Gold suffers as irrationality Trumps reality
The markets have gone into fantasy mode since the US presidential election. US stocks reached new all-time highs, the US dollar has soared, copper has had a parabolic rise, interest rates are up substantially while gold has tumbled.
The markets have gone into fantasy mode since the US presidential election. US stocks reached new all-time highs, the US dollar has soared, copper has had a parabolic rise, interest rates are up substantially while gold has tumbled. All of these strong moves indicate the market is pricing in a rosy scenario in which projected Trump tax cuts, infrastructure spending and regulatory reforms ignite robust economic growth that enables the Federal Reserve (the “Fed”) to normalise rates. This outlook works against safe haven assets like gold and bonds. While we are hopeful for such an outcome, it will be very hard, if not impossible, to achieve in reality.
Market's positive response to Trump unexpected. Gold suffers under pressure
No one forecasted such a market response to a Trump victory. We thought a Trump win would be positive for gold… and it was for about an hour when gold rose US$50 per ounce as news outlets began to declare a winner. However, gold quickly reversed course. Redemptions in gold bullion exchange traded products began the day after the election and continued through month-end. The selling pressure caused gold to fall below important technical levels. For the month, gold declined US$104.05 (8.2%) to US$1,173.25 per ounce. Gold stocks took their lead from gold bullion, as the NYSE Arca Gold Miners Index (GDX Index) dropped 14.9%. For the year, gains have been trimmed to 10.5% for gold bullion and 49.5% for GDX Index.
While lower fourth quarter gold prices will likely put a dent in the profits of many mining firms, the industry remains in good health. Third quarter results were positive, as Scotiabank’s universe of gold stocks reported production is 2% ahead of expectations and all-in sustaining costs (AISC) came in 5% lower than estimates. The bear market forced the industry to reorganise around lower gold prices. With AISC averaging roughly US$900 per ounce, companies are well positioned to weather the current downdraft in gold prices.
Currency changes drive India’s demand in November
Demand from India has been weak this year due to rising prices, existing taxes and import restrictions. The World Gold Council trimmed its demand estimate to between 650 and 750 tonnes, which would be the weakest since 2009 and down from 858 tonnes in 2015. Despite this, we are seeing good seasonal demand from India, as the Reserve Bank of India reports 86 tonnes of imports in October, which is more than twice the September volume and above the historical October average of 70 tonnes.
There have been some emerging issues in India that are likely to have an uncertain impact on its gold market. A goods and services tax (GST) is set to be implemented on April 1, 2017. GST rates range from 5% to 28% for different categories, with the food category to have a zero rate. A 4% GST has been proposed for gold, but the finance ministry has delayed its decision.
Indian gold premiums spiked in November when the government abolished two high-value currency notes. This is aimed at curtailing counterfeiting, black market activity and motivating people to hold savings in bank accounts. There has also been unsubstantiated rumours that the government is considering an import ban on gold. We believe it is unlikely the government would take such draconian action because it would encourage rampant smuggling that would circumvent any monitoring or taxation. Many Indians use gold as a store of wealth because there is little trust in the financial system. We doubt that any of the recent policy changes are increasing this sentiment of the system.
US regulations stifle growth
One of the reasons monetary policies have lacked efficacy since the sub-prime crisis is that fiscal policies have been working against the central banks. Since the crisis, governments have implemented higher taxes and increased regulations, rather than policies that would stimulate the economy. We have long believed that regulations have reached a breaking point, where the time and cost of compliance saps profitability and deters start-ups and innovation. Large companies have easier access to the credit markets and can afford to deal with a maze of regulations. This places small, dynamic companies at a disadvantage. The rate of start-up formation (firms less than 1 year old) is at a historic low of 8.0%. Job gains from opening establishments has dropped to the lowest since the Labor Department began the data series in 1992. Large, inefficient companies are able to remain large and inefficient. The US economy is structurally unable to reach its potential, hence the popularity of Donald Trump and Bernie Sanders.
