A Test of Strength for Gold
By Frank Holmes
CEO and Chief Investment Officer
U.S. Global Investors
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When investing in gold, I often say diverse opinions promote critical thinking and a healthy market. I believe elevated groups of buyers and sellers create a competitive tug-of-war in the bid and ask price of the precious metal.
This week, we saw the gold bears growling louder and gaining strength, as the world’s largest gold-backed ETF, the SPDR Gold Trust, experienced its largest one-day outflows since August 2011. The Fear Trade fled the sector following the Federal Reserve’s meeting that revealed a growing dissension among some of its members over the central bank’s bond-buying program.
Despite the discord, the Fed is continuing its course to purchase $85 billion of bonds every month and keep interest rates near zero. Ben Bernanke’s plan bloating the balance sheet to more than $3 trillion has been keeping the Fear Trade coming back for more metal.
For good reason, too, as the correlation between the Fed’s balance sheet and the price of gold has historically been very high, at 0.93, according to Macquarie Research. The firm found that for every $300 billion expansion in the balance sheet of the U.S. government, there was a $100 an ounce increase in the price of gold. When you factor in the Fed’s current bond purchases totaling $85 billion per month for the next nine months, the central bank will be adding $765 billion in new assets. “Using the previous ratio, this would compute to a $255 an ounce increase in the gold price,” says Macquarie. By this measure alone, gold would rise approximately 16 percent over the next several months.
On Bloomberg’s Taking Stock with Pimm Fox this afternoon, I said that Bernanke will likely keep liquidity high for quite some time, in his effort to meet his goal of lowering the unemployment rate. If the Fed did take its foot off the bond-buying pedal sooner than planned, such a move is apt to shake the resolve of some gold buyers. It’s easy to be confident in gold in times of extreme fear; when the economy improves, one may no longer feel that gold stands on solid ground.
Take another period characterized by extreme volatility and fear, when there was conflict in the Middle East, oil-related inflation shocks, declining value in the U.S. dollar, rising U.S. unemployment and a strong resolve from the Fed to act aggressively. This was four decades ago, after President Richard Nixon removed the gold standard, and the yellow metal climbed to a peak of $850 by January 1980.
Back then, India and China had little financial footing in global markets; gold demand from these areas of the world was about 15 percent of total demand.
Since then, we’ve seen a rapid increase in GDP and incomes, resulting in a dramatic rise in gold demand. According to the World Gold Council (WGC), there’s now an “increasing relevance of emerging markets in the gold market, particularly over the past 12 years.” In 2011, you can see that emerging markets accounted for 74 percent of total bar and coin, jewelry and ETFs gold demand. India and China alone make up 50 percent, and together with Turkey, Vietnam, and Southeast Asia, these countries’ residents clearly “have a cultural affinity to gold,” says the WGC.
To help investors analyze whether gold continues to be a wise investment, I like to refer to the book The Wisdom of Crowds by James Surowiecki. There are four factors to consider whether a crowd is suffering from groupthink or is making wise decisions:
- 1. Is there a diversity of opinion?
- 2. Are investors independently acting on their best interests?
- 3. Is there a decentralization of gold believers?
- 4. Is there aggregation?
Read Evaluating the Wisdom of Buying Gold to see a summary of each factor for your reference. I believe you’ll find these factors continue to be valid for gold.
Ultimately, the key to gold is moderation. As I said in my book,The Goldwatcher, and often reiterate to investors when I speak at conferences, gold is a volatile asset class and the daily price can be more dramatic than blue-chip stocks. We have always advocated that investors hold a modest 5 to 10 percent weighting in gold and gold stocks. In other words, we feel strongly that an investor should not try to get rich from the metal.
Marc Faber expressed a similar idea in this month’s Gloom Boom and Doom Market Commentary. Instead of selling his gold when the price is falling and buying it back at a lower price, he says he doesn’t stray from his asset allocation approach. He holds a 25 percent allocation to gold, which is much higher than we recommend, and believes that if the price of gold declined, it is likely that his financial assets would increase.
