This week, the U.S. Federal Reserve (the "Fed") made a surprise interest rate cut of 50 basis points on Tuesday, March 3, and gold bullion closed the week higher, above $1,670. This follows gold's February breakout from the critical $1,585/$1,600 overhead resistance range that we have highlighted for several months.
|Gold Bullion||$1,586||$1,589||($3.47)||(0.22)%||Closed on $1,585 support|
|Silver Bullion||$16.67||$18.04||($1.38)||(7.63)%||Closed on $16.50 support|
|Gold Equities (SGDM)1||101.51||109.79||(8.28)||(7.54)%||Gold equities caught in systemic selling|
|Gold Equities (GDX)2||$26.22||$28.99||($2.77)||(9.56)%||same as above|
|DXY US Dollar Index3||98.13||97.39||0.74||0.76%||Flight to safety|
|U.S. Treasury 10 YR Yield||1.15%||1.51%||(0.36)%||(23.77)%||Back to low end of range|
|German Bund 10 YR Yield||(0.61)%||(0.41)%||(0.20)%||49.51%||Recovery over, breaking lower|
|U.S. Treasury 10 YR Real Yield||(0.29)%||(0.14)%||(0.15)%||(107.47)%||New cycle lows, heading lower|
|Total Negative Debt ($Trillion)||$14.57||$13.56||$1.01||7.47%||Heading higher to $17 trillion|
|CFTC Gold Non-Comm Net Position4 and ETFs (Millions of Oz)||123.06||118.14||4.92||4.16%||ETF holdings at all-time highs|
The coronavirus outbreak has worsened to now more than 95,000 infected worldwide and has spread globally. The threat of the coronavirus on global economic growth has now impacted all asset classes, global trade, liquidity and central bank policies. It was in mid-February when the severity of the economic impact of the coronavirus began to be reflected by major companies, such as Apple when it provided earnings warnings. For several weeks major parts of China were locked down (closing businesses) to contain the outbreak. The impact was a reminder of how important China is in the global supply chain and its impact on global growth. Yields fell, yield curves flattened and inverted, inflation expectations rolled over and commodity prices collapsed.
All asset classes were confirming the severe impact of the coronavirus outbreak on global growth except for the equity markets, which were making new highs as expectations were for more liquidity stimulus. By the last week of February, equity markets finally sold off in a spectacular manner posting some of the worst multi-day sell-offs in several years. Systematic funds flow and CTA (Commodity Trading Advisors, i.e., quant funds, an investment fund that selects securities using advanced quantitative analysis) repositioning were the main drivers of this price action. The enormous amount of selling (some of the highest trading values recorded) morphed into a systemic selling event, taking down gold bullion on the last trading day of the month as liquidity and available profits to take, became scarce.
On March 3, the U.S. Federal Reserve (the "Fed") made a surprise emergency cut in interest rates taking the Fed Funds rates down 50 basis points to a range of 1.00%-1.25%. The rate cut made an immediate, positive impact on gold bullion and gold equities.
Gold bullion broke out of the $1,585/$1,600 overhead resistance range in February that we have been highlighting for several months. Gold bullion traded as high as $1,689, its highest level since 2013. The breakout through the $1,585-$1,600 level occurred on an impulsive thrust on a flight to safety event. Gold was consolidating in the $1,630-$1,660 range until the last day of the month before it fell $59. Gold sold off for several reasons, mostly due to systemic factors; first, because it was a source of liquidity that still had a meaningful profit. Gold was a significant portfolio weight in systematic funds and CTAs. All these funds were de-risking, deleveraging and bringing down exposure. After the S&P 5005 was down more than 12% from all-time time highs and gold bullion was still up 8.4% year to date, the source of proceeds was obvious. Gold in ETF holdings, however, closed at their all-time high in comparison as they were not under any pressure to sell. We have seen this liquidity forced selling before over the years; the most notable was in 2008.
After the emergency rate cut, gold bullion closed at the $1,640 level, back to the recent trading range. There are several technical price points we will be watching: $1,675, $1,715 and $1,800. We would expect some consolidation to occur between $1,600-$1,800 before we retest the all-time highs of $1,921.
Figure 1. Gold Bullion Breaks Out
Source: Bloomberg. Data as of 3/4/2020.
Gold equities traded up to the cusp of a major breakout level before falling back, caught in the market vortex of all-out systemic selling. Generally, when the broad markets are selling off aggressively and volatility spikes, liquidity conditions force equity correlations essentially go to "1" (everything goes down). After the storm, stocks revert to their primary fundamental drivers in time.
