October 22nd, 2016
By Shane Obata.
Some people say that gold is dead. They point to deflationary pressures and a bear market that started back in September of 2011. The bulls have been wrong for years; however, that may be about to change…
At present, there are multiple reasons to consider gold:
- Sentiment is very negative and almost everyone is underweight
- Supply & demand fundamentals are positive
- Chinese demand continues to rise
- Gold is a means to portfolio diversification
- The main risks to prices are overblown
In the next sections, we will examine the bull case for gold and the risks facing it. In conclusion, we will try to answer the following question: Is this the beginning of a new golden age?
Sentiment & Positioning
In the latest Barron’s Big Money Poll, only 3% of respondents thought that gold was the most attractive asset class. Moreover, 71% were bearish on the yellow metal. Volume traded in $GLD (the SPDR Gold Trust ETF) has come down dramatically, which indicates a lack of interest in gold bullion. Volume traded in $GDX (miners) and $GDXJ (junior miners) has been increasing; however,interest in “gold mining stocks” has been falling since mid-2011. This suggests that traders are trying to catch the falling knife, even though investors are not convinced that gold is undervalued.
In terms of positioning, market participants are heavily underweight materials and commodity stocks. Is this a contrarian buying opportunity? It could be. Especially because the current bear market is getting old. The following table shows the 5 most recent bull and bear markets:
Gold prices fell by 44% over the 52 months from September of 2011 to January 7th of 2016. Those numbers match the median length and average cumulative return of the previous 4 bear markets. Gold may continue to fall from here; however, we are probably closer to the end of the bear market than to the beginning…
Supply & Demand
~46% of gold production is FCF negative at current prices. In other words, $1100 is not the equilibrium price. If we stay at these levels then supply will likely decline. Analysts at Credit Suisse ($CS) are projecting a deficit to begin in 2016. They expect that mine supply will fall by 11.5% from 2015 to 2018:
Even at higher prices, gold miners will be unable to replace all of their depleting reserves. Also, it will be very expensive for them to bring new projects online. Lastly, it is important to note thatmajor gold discoveries have become scarce. These trends are negative for supply and positive for prices.
On the demand side, Asia and Europe should continue to support the market. Total bar and coin demand (in tonnes) increased 33% YoY from Q3’14 to Q3’15. Furthermore, consumer demand was up across the board, with exceptionally big numbers in the US. According to the World Gold Council (WGC), “coin sales by the US mint during the quarter were on par with that of Q4 2008.” Another key source of demand is central banks. They have continued to buy as they look to diversify their reserve assets. This speaks to gold’s utility as a portfolio diversifier. Total demand has been falling; however, the quarterly numbers suggest it could be stabilizing. Going forward, consumer demand is likely to offset ETF outflows.
India & China are the main drivers of demand for gold. In 2014, they accounted for ~1710 tonnes of demand. To put that in perspective, 1700 tonnes = 53% of total consumer demand:
Gold is a big part of both India’s and China’s culture. As such, it is likely that demand will remain strong.
China’s Gold Market
There is an interesting divergence taking place in the physical gold market. China’s demand numbers, as measured by withdrawals from the Shanghai Gold Exchange (SGE) are much higher than those reported by the World Gold Council (WGC). SGE withdrawals exceeded the WGC’s demand estimates by 3,193 tonnes from 2007 to 2014.
The following passage is from Bullion Star’s Koos Jansen helps to explain the discrepancy. “The difference was labeled as net investment (in the CGA Gold Yearbook 2013 at 1,022.44 tonnes), which is calculated by the China Gold Association (CGA) as a residual between what is withdrawn from the SGE vaults and gold sold at retail level (jewelry shops and banks). The WGC doesn’t count net investment on its demand balance, but only measures what is being sold at retail level. Net investment, which roughly equals the difference, can only be caused by direct purchases from individual and institutional customers at the SGE that withdraw their metal.”
In China, gold imports must pass through the SGE before entering the market place. In addition, bullion exports are prohibited. It follows that Imports + Mine Supply + Scrap = Total Supply = SGE Withdrawals. Said another way, SGE withdrawals are equivalent to domestic wholesale demand. The preceding formula is supported by reports from the CGA and the SGE. For example, the SGE reported that 2197 tonnes were withdrawn its vaults in 2013. That is the same number that the CGA reported for total demand in 2013. More evidence comes from the SGE’s chairman, Xu Luode, who said the following in 2014:
The main conclusion is that the SGE’s measure of Chinese gold demand is much higher than the WGC’s. If the SGE’s number are correct then China is absorbing most of the world’s mine supply. Gold withdrawals from the SGE for 2015 amounted to 2596 tonnes, or 91% of world gold production:
Diversification & Protection
Gold has a negative correlation with US stocks during expansions. More importantly, its correlation with both global and US stocks is more negative during contractions:
As a result, gold tends to rise when stocks fall, which is good for portfolio diversification.