In his closing, Faber reminds readers of the English Proverb: “When we have gold, we are in fear; When we have none, we are in danger.” If the proverb were written today, it might be revised to say, “When we have gold, we are in love.”
Index Summary
- The major market indices generally finished lower this week. The Dow Jones Industrial Average was the exception rising 0.13 percent. The S&P 500 Stock Index fell 0.28 percent, while the Nasdaq Composite lost 0.95 percent. The Russell 2000 small capitalization index closed the week with a 0.76 percent loss.
- The Hang Seng Composite fell 3.19 percent; Taiwan rose 0.52 percent after being closed all last week and the KOSPI gained 1.90 percent.
- The 10-year Treasury bond yield fell 4 basis points this week, to 1.96 percent.
Domestic Equity Market
The S&P 500 fell for the first time this week as the market reacted to the Federal Reserve’s minutes from the January 29-30 meeting which indicated policymakers were concerned with the risks surround the current Quantitative Easing (QE) program. The market is concerned that if the Fed were to prematurely stop the QE program, a key support for the market would be withdrawn.
Strengths
- Defensive areas outperformed this week as the staples sector led the way. Safeway was the best performer, rising by 11.1 percent on better-than-expected earnings results. Coca-Cola, Philip Morris and Colgate-Palmolive also were strong performers.
- Telecom services and utilities were strong this week as they are classic defensive areas in a market sell-off.
- Hewlett-Packard was the best performer in the S&P 500 this week, rising 14.4 percent. The company reported earnings and updated investors on its turnaround efforts, which included raising the company’s forecast for the second quarter above Wall Street estimates.
Weaknesses
- The materials sector was the worst performer by a wide margin. Fears of a premature ending to QE and reports of China implementing policies to slow the property sector were the likely culprits pulling the sector down.
- The consumer discretion sector also underperformed, largely driven by housing-related names which suffered a bout of profit taking.
- Garmin was the worst performer in the S&P 500 this week, losing 10.6 percent. The company reported fourth quarter earnings that missed estimates and guided full-year 2013 earnings lower.
Opportunity
- Retailers are beginning to report and a few of key names to watch for next week are Lowe’s, Home Depot and Target.
Threat
- The market finally pulled back just a tad this week, but more consolidation wouldn’t necessarily be a surprise.
The Economy and Bond Market
Treasury bond yields fell modestly this week as economic news was mixed and the biggest story of the week was the Fed minutes from the January 29-30 meeting which indicated concerns with the current pace and magnitude of the Fed’s QE program. While some commentators came to the conclusion that the Fed could stop or reduce its QE program as early as the March 20 meeting, the chart below argues against it. The chart depicts retail gasoline prices which have risen almost 15 percent just this year. Adding the economic drag of higher gasoline prices to the uncertainty surrounding the pending sequestration and other political risks, it appears unlikely the Fed will reverse policy so soon after implementing it. Continued low inflation and high unemployment also add to the argument against curtailing the QE program.
Strengths
- Inflation remains low with both the Producer Price Index (PPI) and Consumer Price Index (CPI) being reported this week. Year-over-year PPI rose 1.4 percent while CPI rose 1.6 percent.
- The Conference Board U.S. Leading Index rose 0.2 percent in January indicating continued economic expansion.
- Headline housing data was mixed, but under the surface the trend continues to look positive as new permits hit the highest level in more than four years.
Weaknesses
- Gasoline prices hit a four-month high and act to slowdown the economy.
- Several Fed policymakers expressed concerns about the risks of the existing QE program, causing the market to question the Fed’s resolve.
- The Philadelphia Fed Index unexpectedly declined in February and is the worst reading since June.
Opportunity
- While some Fed members expressed concerns over continued quantitative easing, the Fed still remains committed to an extremely accommodative policy until the economy improves.
- With the stock market struggling some this week, investors appetite for fixed income may return.
Threat
- The economy appears to be gaining momentum and bonds have sold off; the risk for bondholders is that this trend continues.
