Authored by Trey Reik, Senior Portfolio Manager, Sprott Asset Management USA, Inc.
At Sprott, our investment thesis for gold is significantly long-term in scope. We believe gold’s methodical advance since 2000 has had more to do with the growing disconnect between productive output (GDP) and ever-inflating claims on that output (debt and equity valuations), than with short-term fluctuations in variables such as CPI-type inflation or interest rates. Because we view gold as a highly productive, portfolio-diversifying asset until these gaping imbalances are finally resolved (through default or debasement or both), we are generally loath to focus on short-term projections for gold markets. However, the current alignment of fundamental, technical and quantitative factors underpinning gold markets has become so asymmetrical to the upside, we have developed high confidence for an imminent and potentially significant rally in precious-metal valuations.
Post-election advances in market-sentiment measures are now clashing head-on with intransigent U.S. realities of excessive debt, dismal productivity, structural under-employment and chronic economic stratification. In short, the Trump-induced reflation trade is dying a quick death amid epic (mis)positioning. In this report we provide a short precis of our updated reasoning for an allocation to gold, followed by a visual tour of our “top ten” list of technical and quantitative factors we see powering gold’s developing advance.
In our 2017 Investment Outlook, we made the case that excessive U.S. debt levels all but preclude significant Fed tightening. We suggested that, with total U.S. credit-market debt of $66 trillion atop U.S. GDP of only $18.8 trillion, any sustained increase in fed funds target rates would catalyze immediate upticks in a wide array of financial-stress measures, as well as surging default rates in sketchier components of the U.S. debt pyramid. To us, the greatest shortcoming of consensus economic analysis has been the failure to recognize the cumulative and corrosive damage which eight years of ZIRP and QE have inflicted on the market dynamics of nearly every global industry. By artificially depressing interest rates for so long, global central banks have destroyed time preferences, inflated sales by borrowing from the future, and completely distorted legacy sales practices and consumer buying habits. The U.S. has evolved into a “zero-down, zero-percent” society, for everything from cars to leaf-blowers, to jewelry to big-screen TVs. Manufacturing supply chains have expanded across the globe, enabled by the reduced cost-of-time in a ZIRP world. The day of reckoning for trillions-of-dollars-worth of uncompetitive U.S. businesses (and credits) has been postponed by the palliative of illusory (ZIRP) financial conditions. As the Fed attempts to migrate from the zero bound, these profound economic changes will not be reversed without significant pain and dislocation.
We believe the three FOMC rate hikes since December 2015, (together with consequent U.S. dollar strength and curve-steepening), have already set in motion a cascading downward spiral in crucial sectors of the U.S. economy, such as retail and automobiles. Somewhat at odds with recent upticks in consumer sentiment, March retail sales (released 4/14) declined 0.2%. Together with February’s harsh downward revisions (from +0.1% to -0.3%), retail sales have now registered their steepest two-month tumble in over two years. During the same two months, the BLS reports payrolls shed 60,600 retail jobs (seasonally adjusted), the worst two-month drop since 2008. Ten U.S. retailers have already filed for bankruptcy during early 2017 (compared to only nine during all of 2016), with several industry heavyweights suddenly on the ropes (Sears, Gymboree, Nine West). Prominently featured in the current rash of retail insolvencies is a recurring theme of excessive corporate leverage. Morgan Stanley (3/29/17) reports major U.S. retailers shuttered 2,087 stores in Q1 2017, up nearly 70% from the Q1 2016 total. Bank of America (3/14/17) estimates that February U.S. department-store spending collapsed at an historic 15% year-over-year pace.
We are not suggesting that weak retail sales and heightened stress among retail credits have arisen solely from recent Fed tightening. Obviously, there are monumental changes occurring in retail delivery channels. Our point is that eight years of ZIRP have delayed inevitable rationalization of hundreds-of-billions of-dollars-worth of outdated retail formats and outmoded brick-and-mortar storefronts and malls. Three FOMC rate hikes have quickly ignited a painful reckoning process which will now crystalize significant capital losses throughout the retail sector. Each additional FOMC rate hike will only broaden and accelerate the coming writedowns.