Companies are reluctant to invest in a world with geopolitical, economic, and regulatory uncertainty. As a result, firms have shown a preference to use the cheap credit made possible by central banks for share buybacks and dividends, rather than capital improvements and research. Consequently, productivity has suffered. Over the last five years annual productivity gains averaged 0.6%, well below trend and the weakest since 1978 to 1982, according to The Wall Street Journal. Wealth creation suffers and living standards deteriorate in an economy that lacks productivity gains, again, contributing to the popularity of Trump and Sanders.
Will President-elect Trump solve imminent issues? Markets think so. We don’t.
These are insidious post-crisis trends that we believe can be reversed with the right fiscal and monetary policies. While we believe Trump along with the Republican-majority in Congress will likely enact many measures that benefit the economy, there are a number of obstacles that pose an imminent risk to the rosy scenario that is currently priced into markets:
Extreme debt levels – Aggregate household, business, and government liabilities currently total 250% of GDP. At such debt levels, servicing and/or reducing debt take priority over spending and investment. The 2016 fiscal deficit was US$523 billion, 2.9% of GDP. The total government deficit amounts to 77% of GDP and the Congressional Budget Office (CBO) projects it will reach 85% in 2026. The Wall Street Journal estimates of the cost of the Trump tax plan range from US$3.5 to US$6.2 trillion over 10 years, which would boost government Debt/GDP to over 100%, according to the Tax Policy Center.
Late cycle constraints – At over seven years, this economic expansion is the 4th longest since 1902. Pent-up demand for big-ticket items might be exhausted. Trends in a number of leading indicators are following past late cycle trends. The risk of recession in the next four years appears to be increasing.
Fed tightening – Tightening policies are inherently designed to bring slower growth. Rising rates are also an impediment to the housing and auto markets.
Infrastructure limitations – Mr. Trump plans US$1 trillion of infrastructure spending over 10 years, however, we have already seen how little impact President Obama’s 10 year US$860 billion “shovel ready” infrastructure program launched in 2009 has had on the economy.
US dollar strength limits growth – As the US dollar strengthens, it becomes a drag on exports and industrial growth.
Fully valued stock market – The S&P 500 Index is up 229% in a bull market that is over seven years old with lofty P/E (price-to-earnings) valuations of 20x.
It doesn’t seem the current market is accounting for the challenges the Trump administration faces. The market response to the US election is, in our opinion, all based on expectations, not fundamentals. Markets have also lost sight of the potential risks that radical monetary policies globally pose to financial well-being. We believe that at some point sentiment will evolve to reflect these inherent risks. It is impossible to predict the catalyst that shifts market psychology but it could come soon after the 14 December Fed rate announcement, as happened last year. Until a catalyst emerges, and as long as bullion ETP outflows continue, gold is likely to struggle. In the longer term, our conviction remains for a strong gold market.
Inflation is not a concern for the time being
There has been talk in the press about rising inflation expectations. Gold has obviously not responded to this and we think for good reason. It is not reflected in the latest Consumer Price Index (CPI), Producer Price Index (PPI), or Personal Consumption Expenditure (PCE) figures. Core inflation is within the Fed’s target levels and headline inflation is catching up to core due to a bottoming in energy and other commodity prices. Gold responds to worrying levels of inflation and especially inflation that drives real rates lower. We have yet to see signs that inflation is getting out of control and therefore, there has been no response in the gold market.
Stock market highs and past inaugurations may be a precursor
Finally, a couple of historic points of interest: The S&P 500 Index, the Dow Jones Industrial Average and the Russell 2000 Index hit new all-time highs at the same time in November. The last time this happened was 31 December, 1999. The best election to inauguration stock market performance in history was with Herbert Hoover, who was sworn in on March 4, 1929. Both of these events occurred just prior to monumental stock market crashes.
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