- Inflation in some corners of the globe is getting the attention of policymakers and may be an early indicator for the rest of the world.
Gold Market
For the week, spot gold closed at $1,581.40, down $28.70 per ounce, or 1.78 percent. Gold stocks, as measured by the NYSE Arca Gold Miners Index, lost 5.01 percent. The U.S. Trade-Weighted Dollar Index gained 1.12 percent for the week.
Strengths
- ISI noted in its Weekly Economic Report that its Company Economic Diffusion Index for the U.S. ticked down from a week earlier. In each of the last three years this index has surged on optimism, only to attain lower highs and then fall to lower lows. These declines from unfulfilled expectation of growth marked what ISI has called a “Growth Problem” and typically these declines line up with downturns in the broader market. In the near term, this could dampen the enthusiasm for the wall of money that is chasing performance and lead to a strengthening of gold prices.
- Despite the call to be ready to vary the pace of monthly bond purchases by several Federal Reserve policymakers, Fed Chairman Bernanke said the economy was far from operating at full strength, reiterating his commitment to monetary easing. Over the past three months, the Fed’s balance sheet has surged almost $200 billion after remaining flat for the last 18 months. Gold price changes have exhibited a strong correlation with the Fed’s balance sheet expansion over the last decade. However, the price of gold has headed south with surging stock prices in January, yet the monetary base continues to rise, thus creating a very bullish scenario for gold in the coming months.
- On Wednesday, the price of gold hit the “death cross,” a technical indicator used by analysts when the 50-day moving average crosses below the 200-day moving average. The hitting of a death cross is normally associated with a continued sell-off. However, Ryan Detrick of Schaeffers Investment Research noted this is a bit of a false indicator when it comes to gold. He showed that the past 22 times gold has hit the death cross, it has gone on to post positive returns for the 1-, 2-, 3-, and 6-month periods after the cross.
Weaknesses
- The SPDR Gold Trust, the world’s largest gold-backed exchange traded fund, reported its bullion holdings decreased by 20.77 tonnes on Wednesday, marking the largest one-day outflow in the last 18 months. The drop coincided with an intraday $40/ounce fall in the gold price, the largest in almost a year. In addition, the Market Vectors Gold Miners ETF traded at its highest daily volume since inception in 2006. Typically, though, this type of high volume liquidation event bodes well for higher bullion and gold stock prices.
- David Rosenberg of Gluskin Sheff noted the currency skirmish (read: full out war) being waged by countries across the globe should have gold peaking; but not only is gold selling off, it has dropped by 1.8 standard deviations over 60 days. Higher inflation expectations are becoming evident across the bond market, where Treasury Inflation-Protected Securities (TIPS) breakeven rates keep grinding higher as the consequences of central bank actions are starting to show. It is ironic that in the same universe where inflation protection is become more valuable, the most natural hedge against inflation risk – gold – is not peaking. David Rosenberg and others suspect there might be something else driving gold, most likely forced selling somewhere from redemptions.
- One would think investors would have learned by now not to believe every politician’s utterance. But investors and the masses seem fairly comfortable absorbing the enormous spread of disinformation by politicians in an effort to keep their constituencies in line. The result has been evident in consumer and investor sentiments, which have largely preferred risky assets over gold.
Opportunities
- In his notes to clients, David Zervos of Jefferies continues to write critically of the central banks’ printing frenzy. This week he argues that the current trade does not involve one currency against another, but rather a trade of ALL currencies against real assets. Banks are printing to force risk-taking, leading investors to buy the limited supply of risky assets before someone else with a bunch of printed reserves beats them to it. The current race among central bankers is to lower rates faster than anybody, and in doing so they are risking the long-run inflation stability which could prove difficult to contain.
- There is major change happening across the top management of gold miners after massive write-downs of enormously expensive projects. For a gold and precious metal investor, this means a serious change in policies and the establishment of a more cautious approach to pursue profits and dividends. The key play new CEOs are charged with is that of containing costs, both in production and in resource increases, and delivering value to shareholders. Next week, BMO Capital Markets is hosting its Global Mining Conference, one of the largest company and investor meetings of the year. Investors are demanding change in practices of the past or expecting a change in management.
