn’t be underestimated.
The drop in gold prices and share prices mean we’re likely to see significant tax loss selling. It’s already started and should peak during the second week of December unless we get a big bounce in the gold price first. I fully expect the Fed to raise rates next month. That should be a non-issue but traders will watch the dot plots and press conference to get a sense of how many increases may be on tap for next year. Markets shouldn’t react much to a priced in rate increase but if they suddenly expect several next year that’s a different story.
I view the last two weeks as a Trump honeymoon. It’s too early to know if it will last. Most markets are stretched so a partial return to normality is likely through December. If Trump delivers on his promises I think there is higher inflation in our futures. When the market comes around to agreeing with me on that gold should stabilize.
On the bright side, the optimism lit a fire under base metals so the exploration sector should be more balanced going forward.
Unexpected. How’s that for understatement?
The US election followed the pattern set by BREXIT. The electorate gave the “elites” the proverbial finger, and pollsters too.
The polling going into the US election was even worse than BREXIT, where at least some were talking, and worried, about a momentum shift to the “yes” side. There was a shift in US polls too, but nothing like the move that actual voting results displayed.
Clearly, there are some bad assumptions being made about US, and other, electorates. Populism is on the rise. The move is understandable. Eight years out from the Great Recession and the middle class still isn't seeing much by the way of gains. People are angry that government policies directed at resolving the financial crisis seem to only benefit the top few percent of earners.
I suppose I should have been less surprised. I’ve been saying for years that G8 economies won’t see a return to pre-2009 growth unless the economic gains are more evenly shared. It makes you wonder how the Italian referendum and state and national elections in Europe through the next year are going to go. Few could conceive of the hateful nationalist parties over there coming into power but, after this month, who knows?
That’s not a good thing and definitely isn’t a less risky market backdrop. Populists tend to focus on negative stereotypes and identity politics. Their economic platforms, to be polite, are on the simplistic side. That makes it hard to know what their market policies will look like.
People talk about Trump’s economic policies but his campaign was always light on specifics. The main thrust seems to be a tax cut, some sort tax holiday on earnings repatriated from overseas by US companies and a “Yuge!” infrastructure spending program.
Trump got elected by promising jobs. How he delivers on that is anyone’s guess, including his. Strictly speaking, the US doesn’t have a big job shortage. It has a shortage of good paying jobs to replace those lost by de-industrialization and globalization in the US Rust Belt and Flyover states. People expecting him to deliver on that promise elected him in those states. We’ll see how long they’re patient if those jobs don’t suddenly appear.
I was wrong about the impact of a Trump win, and so was pretty much everyone else. Part of the reason is that we underestimated the potential short term impact of some of Trump’s backers like Carl Icahn.
Icahn told reporters he left the nascent Trump victory party the night of the election so he could buy the market. Hard. He claims to have put $1 billion to work by the next morning.
Is this true? I have no idea, but it would help explain the massive swing in S&P futures the night of the election. SPX went from “limit down” (down 5%) to close to even by the time Wall St opened the next morning.
Assume Icahn was buying options and futures, likely at that time of night. $1 billion buys you anywhere from 2000 to 20,000 SPX contracts if you’re buying the near month, more if you move farther out the price curve and way more if you’re trading options or the SPY ETF rather than futures contracts.
That’s a lot of volume, even for markets as heavily traded as SPX and SPY. Both traded twice their average volume the day after the US election. I have no idea what Icahn did but he and a couple of others like him had the firepower to turn the market that night if they had sufficient conviction, which Icahn says he did.
Look at the 18 month US Dollar chart near the top of the article and two-year (weekly) chart of US 10-year Treasury yields above. Those are huge, relentless moves. What’s driving them?
First, I think it’s the yield chart driving the USD, not the other way around. Everyone and their dog was long the bond market, even though everyone knew we had to be near, if not past, a top. You get to zero interest rate policy and there isn’t much upside left.
