Gold may offer safeguards beyond the vaccine

Positive news about COVID-19 vaccines created euphoria in the stock market, causing gold to fall through the US$1,800 per ounce level, but risks remain that we believe can drive gold to new highs.

Gold retreats on vaccine hope

News of positive test results for several COVID-19 vaccines created euphoria in the stock market and caused gold to fall through the technically important US$1,800 per ounce level. Gold had a positive start in November. US dollar weakness caused the gold price to break out of a three-month consolidation pattern to its monthly high of US$1,965/oz on November 9. However, the breakout failed on the same day when Pfizer announced better-than-expected vaccine test results. Steady redemptions from gold bullion exchange traded products (ETP) beginning on November 12 brought the first month of bullion ETP outflows in 2020. The gold price later suffered another drop when AstraZeneca released its vaccine trials, then declined to US$1,810/oz after the Trump administration finally allowed President-elect Biden’s team to initiate a formal transition. Gold fell below the threshold level amid selling pressure in thin Thanksgiving holiday trading ending the month with a US$101.86 (5.4%) loss at US$1,776.95.

Gold companies down but not out

Gold equities fell with gold, the NYSE Arca Gold Miners Index dropped by 12.11%. While the gold price is experiencing near-term weakness, gold companies are still enjoying ample free cash flow. Many companies increased dividend payouts with third quarter results.

Scotiabank figures the senior and intermediate producers they cover now have an average yield of 2.0%, which, per Bloomberg data, surpasses the S&P 500's average yield of approximately 1.5%. More companies are positioned to maintain dividends throughout the gold cycle. Newmont and Barrick are laying out new frameworks for distributing excess cash. While Yamana has established a dividend reserve fund. These efforts set the companies apart from gold, which pays no dividend, as well companies in other sectors with lower yields.

Bearish near-term technicals?

Gold responds negatively to anything that convinces markets that the economy, the financial health of businesses and households, and life in general, can return to normal without inflation. This risk-free scenario is being priced into the markets, along with the news that vaccines will become widely available in 2021. This caused gold to briefly dip below the bull market trend that began in June 2019 (see Chart 1).

Chart 1: Gold price sees brief dip

Gold Price Sees Brief Dip

Source: Bloomberg. Data as of December 4, 2020.

This selloff and the fall below the threshold level of US$1,800/oz suggest that the gold bull market does not carry as much near-term strength as we had assumed. Bullion ETP selling suggests that some investors saw gold solely as a pandemic trade, ignoring longer-term economic, financial and other ramifications. With jewelry and central bank demand weakened by the pandemic, gold will likely remain under pressure until ETP flows turn positive. As such, it looks like the current consolidation might continue through the first half of 2021.

Return to normal far from guaranteed

We find the market’s view that the world can emerge from the pandemic as if nothing ever happened to be preposterous. There will be lasting damage as COVID-19 appears set to continue wreaking havoc through the spring. Moody’s Analytics estimates that state and local governments could face a US$70 billion shortfall this year, that could balloon to US$268 billion in 2021 and US$312 billion in 2022. Meanwhile, Rosenberg Research figures show that nearly 30 million American households will be affected by an end to unemployment support, eviction moratoriums and home loan forbearance in 2021. Many of the unemployed won’t have jobs to go back to. And the longer they remain out of work, the more their skills erode. According to the same research, the savings rate at 13.6% is nearly double pre-pandemic levels. Rather than representing a potential spending bonanza, perhaps high savings levels represents a new conservatism in investing and consumption. Young people coming of age have already experienced two historic crises in 12 years, they adopt the values of their Depression-era great grandparents, rather than those of their Boomer or Gen-Xer parents.

In the longer term, there are unknown side effects from the overall clinical, psychological, social and economic shocks of the pandemic. The legacy of COVID-19 could transform political attitudes, global supply chains, demand patterns, work habits, risk tolerance and business practices.

While the news of vaccines is welcomed by all, a return to normal is far from guaranteed. Many risks remain that we believe can drive gold to new highs.

Let us count the ways…

Beyond the pandemic are a host of risks that could threaten the financial system. Foremost is the massive debt that has been issued since the global financial crisis and that has accelerated with the pandemic. A few of the characteristics of the global debt load that cause concern:

  1. The Institute of International Finance (IIF) estimates that global debt rose to US$272 trillion through the third quarter and will reach a record 365% of global GDP by the year-end. Advanced nations have seen a 50 percentage point increase in nine months to 432% of GDP. The IIF says it isn’t clear how debt levels can be brought back down without significantly hurting economic activity.
  2. According to Bloomberg, since the onset of the pandemic, some of America’s most esteemed companies have become zombies – unable to earn enough to cover their interest expense. Zombies totaling 20% of the country’s 3,000 largest companies added almost US$1 trillion in debt. The unintended consequence of the Fed’s propping up of the bond market may be directing the flow of capital to unproductive firms, depressing employment and growth for years to come.
  3. The US Education Department’s latest estimate shows student loan losses have reaching US$435 billion, equal to 32% of student loans outstanding. This is approaching the US$535 billion lost on subprime mortgages in 2008.
  4. The world’s inventory of negative yielding bonds reached a record US$17.05 trillion in November. Rosenberg Research reckons this represents 26% of the world’s investment grade debt.

The real wild cards: bubbles, inflation

Perhaps the most worrisome and least predictable of the financial risks is the effect of the liquidity that has been pumped into the financial system by the Fed’s quantitative easing and the government’s deficit spending. The massive scale is captured in the change in M2 and total debt charts 2 and 3:

Chart 2: US M2 money stock

U.S. M2 Money Stock

Source: U.S. Federal Reserve Bank of St. Louis. Data as of Q1 2020 (latest available). Domestic debt reflects debt securities and loans for all sectors.

Chart 3: US domestic debt to GDP

U.S. Domestic Debt to GDP

Source: U.S. Federal Reserve Bank of St. Louis. Data as of November 23.

Both the Fed and the Treasury are expected to implement more stimulus when US President-elect Biden takes office. Far too much money in a financial system carries the risk of unintended consequences, such as asset bubbles, currency volatility, or inflation. Already we are seeing bubbles develop in large tech stocks, initial public offerings and residential real estate. The velocity of money (rate of turnover of the money supply) is currently extremely low, which keeps inflation in check. A return to normal velocity with stronger economic growth might trigger an inflationary cycle.

Gold should still be in your portfolio

Aging demographics over the next 20 years will require funding of social security and many pensions whose obligations far exceed their ability to pay. The traditional 60% stock / 40% bond portfolio no longer works when interest rates are at zero. Many investors are seeking alternatives to generate the returns that are missing in their bond allocation. Gold, private equity and bitcoin are among the limited number of alternative asset classes to choose from. Gold is the only one with an established history as a store of wealth and hedge against tail risks.

Published: 08 December 2020


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