- Investor optimism appears irrational at times. The S&P 500 just hit a 5-year high and the NASDAQ is now at 12-year highs. Investors seem to have just taken notice as record inflows into U.S. equity mutual funds surged to their highest level in a decade. Incidentally, record outflows from mutual funds took place at the market bottom of late 2008.
Threats
- India is considering a second gold import tax hike this year as it battles a widening current account deficit. The country, which holds the spot as the world’s biggest gold buyer, is looking at raising the current 6 percent tax rate to 8 percent.
- The fall of gold below the $1,600 level acts as a reminder of Alan Greenspan’s famous “irrational exuberance.” The global trend is one of fiat money chasing anything supported by loose monetary policy on the back of shorts on hard assets such as gold. Low inflation means lower risk premiums, which support high valuations of depreciating assets, and lower premiums for safe havens.
- Gas prices have increased dramatically year to date in what imposes a $60 billion annual drag on the economy’ the housing sector has started to cool down with mortgage applications down 1.7 percent, sequestration budget cuts are approaching fast with a likely hit of 0.5 percent to GDP and higher taxes are being proposed as the cure to head off any cuts in spending. Contrarian investors are likely positioning for a less rosy outlook.
Energy and Natural Resources Market
Strengths
- U.S. existing home sales increased 0.4 percent month-over-month to 4.92 million units at an annualized rate in January, and the number of unsold properties declined to the lowest level since 1999. For comparison, total sales last year were 4.66 million units, the highest number since 2007. According to Macquarie, this data suggests the U.S. housing market recovery continues to progress, and further positives can be drawn from the fact that distressed sales continued to decline as a proportion of existing home sales, accounting for 23 percent of the total last month, compared with 35 percent in January 2011.
- World industrial production, a key determinant of metals demand, rose a seasonally adjusted 0.6 percent month-over-month in December 2012, according to research group CPB. On a year-over-year basis output was 2.8 percent higher, a relatively modest increase, with production in the advanced economies down 0.8 percent year-over-year and in emerging economies up 5.9 percent year-over-year. The data underlines the contrasting fortunes in industrial production seen in the last decade, with output in the advanced economies in 2012 as a whole just 1 percent higher than it was in 2000; over the same period it has risen by 141 percent in the emerging economies.
Weaknesses
- Oil prices fell this week as the NYMEX crude oil contract settled at $92.84 on Thursday, the lowest settlement this year on continued weakness following the Department of Energy weekly supply report showing that crude inventory climbed to the highest level since July. Selling pressure also weighed on crude as indications that Saudi Arabia would raise production in the second quarter after making sizable cuts to supply since late last year.
- Commodities endured a broad-based sell-off this week as the U.S. Dollar strengthened after the Federal Open Market Committee minutes revealed concerns about costs and risks of further asset purchasing plans. Tighter policy aimed at property speculation in China and liquidity withdraw by the People’s Bank of China (PBOC) also exacerbated market fears. Most industrial metals have given up their gains year to date and moved into negative-return territory.
Opportunities
- China has a “structural shortage” in its grain supply because demand continues to rise, Minister of Agriculture Han Changfu said in a statement posted on the central government website. For the second year, China has been a net importer of rice, wheat and corn, Han said. China faces a “very difficult task” balancing its grain demand and supply, according to the statement, which summarized the minister’s speech at a February 17 national conference on this year’s planting.
