By At Williams Market Analytics, we have been recommending that investors avoid at this stage all risk assets that have been bid up on primarily on hopes of endless central bank easy money policies. A recent Commentary (“Survival Tool Kit For The Next Crisis”) highlights the asset classes and themes that we expect will outperform over the next couple of years. We are particularly fond of real assets which have not been bid up by artificial monetary stimulus. Among these real assets, we expand on the argument in favour of gold and related assets (other precious metals and the mining stocks) in this Commentary, as prices have been battered over the past weeks by speculation over Federal Reserve policy action. With reassurance by the Federal Open Market Committee (FOMC) that actions have no intention of following words, we see an opportunity for investors to reestablish (or get more long) gold, precious metals and mining stocks.
We have discussed previously the overlying reasons to like gold and the mining stocks today. Recall that these asset classes are coming off a brutal, five-year bear market during which gold fell over -44% and the gold miners index collapsed by -80%. Unlike S&P 500 stocks, there is currently little air under the gold price and mining stocks, therefore less risk of a down-draft should a global rout of risk assets finally materialize. Gold and the miners have also historically had a near-zero correlation coefficient with the S&P 500. That is, the gold price can be expected to decouple from the S&P 500 (as we saw from 2011-2016). A bursting of the bubble in central bank inflated assets does not imply precious metal-related assets will also fall. Finally, U.S. election uncertainty may drive the safe-haven value of gold higher. We expect the U.S. presidential election race to continue to tighten and the chances of a Trump victory can no longer be minimized. As we discussed in our September 9th Commentary “Rage Against The Fed”, Trump is hostile towards the Federal Reserve and the odds of reforming the Fed under a Trump presidency are high. Obviously any constraint on Fed power is bullish for gold. Trump has also made off-the-cuff remarks on a return to the gold standard. In sum, a Trump win on November 8 should reinforce the bullish uptrend in gold.
Aside from its value as a safe-haven asset in times of panic, gold typically outperforms when real interest rates are falling. Recall that the real rate is simply the nominal interest rate less the rate of inflation. The real rate of return is what matters for investors. Our chart below compares the real Two-Year U.S. Treasury rate to the 12-month rate of change in the gold price. We inverted the right scale showing the rate of change in the gold price to better visualize the correlation. Falling real yields (green curve) have systematically corresponded to rallies in the gold price (shown by an inverted falling blue curve). In 2016, we see that the two-year real yield slipped back into negative territory. To make a strong fundamental case for holding gold, we need to correctly forecast the direction of real yields in the U.S.
As there are two drivers of real yields, we need to consider both the likely direction of nominal rates and the risk of inflation. First, will nominal yields be rising in the U.S.? Despite all the gibberish coming out of the mouths of FOMC members, we are formal in our believe that U.S. nominal short rates will stay low and may possibly turn negative. The Fed will not follow through with a rate hike cycle as the U.S. teeters on the edge of dipping back into recession. Moreover, the Fed is first and foremost managing asset prices today. Therefore the central bank will not seek to raise rates (beyond a symbolic 25 bp move) and sabotage the work they have done to inflate stock and bond prices.
Second, what are the chances that rising inflation drives real yields even more negative? In our opinion, the chances are very high. The Fed is not worried about inflation. This, in itself, worries us, as Fed economists are now famous for their inaccurate forecasts. The Greenspan Fed in the early 2000s kept rates too low for too long and blew a housing price bubble. The Bernanke/Yellen Fed has made the same monetary policy mistake. Same causes, same effects. We know that the Fed has quadrupled its balance sheet (increasing the money supply) since the financial crisis. Milton Friedman said that inflation is always and everywhere a monetary phenomenon. Despite the Consumer Price Index (CPI) and the Personal Consumption Expenditures (PCE), which show inflation holding below the Fed’s 2% target level, inflation is still a monetary phenomenon. Inflation caused by Fed balance sheet expansion, however, has just manifested itself in financial asset prices and not the real economy (CPI, PCE readings). Bank lending activity did not pick up (as the Fed had hoped), although bank prop desk activity has!
So how will the Fed’s quadrupled balance sheet translate into inflation and drive real yields lower? Although many Wall Street professionals are trying to convince their clientele that asset valuations “remain compelling” and are downplaying the chances of an implosion of the Federal Reserve-induced asset price bubble, we are much more realistic. At some point valuations will matter again and we’ll see a flight out of U.S. equities and bonds. Money leaving financial assets will find its way to the real economy. And we are certain that Fed officials, concerned about economic growth and asset prices, will not be thinking about soaking up all the liquidity created over the past several years in a timely manner. Fed officials have been discussing letting inflation temporarily “overshoot” their 2% target while some central bankers at the Jackson Hole Symposium even debated raising the central bank inflation target to 3% or 4%. We believe that we will finally see inflation in the real economy (a positive for gold and drag on real yields) even as the economy dips into recession. A recipe for stagflation is being cooked up by near-sighted Fed officials. JP Morgan strategist David Kelly correctly observed after the FOMC meeting that “the Fed is imposing long-term harm for no short-term good here”. And yes, gold is the asset class of choice in stagflationary periods: during the stagflation in the 1970’s, gold rose almost +600%.
Finally, we also want to debunk a myth that we are hearing frequently today. Many are saying that the gold price will be coming down since Fed rate hikes will strengthen the dollar. Assuming that the Fed does continue this hike rate cycle (a BIG assumption) and the dollar strengthens, we can not conclude that gold would perform poorly in this environment. We looked at the performance of gold and the dollar from the end of economic expansions since 1971 (the year Nixon announced the end of convertibility of dollars into gold). Our table below shows that the dollar and gold tend to be positively correlated as economic growth turns down. And with the single exception of the 1990-91 recession, gold has generally be a winner as the economy struggles.
In the wake of the September FOMC, the recent pull-back in gold and the Gold Miners on unfounded fears following distracting Fed hawkish discourse would seem to have just created an excellent entry point for gold bulls. The gold chart (top) has shown a classic triangular consolidation pattern. The fact that gold only fell -4% from its summer peak is a testament of the strength of the new gold bull market.
Despite some high percentage daily moves, the NYSE Gold Miners index suffered nothing more than a garden variety correction over the past weeks within its new bull market. We called for patience in not buying the initial bounce in the miners the first week of September based on our market indicators. We moved back into the Gold Miners prior to the Fed meeting as internals began reversing up and the key 700 level (red line in chart below) held for several days. We recommend adding to existing gold positions on any modest pull-back or on a break-out above 800 on the index.
Conclusion
We remain massively overweight large cap Gold Miners (GDX), smaller cap Gold Miners (GDXJ), Silver Miners (SIL), physical gold (GLD), and physical silver (SLV). While investors can still play the Fed’s game of Russian roulette with S&P 500 (SPY) stocks and bonds (TLT) and potentially extract more gains, the risk/reward ratio in the broad equity market and bond markets is decidedly more attractive for short-sellers. Positions in the precious metals and mining stocks may be used to diversify portfolios of investors choosing to remain fully invested in risk assets.