Bonds started to top out in late summer but the move since the US election has been breathtaking. Its not so much the scale of the move as the speed that has been damaging. A big chunk of the market was on the wrong side of that trade, including pretty much every Wall St all-star you can name. We’re in the middle of a big unwind.
To understand what’s driving this change in positioning by Wall St’s big players, look no further than the chart below. There has been a big increase in inflation expectations since Trump was elected. Again, its not so much the scale of the change (up to now at least) that has mattered; it’s the speed.
The main themes Trump has talked about since election are tax cuts, infrastructure spending and profit repatriation. Assuming his administration pushes those through, there would be an immediate revenue drop and plenty of new spending.
Its assumed repatriated profits would be put to work creating jobs and building US plants. Why? The US still has very low capacity utilization by historic standards. They don’t need more factories. Call me cynical (many do) but I expect the bulk of profits repatriated from offshore would go to share buybacks and dividend increases. In other words, it would mainly favor the same class favored by current policies. No “swamp draining” there.
Bond Vigilantes heard “tax cuts” and “new spending” and immediately hit the sell button. That magnified selling by others who were on the wrong side of the bond trade and already trying to get out. Others view the Trump win as a game changer that will finally lead to US economic growth accelerating.
Stronger economic readings in the US and the growing yield gap generated strong buying of the $US. You can see from the chart on the page 1 that its broken above 2015 high. It will go higher still if the euphoria lasts but its getting into the danger zone. It’s at levels that generated crashes in emerging market currencies and bourses a year ago. Maybe emerging markets catch a bid soon but the situation is eerily similar to that a year ago and that didn’t end well.
Emerging Markets aside, the USD is at a level where it will impact exports and overseas profits for SPX companies. With the huge amount of momentum and sentiment buying going on the $US could surge higher but it will start to harm the US economy if it does.
The move in yields and the USD has crushed the gold price since the election. The top chart, below, shows the percentage move down in the gold price pretty much matched the percentage increase in the USD index during that period.
The “currency effect” can be seem clearly in the middle chart which tracks the percentage change in the gold price since July. You can see the post election loss for gold priced in Dollars is much larger than gold denominated in Yen or Euros.
The strange thing about the reaction of the gold market is the move in yields and the USD seem largely driven by fear of inflation moving higher going forward. That should be gold positive. It’s very unusual for both bonds and gold to sell off simultaneously.
Traders assume a major uptick in US growth and optimism. Maybe, but the market has already priced in a brighter tomorrow. Trump doesn’t take office for two months and many of his policies, if they get legislated at all, will take months or years to generate real world impact. Markets are ignoring the potential for Trump or his inner circle to do something stupid or say something that freaks the markets out. Sorry, but we’re talking about Donald J. Trump here. There’s no way the election of someone with his track record has lowered risk going forward.
Likewise, I think anyone assuming budgets will magically balance under “Trumpinomics” is kidding themselves. This guy owes his fortune to leverage and inflation. If there’s anything Trump isn’t afraid of, its debt.
Would Trump sit down with Grover Norquist and promise never to raise taxes? Sure. Would he promise to balance the budget? If it stopped the moaning from his corn-fed Tea Party caucus from the flyover states, probably. Would he then immediately ignore that promise he made just to shut them up? Almost certainly.
The combination of large deficits and (maybe) sustained optimism mean Trump is likely to be “the inflation President”. That will be gold positive once the market recognizes it.
Some of the move in gold is unwind of one sided positioning. The bottom chart on the previous page shows the speculative long positon in gold held by large traders. You can see its dropped by 40% in the past two months including a large drop since the election.
Gold prices fell for several days after the cut off date for the latest COT report so it should be lower still now. I think we need the speculative long positon unwind further to be comfortable we’re at a bottom.
The current market for the USD is very overbought and bonds and gold are just as heavily oversold. We’re due for a bounce. Whether that marks a medium-term bottom remains to be seen.