The primary fundamental driver we see for gold equities is the enormous earnings growth. The average gold bullion price in the fourth quarter of 2019 was $1,483. The quarter-to-date average gold price thus far is $1,578, an increase of $95/oz or 6.4%. As a reminder of gold companies' operational leverage to higher gold prices, we highlight the following example. Using an industry average AISC (all-in sustaining costs) of $975/oz (World Gold Council Q3 2020 estimate), Q4 industry margins would be $508/oz. So far, the quarter-to-date margin in 2020 would be $603/oz, an increase of +19% quarter over quarter. This earnings growth will be very impressive in Q1 of 2020, especially compared to company earnings impacted by the coronavirus outbreak. The year-over-year increase in gold company profits will be even more impressive. In Q1 of 2019, the gold bullion average price was $1,304, and the estimated industry AISC was $925/oz for a margin of $379/oz. Assuming gold prices hold steady for March, the year-over-year growth in Q1 profits should be around +59%.
Earnings revisions for the broad market, on the other hand, are likely coming down significantly. Depending on the severity of the coronavirus impact, we are starting to see year-over-year estimates revised down to around the zero to mid-single-digit level. In Figure 2, we overlay the S&P 500 EV/EBITDA6 multiple with the GDM Index.7 The S&P 500 valuation levels are back to near the 2000 peak level, the all-time high in the last market bubble. The contrast is quite stark: the S&P 500 is near its all-time highs in valuation with near-zero earnings growth and a growing risk of a global recession. Gold companies conversely are trading near the lower-mid end of their valuation band with a +50% year-over-year earnings growth outlook. The ongoing broad market hope is more central bank liquidity to support the stretched valuation multiples. The Q1 2020 consensus gold estimate is $1,515 (2Q 2020 is $1,500 and 3Q 2020 is $1,523). There is a month to go, but the chances of Q1 positive earnings surprises for gold companies are very high, along with revisions higher. The opposite is true for the broader market.
Figure 2. S&P 500 EV/EBITDA Multiples Near 2000 All-Time High, the Last Equity Bubble Valuation Level
GDM EV/EBITDA remains in a narrow trading band near the low-mid range. One has a very high probability of downward earnings revision from a very high valuation level, while the other has a very high likelihood of an upward revision from a modest valuation level.
Source: Bloomberg. Data as of 2/29/2020.
U.S. yields fell to new lows as the global growth outlook worsened. U.S. 10-year yields set an all-time low tick of 0.904% shortly after the Fed emergency rate cut. Prior to the rate cut, the 10Y-3M yield curve inverted, signaling a heightened recession risk in the next 12-18 months. U.S. 30-year yields closed at an all-time low of 1.50%. U.S. 10-year breakeven yield (a measure of growth expectations) has completed a large top. U.S. 5Y/5Y inflation swaps have also rolled over to new 52-week lows. Despite the 50 basis points emergency rate cut, the market is still expecting at least two more rate cuts by the April Federal Open Market Committee (FOMC) to bring the Fed Funds rate down to 0.50%-0.75%. The entire fixed-income complex is signaling a major risk-off environment with growth expectations under enormous downside pressure. The commodities complex is also confirming the weak growth outlook. The Commodity Research Bureau Index (CRB) has now fallen to near its multi-year lows.
There are many consequences of further rate cuts, but for gold, the level of real yields is the most important by far. In Figure 3, we highlight the correlation of gold with real rates. Since the beginning of the credit crisis in 2007, the long term correlation of real interest rates and gold bullion is -0.89, an extremely high level of correlation. The R-square over this period is 82%, a very high level. After the emergency rate cut, the level of negative yields is now firmly in the range of financial repression. If the Fed cuts rates by another 50 basis points in April as expected, the 10-year TIPS (Treasury Inflation-Protected Securities) yield will fall below its low of 2012. At the -1.00% level, it will be apparent to all that we will have entered into a state of financial repression. And it will become more negative if, along with the rate cuts, we begin to see the expected fiscal policy measures.
Figure 3. Gold Bullion and U.S. 10-Year TIPS Yield
Source: Bloomberg. Data as of 3/4/2020.
The U.S. dollar ("$USD"), which we were looking to weaken throughout 2020, surged to near its 52-week highs before rolling over and has given up most of its recent gains. The $USD strengthened due to three broad factors. The first was as a flight to safety. Second, the early belief was the majority of the negative growth impact of the coronavirus would be outside the United States. China and its nearby trading partners would be the most severely impacted. Europe, with its higher exposure to export markets and already weak economic numbers, would be more vulnerable than the United States. Third, as the Fed had gone into a holding pattern with its monetary policy, other central banks began easing as the economic impact of the coronavirus deepened. This divergence in monetary policy initially favored a stronger $USD. A couple of weeks later, the $USD reversed lower as the realization that the U.S. would not be immune to the coronavirus. With the emergency rate cut, the relative U.S. yield spread has now narrowed in further. Depending on how much other countries can lower rates, we would expect the $USD to further weaken from here.