No industry has been more disfigured by the Fed’s easy-money policies than the U.S. automobile industry. During the past eight years, cheap Fed credit has engrained zero-percent financing gimmicks at the very heart of U.S. automobile consumption. Contemporary auto-financing terms have evolved towards borderline ridiculous (record average principal balances, ever-lengthening loan periods, rising prevalence of negative-equity trade-ins). Lured by skinny “cost of money” calculations, lease penetration-rates roughly doubled in the five years through 2016. Even used-car pricing has remained remarkably buoyant amid such ample cheap credit.
Many will view as coincidence that key metrics in the U.S. auto industry have suddenly frayed amid the Fed’s December/March (FOMC) two-step. March U.S. vehicle sales slumped to 16.53 million SAAR (versus 17.3 million estimates), despite a 15% year-over-year increase in new-car incentives, to a record $3,768 per car, or 10.4% of average suggested retail (JD Powers). The all-important NADA used-car price index fell 3.8% in February, its sharpest decline since November 2008. Lease volumes have quickly reversed, coincident with accelerating rates of lease turn-ins, exacerbating the used car pricing picture. Morgan Stanley (3/31/17) estimates the confluence of reinforcing factors now afoot in auto markets could lead to a 50% collapse in used-car pricing during the next five years.
Figure 1: Cumulative % Net Losses by Subprime ABS stress among retail credits have arisen solely from recent Fed Vintage (2006,7,8,15,16Q1,16Q2)
Source: S&P, UBS.
As in the retail sector, the unfolding reversal of fortune in the auto industry cannot be blamed exclusively on the Fed’s recent tightening moves. However, eight years of ZIRP fostered huge imbalances between true economic demand and artificially inflated consumption which will now plague auto manufacturers, creditors and financiers for years to come. Once again, every FOMC rate hike will only exacerbate the downturn. Given the fact that 2016-vintage subprime auto ABS structures are already underperforming 2007/2008 vintage securitizations (Figure 1), we view probabilities for two additional Fed hikes this year (and three more in 2018) as significantly below consensus.
Despite downticks in commercial bank lending and tightening of commercial banking standards during Q1 2017, U.S. equity markets continued to set new all-time highs. Consensus attributes buoyant equity markets to post-election upticks in sentiment measures and strengthening “soft” economic statistics. A popular theory suggests hard economic data will soon follow suit. We disagree strongly with this analysis. Importantly, we believe U.S. asset markets were given enormous support during the first quarter from an important source of liquidity which has garnered almost no attention in financial media.
As the Fed collects interest on the enormous portfolio of Treasuries and MBS securities on its balance sheet, this cash is passed on to the U.S. Treasury. Logistically, the Fed credits interest payments (as they are received) to the Treasury’s “general account,” where they appear as a liability on the Fed’s weekly balance sheet (H.4.1). In essence, the Treasury’s Fed balances serve as a giant piggy bank which can be drawn upon whenever Treasury has short-term liquidity needs (or faces a looming debt ceiling such as is currently the case). As shown in Figure 2, the Treasury’s Fed balances have oscillated during the QE era, but have been in a sustained uptrend since late-2015.
For reasons that may never be entirely clear, the Treasury chose to draw down its Fed balances at a frenzied pace during the first quarter. Between 10/26/16 and 3/15/17, the Treasury’s general account balance at the Fed declined from $429 billion to $38 billion. Coupled with pro-rata earned-interest credits accruing to the Treasury’s account during the span ($150 billion annual run-rate), Treasury withdrawals from its Fed account totaled roughly $450 billion in little over a four-month period. Unlike excess commercial bank reserves held at the Fed, Treasury balances are essentially a dormant deposit, so when they are drawn down they amount to a direct liquidity injection into the U.S. financial system. As the Treasury drew down its Fed balances during the past four months, an amount of liquidity was injected into the commercial banking system equal to roughly 7% of GDP, or significantly greater than the rate of stimulus from QE3! Andy Lees (MacroStrategy Partnership) informs us that there is simply no historical precedent for such a concentrated drawdown of Fed balances by Treasury, the next closest having been drawdown of an amount half as large over a period twice as long, just prior to the market dislocation of August 2015. Over the next several months, we expect U.S. asset markets to feel a pronounced pinch from extinguishment of this unprecedented liquidity source.