As this issue was being completed gold spiked below $1200 on a strong durable goods report (mainly highly volatile aircraft orders) How the metal responds through the next payroll report and Fed meeting will determine whether we’re facing a multi-month rather than multi-week correction. I think the pre-election assumptions about Trump’s impact on the gold market will ultimately prove to be correct. It could be rough sailing in the near term though.
Things are much brighter on the base metal side, for the same reasons. Updated versions of the copper and Yuan charts from the last issue appear on this page. I recommended caution on copper last issue and you can see why. In the wake of the US election we saw a huge speculative blow off, with the price peaking at $2.70.
That is a crazy move for a commodity expected to show at least a slight oversupply next year. Seasoned copper explorers and developers I spoke to during this period are leery of this move. The move doesn’t seem justified but it won’t matter as long as Wall St keeps piling on.
Its interesting and perhaps significant that the selling that is plaguing precious metals isn’t affecting the broader commodity market nearly so much. I think the increased optimism is real, we just don’t know how much of its justified yet.
In general, commodities have stabilized. We must continue to treat metal markets individually though. Some of the buying is pure speculation by Chinese punters and NY hedge funds. I don’t consider either group “smart money” but they can buy enough that metals like copper could hold part, perhaps a large part, of recent gains. I wouldn’t be shopping for “copper optionality” plays that require a higher price just yet though.
As you can see from the chart on the previous page, the Chinese Yuan continues to weaken. That is also driving some of the speculative trading. You have to wonder how a Trump administration will react to that if it continues. Considering how Trump vilified the Chinese on the campaign trail, I don’t think it’s hard to guess.
One base metal that I do think deserves its price move is zinc. As the chart on this page shows that move looks more significant than some others. Zinc has decisively broken above the $1.10/lb level that capped it twice in the past two years and is holding multi-year highs. There is a reason the last couple of additions to the Journal list were predominantly zinc stories.
We’re only two weeks into the Age of Trump. Markets have reacted very favorably so far. We all know that highly liquid markets like Wall St and the Treasury markets are leading indicators. Note, and this is important, that is not the same thing as saying they are always right. On the contrary, fast moving traders often get the market wrong. There are plenty of examples of that in just the last couple of years.
The leading indicators, equity indices and bond yields, are pointing to faster growth and higher earnings and, probably, higher inflation. While the leading indicators have traders enthused, its lagging indicators that will determine if those hopes are grounded in reality.
Traders are taking great comfort from the surge in US growth in Q3. I’ve noted already some of that was one-off events like soybean exports. More importantly though, some of the biggest contributors recently have been interest rate sensitive sectors, namely residential construction and auto sales, which are virtually all debt financed.
The surge in car sales and housing starts are all measured for periods before yields started to rise. I think it’s a done deal that the Fed raises rates 25 basis points next month. My main worry is they go for 50. That is moot for both auto loans and mortgages. Rates for both are set by the market, not the Fed. Those rates are rising already.
I’m not predicting impending disaster, but if rates keep rising its reasonable to assume we’ll see both car sales and residential construction roll over. I don’t know what the magic number is, in terms of prevailing yields, where that starts to happen. I don’t think anyone knows, but its quite possible we’re about to find out. We might see a surge while consumers lock in purchases before rates rise further but beware of a pull back after that.
When it comes to the economy, the devil is in the details. We won’t know the true effects of Trump for a few months. Beware those lagging indicators. The Fed has been afraid to raise rates this year. We’ll know soon if those fears were justified. I think the optimism is great but that will only be self sustaining for so long. The Trump team needs to show the middle class it can deliver on its promises. I hope they can but the jury is still out on that one.
Given the uncertainties, I’m more comfortable with potential discovery stories for the time being. They perform better when metals are strong, but new discovery news can overcome near term weakness in the metals being explored for. I prefer those to optionality plays that are shackled to metal prices. One such discovery potential story is introduced this issue.
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