Gold is also an FX hedge for foreign investors. In 2015, it performed relatively well in non-dollar currencies such as the Brazilian Real, the Russian Ruble, the Chinese Yuan and the Canadian dollar. This is important because non-US countries are the main consumers of gold.
Loose monetary policy is here to stay. This cycle, every central bank that tried to raise rates has had to reverse course. That is bad for currencies and good for gold, since no one controls its supply.
Gold can also protect us against a rising cost of living because it tends to hold its value over time. If you look at the CPI then inflation seems relatively low. That said, the CPI is a utility index, not a measure of the cost of living. Most people would agree that cost of living is rising. For example, education and medical care costs have been outpacing the CPI for years.
Risks
Gold’s main threats are…
1) A stronger USD
Typically, the US dollar index and gold are negatively correlated. Said differently, when the dollar index does up, gold goes down. Even so, last year, the US dollar (USD) influenced gold prices more than it usually does. In 2015, the correlation between the two was -0.50 in 2015, much higher than -0.36, which is the 30-year average. Going forward, it’s likely that the correlation between gold and the USD will revert back to normal.
An additional concern is rising rates. One may assume that higher interest rates are good for the dollar. Actually, that is not the case. Historically, the dollar has stopped appreciating when the US raised rates. If the USD index has peaked then that would be good for gold prices.
2) Rising rates
Despite the fed’s intentions, the yield curve (2s10s) has flattened to its lowest levels of the expansion. The short end has increased but the long end, which is driven by growth expectations, has not. Basically, the market is not convinced that the era of low rates is over.
Even if rates do increase, gold may perform well. According to Sundial Capital Research, gold actually does quite well in rising rate environments. Gold prices increased by an average of 25.2% in each of the rising rate environments from Dec31’76 to Dec27’13. The median gain was 5.2%, which is much less impressive but still positive. Low rates are probably better for gold than high ones. That said, it may show good returns either way.
3) Leverage
In the US, the paper gold market is much bigger than the physical one is. In other words, many contracts are traded but not much gold changes hands. The level of gold dilution has reached unprecedented levels. In a recent blog post, zerohedge showed that there are 40 million ounces worth of open interest but only 74 thousand ounces of registered gold at the Comex. This works out to a gold cover ratio (open interest/registered gold) of 542! The takeaway point is that the amount of gold that is traded is much greater than the amount that actually exists.
The downside risk is that supply in the futures market overshadows demand in the physical market, thereby weighing on prices. Still, there is an upside risk. If demand for physical gold remains strong and inventories continue to fall then then the Comex may run out of supply. If that happens then gold prices will rise as market participants start to question the divergence between the paper and physical markets.
Conclusion
Gold should be considered as a contra buy…
- It is hated
- Its fundamentals are improving
- Demand from the east is robust
- It is negatively correlated with stocks
- The benefits outweigh the risks
Gold is massively under owned. If sentiment improves then it could easily outperform other asset classes in 2016…
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September 1st, 2016
Falling oil prices, China growth fears, submerging markets, Brexit and Italian banks. All of those risks have one thing in common: They have not derailed the US economy. Despite concerns about a recession, it continues to grow at a steady pace. According to the Atlanta Fed, real GDP is expected to grow by 0.7% in Q1’16. That is not a great number; however, the series is extremely volatile.
It would not be surprising to see growth rebound to 2% or more in the coming quarters.
Global investors are counting on the US because of lackluster growth elsewhere. Europe is doing fine; however, deflation remains a concern and bank credit growth is turning down. Japan continues to fall in and out of recession. In the emerging world, the BRICs are crumbling. Brazil & Russia are suffering due to falling commodity prices while China continues to decelerate. Going forward, rate differentials, relative economic strength and divergent monetary policies should provide support for the USD.
Sentiment & Positioning
With all that said, as of Mar29’16, the net speculative long position in the USD was 7% of open interest, the lowest it has been since Q2’14. This indicates that speculators are the least bullish they have been in nearly two years.