Figure 2: U.S. Treasury Deposits ($Billions) on Federal Reserve Balance Sheet (2005-3/15/17)
Source: Federal Reserve Flow of Funds Report.
In recent weeks, whether due to investor recalibration of Trump’s prospects in effecting lasting economic change, or simply due to growing recognition that even successfully implemented policies will take years to address legacy imbalances, market euphoria has clearly tempered. Simultaneously, we believe, cumulative effects of the Fed’s three rate hikes have set in motion a cycle of long-overdue debt rationalization. Complicating matters, the Atlanta Fed announced (4/14/17) that its GDPNow forecast for Q1 2017 has shrunk all the way to 0.5% (from 3.4% on 2/1/17), which would mark the weakest GDP growth during a quarter in which the Fed has hiked rates since Chairman Volcker did so in February 1980. Finally, as shown in Figure 3, the U.S. Treasury reported 4/12/17 that trailing-twelve-month federal tax receipts posted in March their fourth straight month of year-over-year percentage declines (-1.3%), with corporate tax receipts (-16.7%) measuring their steepest collapse since September 2008. Perhaps tanking tax receipts shed a bit of light on the Treasury’s recent rundown of its Fed deposits!
Figure 3: Trailing 12-mos. Percentage Change Total Federal Tax Receipts (1972-March 2017)
Source: U.S. Treasury, Meridian Macro
We expect the second quarter of 2017 to witness a reversal of what we perceive to be unsustainable year-to-date trends in many assets, currency and interest-rate markets. By way of example, as shown in Figure 4, eroding expectations for GDP and S&P 500 earnings have yet to be reflected in valuations for the S&P 500 Index itself. Something has to give, and reigning equity valuations appear substantially vulnerable.
Figure 4: S&P 500 Index, Consensus Estimates S&P 500 2017 EPS, Atlanta Fed Q1 2017 GDPNow (1/1/17-4/13/17)
With respect to precious metals, we have rarely observed such a confluence of gold-supportive technical and quantitative variables across such a wide spectrum of relevant asset classes. While we are the first to admit no one can predict the future path of the gold price, we are intrigued by the degree to which these traditional valuation tools are aligning in gold’s favor. In the next section of this report, we present a largely visual review of the ten most compelling variables supporting our contention that gold prices are poised for a potentially significant advance. Given dominant institutional positioning and proximity to important support levels for each of these variables, the slope of the gold advance we envision may prove surprisingly steep.
We would suggest very few investors were positioned in November 2016 for the onset of a strong reflationary trade. Somewhat counter-intuitively, overwhelming flows in postelection asset markets (strong dollar, rising 10-year yields, industrial commodity strength) have pressured the gold complex. Now that the reflation boat appears to be rocking out of recent channels, repositioning across a broad spectrum of asset classes is poised to benefit the gold trade.
Figure 5: CRB Raw Industrials Index (4/12/13-4/12/17)
In the topsy-turvy era of central-bank dominated asset markets, gold’s traditional profile as an inflation hedge has been overshadowed by (largely misguided) apprehensions over gold’s vulnerability to rising rates of all stripes (short, long, nominal, real). In this regard, on any horizon shorter than the very long-term (when central-bank market influence finally recedes to pre-crisis norms), “contained” nw3 inflation expectations will remain a bullish backdrop for gold prices.
Figure 6: U.S. Breakeven 10-Year Yields (4/9/12-4/12/17)
As the global-central-bank “divergence” trade loses luster (ECB, BOE and BOJ now telegraphing policy taper), President Trump weighed in on 4/14/17 in his inimitable fashion on, 1) the U.S. dollar, “I think our dollar is getting too strong, and partially that’s my fault because people have confidence in me;” 2) interest rates, “I do like a low-interest-rate policy, I must be honest with you;” and, 3) Chairman Yellen, “No, [she’s] not toast. You know, I like her, I respect her.”
