US tax reform adds fuel to gold’s engine

Gold's year end pattern repeated: Oversold ahead of rate increase then rebound

The Federal Reserve (the "Fed") raised rates for the third time in 2017 following the Federal Open Market Committee (FOMC) meeting on 12 December. Since 2015, gold has established a yearend pattern where it is oversold ahead of the December Fed rate decision. This pattern repeated this year as the gold price trended to a five-month low of $1,236 per ounce on the day of the Fed meeting and then promptly rebounded to end December with a US$28.11 gain (2.2%) at US$1,303.05 per ounce. Commodity price strength also aided gold as copper and crude oil both hit multi-year highs in the last week of the year.

Gold stocks also tested their second half lows on 12 December and like gold bullion, staged a comeback to end December with the NYSE Arca Gold Miners Index (GDX Index) rising 1.48% for the month.

Strong 2017 performance on geopolitical risk, US dollar weakness and commodities strength

Gold and gold stocks had positive returns in 2017. The gold price advanced US$150.78 per ounce (13.1%), the GDX Index, in Australian dollar terms, was up 3.89%. These gains were impressive for a market in which investors generally showed little interest in gold while being preoccupied with new records in the stock market, bitcoin, and ancient art. Gold also did not receive much help from the physical markets, as Indian demand remained near the lows of 2016 and China's central bank refrained from purchasing gold. The resilience in the price of gold came from a global sense of geopolitical risk and uncertainty, overall strength in commodities, and unexpected weakness in the U.S. dollar. Gold stocks typically outperform gold bullion in a positive gold market. However, this year was one of mean reversion after a strong 2016 (GDX Index up 55%), along with a lack of sizzle that investors are seeing elsewhere. Healthy earnings and increased guidance among gold companies were not enough to capture much investor interest in 2017.

Tax reform adds to deficit, increases systemic risk

Anyone hoping that Washington DC would become fiscally responsible under Republican Party rule has seen their hopes go up in flames, as new tax rules appear likely to drive the U.S. deeper into debt. Some say economic growth created by tax cuts will likely generate more government revenue. In a recent Wall Street Journal article, ex-Congressional Budget Office (CBO) director Douglas Holtz-Eakin stated that he believes tax policy can partially offset costs if it is well designed. We believe the new tax code is not well designed, as it is nearly as complicated as the old one, widely unpopular, and contains many provisions set to expire in 2025. The tax windfall corporations will receive comes at a time when profits are high and cheap credit is plentiful. If companies were inclined to spend more on capital expansions, they would have done so already.  Instead many companies have used cash to buy back stock and pay dividends. We believe it is too late in the cycle for tax stimulus to have a lasting effect. In addition, fiscal stimulus has limited effects when debt levels are high, as they are today. None of the federal income tax cuts since 1980 have succeeded in shrinking the deficit through growth. The Reagan tax cuts of 1981 could not forestall a recession that started in July of that year, caused by tighter Fed policy. Similarly, any growth resulting from Trump's tax cuts could give the Fed more latitude to raise rates.

Tax reform will add an estimated US$1.5 trillion to the deficit over ten years, according to the Joint Committee on Taxation (JCT). In October, the US Treasury Department reported the budget shortfall increased 14% in 2017 to US$666 billion, which is equal to 3.3% of GDP. At US$16 trillion, public federal debt is 85% of GDP and Harvard University economist Jason Furman estimates debt escalating to 98% of GDP by 2028. The CBO figures interest charges will consume 15% of federal revenues in 2027, up from 8% currently. The annual report from the trustees of the nation's largest entitlement programs show the trust funds running out for Medicare in 2029 and for Social Security in 2034. The new tax law only piles more onto this growing mountain of debt.

Total non-financial debt in the US stands at US$47 trillion, equal to 250% of GDP and US$14 trillion more than at the peak of the last credit bubble when debt/GDP stood at 225%. Thanks to below market rates engineered by central banks, debt service has not yet become a problem. Low rates have forced investors to take on more risk in order to generate acceptable returns. Another side effect is the proliferation of European "zombie companies", meaning their interest cost exceeds earnings and kept on life support by banks fearful of losses if the companies declare bankruptcy. The Bank for International Settlements (BIS) estimates that 10% of publicly traded companies in six major European countries are zombies. As central banks embark on tighter policies, at some point higher rates could create debt service problems. Gluskin Sheff³ reckons every percentage point rise in the level of rates will ultimately drain 2.5% out of nominal GDP growth.

Looming economic downturn, decline in markets supports gold allocation

It appears the only way to stop sovereign debt from growing is through tax increases or spending cuts. By now it should be clear that these options are politically impossible, which suggests that deficits will continue to grow until they cause a crisis severe enough to motivate change. "Crypto-mania" and a stock market that goes nowhere but up indicates that a crisis is the last thing on investors' minds. However, in our opinion, we are at a stage in the cycle when concerns should be high. The expansion is heading into its ninth year. The economy is at near full employment and the personal savings rate has declined from 6% in 2015 to 2.9% in November. By now many have bought their first home, a new car, remodeled the kitchen, taken that overseas vacation, or bought a second home. Some are in a position to speculate on their favourite ETF, cryptocurrency, or FAANG stock (Facebook, Apple, Amazon, Netflix, and Google).

There comes a point when something happens that triggers a selloff – a geopolitical event, an economic downturn, or a black swan emerges. Markets decline, but there are few investors with the capacity or desire to buy more, so markets decline more. Momentum kicks in and there's more selling until sentiment turns for the worse. The selloff becomes a contagion that spreads uncontrollably. It has happened to tech stocks and it's happened to instruments linked to mortgage securities. It is likely to happen again.

Based on the gold price strength following December rate increases in 2015 and 2016, we expect to see firmness in the gold price in the first quarter. However, headwinds may come for gold if economic growth enables the Fed to tighten more than expected. Also, the US dollar might strengthen if the new tax code causes corporations to repatriate profits stockpiled overseas. We believe any weakness in gold during the first half of 2018 could be transitory. Moving through 2018 and into 2019, we believe the chance of an economic downturn increases, along with the probability of a significant decline in the markets. High levels of debt could cause a downturn to turn into a financial crisis. We now know that quantitative easing and below-market rates have failed to generate needed growth or inflation. In the next crisis, look for central banks to resort to even more radical policies, such as directly funding treasuries. It is conceivable that there could be global currency debasement on a scale never seen before. In such a scenario, hard assets, especially gold and gold stocks, could significantly outperform most, if not all, other asset classes in our opinion. There comes a time in every economic cycle when investors should seek portfolio insurance. We believe the time is now.

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