- Japanese Prime Minister Shinzo Abe will ask President Barack Obama to allow shale gas exports as the world’s third-largest economy grapples with soaring energy costs after 2011’s nuclear disaster closed reactors. The request will be made at a meeting Saturday between Abe and Obama in Washington, said three Japanese officials, who declined to be identified because the information isn’t public. The bill for importing liquefied natural gas (LNG), combined with a weaker yen, prompted Japan to post a record trade deficit in January of 1.63 trillion yen ($17.4 billion), the Finance Ministry said yesterday. The switch from nuclear to gas-fired generation after the accident at Fukushima forced Japan to increase LNG imports 11 percent last year. Abe wants Obama to share the benefit of surging output from shale fields, which has depressed the cost of U.S. gas to about 20 percent of Asian prices, by approving export terminals. Some U.S. politicians oppose shipments overseas because the lower energy costs are making manufacturers more competitive, helping to create factory jobs.
Threats
- Grain prices will fall "significantly" in 2013 due to strong corn and soybean production in 2013, U.S. Department of Agriculture’s chief economist predicted this week at the agency’s annual Agricultural Outlook Conference in Arlington, Virginia. Joe Glauber predicted that corn prices will average $4.80 a bushel in 2013-2014, down 33 percent from the marketing year before. Soybean prices, he estimated, would fall 27 percent to $10.50 per bushel. A return to normal weather conditions, he predicted, will result in higher production that will depress prices.
- Bloomberg news reported that a tax break used by oil and gas pipeline companies such as Kinder Morgan Energy Partners LP will cost the U.S. government $7 billion through 2016, about four times more than previously estimated, Congress’s tax scorekeepers said this month. The nonpartisan Joint Committee on Taxation quadrupled its cost estimate for exempting the fast-growing “master limited partnerships” from corporate income tax in the year ended in September to $1.2 billion from $300 million. The annual cost will rise to $1.6 billion by fiscal 2016, the committee said. The revision reflects the growth of tax-free publicly traded partnerships. They have taken over the U.S. pipeline business and are expanding into the rest of the oil and gas industry, partly by gobbling up dozens of tax-paying companies. With President Obama and congressional Republicans calling for a tax overhaul, the higher cost estimate may make it harder for industry to protect the MLP subsidy, said John Buckley, a tax professor at Georgetown University Law Center.
Emerging Markets
Strengths
- Finance Minister Xie Xuren says China will maintain positive fiscal policy and prudent monetary policy, Xinhua News reported.
- China jewelry sales over the Chinese New Year period grew 38 percent, according to the Ministry of Commerce.
- January car sales were up 49.4 percent in China due to extra working days and strong demand for local brands and luxury names, particularly Audi and BMW.
- More than 4 million people from China participated in overseas group tours, up 14 percent year-over-year. Over 90 percent of the travelers went to Asian tourist sites and the hottest destinations were Thailand, Korea, Hong Kong, Macau and Taiwan. This is the reason tourist businesses in those countries and regions are enjoying double digit sales and earnings growth, which is one of the Asia megatrends that investors can potentially benefit from.
- Thailand fourth quarter GDP growth was 18.9 percent, better than the market consensus of 15.3 percent. The accelerated growth was broadly based in domestic and external demand. For 2012, Thailand GDP grew 6.4 percent.
- Malaysia fourth quarter GDP grew 6.4 percent versus the estimate of 5.5 percent, and improved from 5.3 percent in the prior quarter. For 2012, Malaysia GDP grew 5.6 percent.
- Poland’s debt rating outlook was raised to positive from stable by Fitch, which cited the country’s narrowing budget deficit, stabilizing government debt, and economic growth. The budget deficit narrowed by about 4.5 percent of GDP since 2010 to an estimated 3.4 percent last year.
- The Central Bank of Turkey shifted the interest rate corridor down by 25 basis points, while simultaneously raising reserve rate requirements by an average of 20 basis points. The bank acknowledged the strong capital inflow to the country and intends to preserve the financial stability by maintaining the low interest rate environment supported by the macro prudential measures.
- Banco Daycoval, S.A. of Brazil rose 6.46 percent, leading the financial sector in the Brazilian market this week following a strong earnings report, the issuance of a dividend, and the announcement of a share buyback program. A small bank compared to regional giants Itau and Bradesco, Daycoval outperformed by reducing its credit portfolio as credit delinquencies rose across the country. The Bovespa Sao Paulo Stock Exchange Index declined 2.35 percent for the week ended February 22.