Figure 7: U.S. Dollar Index (DXY) (4/16/12-4/14/17)
During the past five years, the correlation between spot gold and the dollar/yen exchange rate has registered -0.56%. During the past year, the (negative) correlation has tightened to -0.70%. In our view, dollar/yen appears poised to visit resistance at “par.”
Figure 8: U.S. Dollar/Japanese Yen Exchange Rate (4/12/12-4/15/17)
The overwhelming 30-year trend in U.S. 10-year Treasury yields remains downward. BMO’s quant extraordinaire Mark Steele observes that this downward channel is not only completely intact, but it also projects negative nominal U.S. 10-Year Treasury yields within the next several years. Importantly, Mark reminds us that in the context of contemporary fixed income markets, once yields start to fall, market players (suddenly short duration) are given to “panic” buying. We have long maintained excessive U.S. debt levels preclude significant increases in 10-Year Treasury yields. We believe consensus expectations for rising yields are the single greatest positioning error in current markets. Look out below!
Figure 9: 10-Year Treasury Yield (4/18/12-4/17/17)
Similarly, global debt levels and overseas QE programs have helped cap global sovereign yields.
Figure 10: 10-Year German Government Bond Yield (4/16/12-4/15/17)
As expectations for global growth have tempered in recent months, the Treasury yield-curve has given up all of its post-election steepening.
Figure 11: 10-Year/2-Year Treasury Spread (4/9/12-4/12/17)
U.S. financials have reversed much of their post-election outperformance and now rest on the cusp of a potentially precipitous downdraft (retracing a gap-like post-election spike).
Figure 12: Financial Select Sector SPDR Fund (XLF) (4/16/12-4/14/17)
Each of the past three FOMC rate hikes (12/16/15, 12/14/16 and 3/15/17) have marked an immediate low in the spot gold price, almost to the precise day! To us, this is clear indication that market concerns over systemic risk (rising yields amid excessive structural debt) are outweighing traditional perceptions that gold’s investment utility diminishes as interest rates rise.
Figure 13: Spot Gold Price (FOMC Rate Hikes Highlighted) (4/1/15-4/13/17)
COMEX open interest and CFTC positioning remain well below prior peaks.
Figure 14: CFTC Gold Positioning—Net Spec Longs vs. Net Commercial Shorts & Open Interest (2008-4/11/17)
Similarly, total bullion holdings in publicly disclosed vehicles (ETF’s, funds and exchanges) rest below 2016 peaks, and well below 2012 peaks.
Figure 15: Transparent Gold Holdings in Public Vehicles (1995-4/14/17)
Significant advances in gold equities are frequently signaled by relative outperformance of higher-beta components of gold equity indices. We plot below the relative performance of the five highest-beta GDX components (AUY, KGC, HMY, AU, and IAG) versus GDX itself. This breakout action bodes well for the future performance of gold shares.
Figure 16: Relative Performance of Five Highest-Beta GDX Components vs. GDX (4/13/15-4/12/17)
To us, spot gold faces little overhead resistance through $1,300, and once through $1,370, faces multiple open higher-gap targets. On the wonky side, we perceive unusually bullish fractals and embedded patterns in spot gold’s current technical patterns (call us for more detail).
Figure 17: Spot Gold Price (4/30/10-4/17/17)
During the advance in gold equities between 2000 and 2008, individual legs were characterized by triple-digit-percentage surges, punctuated by sharp pullbacks, sideways consolidations and then resumption of strong upward gains. In essence, gold equities are marked by emotional, high-beta swings. Since 2000, during periods of downward recalibration of excessive enthusiasm for U.S. financial assets, gold equities have provided unparalleled portfolio alpha. We expect that to continue to be the case during future corrections in broad U.S. equity averages.
Figure 18: NYSE ARCA Gold Miners Index (June 2000-June 2008)
From its 1/19/16 intraday low (347.41) to its 8/12/16 intraday high (881.18), the GDM Index surged 153.64%, followed by a 41.06% correction to its 12/20/16 intraday low (519.41). While past is never prologue, we believe current market valuations pose high probabilities for a downward recalibration of enthusiasm for U.S. financial assets which is likely to be reflected in the strong relative performance of gold equities. Time will tell!
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