The US Dollar Index is sitting at 94.62, just above a critical support zone at 93-94. Meanwhile, the Trade-Weighted Dollar Index has pulled back ~3.4% from its high on Jan20’16. It is hard to tell that long USD is a consensus trade because investors have lost their conviction.
FX, Rates & Monetary Policy
USDCAD: Has fallen to 1.3011 from a high of 1.4692 on Jan20’16. This is a direct result of the relief rally in oil, which has risen to $36.79 from a low of $26.05 on Feb11’16. These moves have not been driven by improving fundamentals. Rather, they are mostly attributable to short covering.
Rate differentials (see the following chart), relative economic strength and divergent monetary policies should support USDCAD in the near term. Also, it is unlikely that the bear market in commodities is over.
EURUSD & USDJPY: In Europe and Japan, easy monetary policy will be present for an extended period of time. The ECB and BOJ have made it clear that they will do “whatever it takes” to protect their countries from deflation. The ECB recently announced a set of new measures intended to support the Euro Zone. Equities have responded positively but the Euro has not. EURUSD is trading at 1.1389, up from a low of 1.0538 on Dec3’15. Japan is facing the same issue. Even though Japanese equities are up since oil bottomed on February 11th, the Yen is the strongest it has been since Q4’14. It is unlikely EUR and JPY strength will persist for the same reasons mentioned in the previous paragraph.
World Reserve Currency
The USD is the most widely held reserve currency in the world. It represented 64% of official foreign exchange reserves at the end of Q3’15. Countries tend to hold Dollar-denominated assets because they are relatively stable. Foreign central banks also use the USD as collateral for loans and to protect their currencies. For example, if the ECB feels as though the EUR is too strong, it can sell Euros to buy Dollars, thereby reducing the amount of USD in circulation. In theory, this would weaken the Euro.
The foreign exchange market also speaks to the structural importance of the USD. According to the BIS’ Triennial Central Bank Survey, “FX deals with the US Dollar on one side of the transaction represented 87% of all deals initiated in April 2013.”
Lastly, it is important to recognize that many commodities are priced in USD. Therefore, people who want to buy or sell them are required to hold Dollars.
These facts help to explain why demand for the USD will persist. It is still the world reserve currency and that will not change in the near future.
Major Risks
The two major risks to the USD are a dovish Fed and slowing US economic growth.
The Fed is the world’s central bank. Even though both of its mandates are domestic, the Fed has become increasingly concerned about the global economy. This is evident when we look at the rising number of times the Fed has mentioned key terms such as “Global” and “Dollar” in recent meetings.
via @SoberLook
A strong USD is good for US consumers and bad for commodities & exporters. The Fed is well aware of this relationship; however, it alone does not guarantee dovish monetary policy. Not long ago, market participants thought that 4 rate hikes in 2016 was a possibility. Now, it is unclear whether or not we will see 1. As of Mar29’16, the probability of a hike in December was just 65%. The market is positioned for easy US monetary policy. As such, positive surprises from the US or negative surprises out of Europe or Japan will force investors to reassess their outlooks. If that happens then the Fed may turn more hawkish, which would be positive for the US Dollar.
2) Slowing US Growth
The US economy continues to muddle along, backed by steady employment and consumption growth. The Eurozone is doing fine but most of its gains are attributable to Germany. Other major players such as France and Italy have not fared as well. Moreover, Japan continues to tread water. Canada has rebounded. That said, its economy is dependent on commodity prices, which may roll over in the short run.
All in all, the US still looks good on a relative basis. Especially versus developed market peers.
Return of the King
Rate differentials, relative economic strength and divergent monetary policies should provide support for the USD. In addition, it will likely benefit from safe haven flows when global risks return to the headlines.
If the Dollar resumes its uptrend then commodities will suffer.
Oversupply in many industries such as oil, iron ore and coal remains an issue. On the demand side, China’s deceleration is not helping. The emerging markets are inextricably linked to commodities. If prices fall then the EMs will underperform.
There can only be one king…
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April 29th, 2016
By Shane Obata.
Falling oil prices, China growth fears, submerging markets, Brexit and Italian banks. All of those risks have one thing in common: They have not derailed the US economy. Despite concerns about a recession, it continues to grow at a steady pace. According to the Atlanta Fed, real GDP is expected to grow by 0.7% in Q1’16. That is not a great number; however, the series is extremely volatile.
It would not be surprising to see growth rebound to 2% or more in the coming quarters.