Under the current global economic environment, a strong $USD is not sustainable in the long run. A stronger for longer $USD will import disinflationary pressures to the United States. This disinflationary pressure will act to dampen or impede the Fed policy of stronger growth. A feedback loop of lower inflation expectations, flattening yield curves and lower yields will begin to express and reinforce this weakness. In this current economic environment, a weaker $USD is much better for global growth. Once the coronavirus threat crests, the focus of central banks will likely be towards a weaker $USD outcome. However, the flight to safety is overriding the $USD strength effect on gold bullion. In Figures 4a and 4b, we compare the performance of gold bullion to other traditional safe havens (USD, JPY, CHF and bonds). Gold bullion is outperforming all these safe havens by a considerable margin.
Figure 4a. Gold Bullion in $USD, Yen and Swiss Francs
Gold is outperforming all three safe-haven currencies.
Source: Bloomberg. Data as of 2/29/2020.
Figure 4b. Gold Bullion Relative to the Bloomberg Barclays U.S. Aggregate Total Return Index
Gold has been in an outperforming trend relative to bonds for several years now despite the bond market having one of its greatest bull markets ever.
Source: Bloomberg. Data as of 2/29/2020.
The coronavirus outbreak has, for all intent and purposes, negated the Phase 1 trade deal between the U.S. and China. The two primary conditions, a stable yuan exchange ratio and a doubling of U.S. imports to China, are now highly unlikely. While the immediate focus of the market is the supply chain disruption, the expected economic benefits of a Phase 1 deal has disappeared. The economic numbers that will be coming out of China will be very, very bad. The just-released China Caixin Services PMI (Purchasing Managers Index) reported a February reading of 26.5 vs. 51.8 for January, a shockingly bad number.
At the end of January, the consensus view was that the coronavirus would have a minimal impact on U.S. GDP (Gross Domestic Product). At the end of February, the consensus view is now that the coronavirus breakout is a recession risk event. The coronavirus will impact consumer-related businesses the most. U.S. consumer spending was the main reason for the strength in U.S. GDP in 2019 as manufacturing was already hit hard by the trade war. Fear of a pandemic and crashing stock markets will be a significant challenge to consumer confidence to keep borrowing more money, go deeper into debt and keep spending.
If the coronavirus outbreak becomes a full global recession threat, we may finally see a massive global coordinated fiscal stimulus-response that so far has remained elusive. For the past decade, monetary policy has been the primary policy tool for economic stimulus. After many rounds and iterations of monetary policy around the world, its economic efficacy is diminishing at a rapid pace (but it's great at creating stock market bubbles). The coronavirus outbreak may prove that more than just monetary stimulus will be needed to lift investment and increase demand. The global economy was already slowing before the coronavirus arrived as a shock event.
It is becoming likely that we are in the process of leaving the "monetary policy regime" of the past decade and will be transitioning to more of a "fiscal policy regime" over the next decade. As high as debt levels are now, we expect them to be even higher as spending for fiscal stimulus purposes gets added to the ledger. The CBO (Congressional Budget Office) recently published this chart (Figure 5). The forecast for debt expansion is staggering. One look and it is evident that major financial repression is on its way soon and QE (Quantitative Easing) programs are coming to backstop the increase in fiscal policy spending. We remain convinced that sustained deep negative real interest rates will be the primary tool of financial repression. In the months ahead, we will write more about the potential consequences of an increasing shift to fiscal stimulus on gold.
Figure 5. From the Congressional Budget Office: Federal Debt Held by the Public as a % of GDP
Source: Congressional Budget Office.
|1||The Solactive Gold Miners Custom Factors Index (Index Ticker: SOLGMCFT) aims to track the performance of larger-sized gold mining companies whose stocks are listed on Canadian and major U.S. exchanges.|
|2||VanEck Vectors® Gold Miners ETF (GDX®) seeks to replicate as closely as possible, before fees and expenses, the price and yield performance of the NYSE Arca Gold Miners Index (GDMNTR), which is intended to track the overall performance of companies involved in the gold mining industry.|
|3||The U.S. Dollar Index (USDX, DXY, DX) is an index (or measure) of the value of the United States dollar relative to a basket of foreign currencies, often referred to as a basket of U.S. trade partners' currencies.|
|4||Commodity Futures Trading Commission's (CFTC) Gold Non-Commercial Net Positions weekly report reflects the difference between the total volume of long and short gold positions existing in the market and opened by non-commercial (speculative) traders. The report only includes U.S. futures markets (Chicago and New York Exchanges). The indicator is a net volume of long gold positions in the United States.|
|5||The S&P 500 or Standard & Poor's 500 Index is a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies.|
|6||Enterprise value to earnings before interest, taxes, depreciation and amortization (EV/EBITDA) is a key measurement ratio used as a metric of valuing whether a company is under or overvalued as compared to a historical industry average.|
|7||The NYSE Arca Gold Miners Index (GDM) is a rules-based index designed to measure the performance of highly capitalized companies in the Gold Mining industry.|
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