Weaknesses
- In the China State Council meeting, Premier Wen Jiabao called on local governments to “decisively” curb housing prices from rising. In the meeting, China decided to expand property tax trials to more cities. The market had reacted negatively at the rumor but positively when the policy directory was confirmed on Friday.
- In separate news, the People’s Bank of China (PBOC) had withdrawn Rmb910 billion ($146 billion in USD) in the week, which followed a commentary on the central bank’s website that said it was concerned with potential inflation risk. The market is afraid that PBOC may start tightening money supply by restraining the fast growth of total social financing, which again may not happen immediately at this stage of growth recovery.
- Retail and restaurant sales during the Chinese New Year rose 14.7 percent to Rmb539 billion, the lowest pace in four years, according to the Ministry of Commerce. The market speculated this was due to anti-corruption efforts by the new leadership which curbed government officials from spending public funds for gift-giving and entertainment.
- Macau stocks dropped in the week on disappointing month-to-date February revenue growth which was up 2 percent but below market expectation, though mainland visitor growth was up 20 percent during Chinese New Year.
- Russian inflation jumped to 7.1 percent in January from 6.6 percent in December, exceeding the target range and bolstering the International Monetary Fund’s case that the central bank must refrain from easing monetary policy. The government had urged policymakers to cut rates after economic growth slowed to 3.4 percent last year.
- Russian retail sales grew 3.5 percent in January, according to Rosstat, the slowest pace in almost three years as unemployment rose and inflation sapped household purchasing power.
- Peruvian exports tumbled 16 percent in December together with the domestic construction industry bringing economic growth down to 4.3 percent compared to 6.8 percent in November. The strength of Peru’s construction industry had previously shielded the country’s commodity dependent economy from international commodity price fluctuations. Despite missing economic growth expectations local economists believe the construction industry will regain strength in 2013 and foresee no need to alter benchmark rates in the short term.
Opportunities
- As shown in the Chart above, inventories of houses available for sales in the tier 1 cities are low, which indicates rapid sales growth and a supply shortage. The structural land shortage in tier 1 cities favors developers who had plenty of land reserves and growing project pipelines. For the overall real estate sector in China, it is showing inventories are regressing to the average historical levels due to slower start-ups since the beginning of 2012, and rapid sales growth since the second half of last year, which also indicates healthy fundamentals for developers.
- In the current environment, when global slowdown fears come back to the fore, Indonesia, Philippines, Thailand, and Turkey may outperform again as money flows follow growth.
- The Pacific Alliance trade bloc was established in 2012 by Chile, Colombia, Mexico and Peru to bolster free trade and economic integration with Asia. The founding members have vowed to lower the barriers to do business with Chile at the forefront of this initiative. Chile has passed a law that will allow people to instantly register companies for free, has opted to provide selected start-ups with equity-free seed capital, and has significantly eased the path to obtaining Chilean residency. No surprise Chilean President Pinera welcomed European leaders to the Economic Commission for Latin America and the Caribbean (ECLAC) summit two weeks ago saying “Welcome to a better world.”
Threats
- The HSI (Hang Seng Index) Index fell through the 50-day moving average in a profit-taking week. The market found an excuse in the weaker-than-expected sector growth numbers during the Chinese New Year to take profit gained since early September of last year.
- Brazil’s latest inflation reading came out higher than expected at 6.18 percent, making it the eighth consecutive month of rising inflation above economists’ forecasts. The rising inflation continues to put pressure on the central bank to raise interest rates at a time when economic growth is hovering at 1 percent, far below the other BRIC countries. In addition, the country reported a $11.4 billion current account deficit for the month of January, a measure that is likely to increase with an interest rate hike, thus making a monetary tightening more likely to dampen economic growth.
- Despite record high oil prices, free cash flow generation of Russian integrated oil companies is diminishing due to: (i) higher taxes for extraction and (ii) rising costs, driven by higher pipeline and railroad tariffs, as well as double digit increases in electric power prices.
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