Global investors are counting on the US because of lackluster growth elsewhere. Europe is doing fine; however, deflation remains a concern and bank credit growth is turning down. Japan continues to fall in and out of recession. In the emerging world, the BRICs are crumbling. Brazil & Russia are suffering due to falling commodity prices while China continues to decelerate. Going forward, rate differentials, relative economic strength and divergent monetary policies should provide support for the USD.
Sentiment & Positioning
With all that said, as of Mar29’16, the net speculative long position in the USD was 7% of open interest, the lowest it has been since Q2’14. This indicates that speculators are the least bullish they have been in nearly two years.
The US Dollar Index is sitting at 94.62, just above a critical support zone at 93-94. Meanwhile, the Trade-Weighted Dollar Index has pulled back ~3.4% from its high on Jan20’16. It is hard to tell that long USD is a consensus trade because investors have lost their conviction.
FX, Rates & Monetary Policy
USDCAD: Has fallen to 1.3011 from a high of 1.4692 on Jan20’16. This is a direct result of the relief rally in oil, which has risen to $36.79 from a low of $26.05 on Feb11’16. These moves have not been driven by improving fundamentals. Rather, they are mostly attributable to short covering.
Rate differentials (see the following chart), relative economic strength and divergent monetary policies should support USDCAD in the near term. Also, it is unlikely that the bear market in commodities is over.
EURUSD & USDJPY: In Europe and Japan, easy monetary policy will be present for an extended period of time. The ECB and BOJ have made it clear that they will do “whatever it takes” to protect their countries from deflation. The ECB recently announced a set of new measures intended to support the Euro Zone. Equities have responded positively but the Euro has not. EURUSD is trading at 1.1389, up from a low of 1.0538 on Dec3’15. Japan is facing the same issue. Even though Japanese equities are up since oil bottomed on February 11th, the Yen is the strongest it has been since Q4’14. It is unlikely EUR and JPY strength will persist for the same reasons mentioned in the previous paragraph.
World Reserve Currency
The USD is the most widely held reserve currency in the world. It represented 64% of official foreign exchange reserves at the end of Q3’15. Countries tend to hold Dollar-denominated assets because they are relatively stable. Foreign central banks also use the USD as collateral for loans and to protect their currencies. For example, if the ECB feels as though the EUR is too strong, it can sell Euros to buy Dollars, thereby reducing the amount of USD in circulation. In theory, this would weaken the Euro.
The foreign exchange market also speaks to the structural importance of the USD. According to the BIS’ Triennial Central Bank Survey, “FX deals with the US Dollar on one side of the transaction represented 87% of all deals initiated in April 2013.”
Lastly, it is important to recognize that many commodities are priced in USD. Therefore, people who want to buy or sell them are required to hold Dollars.
These facts help to explain why demand for the USD will persist. It is still the world reserve currency and that will not change in the near future.
Major Risks
The two major risks to the USD are a dovish Fed and slowing US economic growth.
The Fed is the world’s central bank. Even though both of its mandates are domestic, the Fed has become increasingly concerned about the global economy. This is evident when we look at the rising number of times the Fed has mentioned key terms such as “Global” and “Dollar” in recent meetings.
A strong USD is good for US consumers and bad for commodities & exporters. The Fed is well aware of this relationship; however, it alone does not guarantee dovish monetary policy. Not long ago, market participants thought that 4 rate hikes in 2016 was a possibility. Now, it is unclear whether or not we will see 1. As of Mar29’16, the probability of a hike in December was just 65%. The market is positioned for easy US monetary policy. As such, positive surprises from the US or negative surprises out of Europe or Japan will force investors to reassess their outlooks. If that happens then the Fed may turn more hawkish, which would be positive for the US Dollar.
2) Slowing US Growth
The US economy continues to muddle along, backed by steady employment and consumption growth. The Eurozone is doing fine but most of its gains are attributable to Germany. Other major players such as France and Italy have not fared as well. Moreover, Japan continues to tread water. Canada has rebounded. That said, its economy is dependent on commodity prices, which may roll over in the short run.
All in all, the US still looks good on a relative basis. Especially versus developed market peers.
Return of the King
Rate differentials, relative economic strength and divergent monetary policies should provide support for the USD. In addition, it will likely benefit from safe haven flows when global risks return to the headlines.
If the Dollar resumes its uptrend then commodities will suffer.
Oversupply in many industries such as oil, iron ore and coal remains an issue. On the demand side, China’s deceleration is not helping. The emerging markets are inextricably linked to commodities. If prices fall then the EMs will underperform.
There can only be one king…
Comments Off on USD: Return of the King
