Gold Correction! Buying Opportunity?

In a bull market, you should either be long, or sitting on the sidelines waiting to get long. It’s a simple message, but one that a senior trader at ABC Bullion is fond of repeating right now, as it illustrates exactly how precious metal investors should be looking at the market today.
 
For despite the corrective action we’ve seen in precious metals over the last few weeks, 2016 is still shaping up as the year that the secular bull market in gold, which dates back to the turn of the century, re-asserted its primary trend.
 
With that in mind, longer term investors will be nothing but thankful that they now have the ability to buy gold with a spot price near AUD $1,650 per troy ounce, and silver at under AUD $23.50 per troy ounce, despite the decrease in the valuation of any metal they already own.

It’s a point that is particularly relevant for Australian investors, given the incredibly strong performance of the local currency right now, which, off the back of a stronger than expected CPI print yesterday, briefly traded back above USD $0.77.
 
The strength of the AUD over the past two weeks (indeed it’s been strong for most of 2016, see image below) has helped limit the price gains of gold and silver in the local currency this year. 

Indeed were it not for the rally in the AUD since January, investors in Australia would be paying over AUD $1,850 per troy ounce for gold, and over AUD $26 per troy ounce for silver right now, a circa 10% premium over current market prices.
 
It is an opportunity that investors may wish to look at taking advantage of sooner rather than later, as there are signs that the AUD rally may soon come to an end (more on this below), whilst the correction in the USD gold price may also be petering out.
 
To that end, ABC Bullion’s latest technical and market positioning report (click here to access), points out that the upward trend in USD gold still appears to be intact, which reinforces the idea of buying dips in the market. Short term targets for gold point toward the USD $1,286oz level, with longer term targets back toward USD $1,390oz. For local investors, a move back toward AUD $1,700oz is entirely feasible.

One of the reasons we’re more optimistic about where prices will head next is the significant reduction in managed money long positions that have taken place over the past few weeks, with bullish bets on gold prices now down some 50% from where they were in July. During this period, speculators dumped over 10 million ounces long gold, with the data suggesting that is the fastest pace of long reduction since 2006.
 
This is an important development, as gold has managed to hold important levels of support price wise, whilst working off a large part of the excessive exuberance that was on display from the speculative end of town.
 
The rapid decrease in managed money longs, as well as the increase in short positions, can be seen in the chart below, with the data coming courtesy of Bloomberg and Saxo Bank.

On the physical side, we’re still seeing relatively robust demand, with buying picking up out of India (no real surprise given it’s Diwali, and a particularly auspicious time for gold buying), whilst the Shanghai premium is back out to $3 or $4 per oz over London, suggestive of decent buying out of China.
 
Silver Eagle sales have also sky-rocketed recently, with data out of the US Mint suggesting that over 3.5 million one ounce silver coins have been sold this month, essentially triple the levels that we saw in July and August when prices were nearer their highs for 2016.
 
It’s a similar story in gold, with sales of 1oz coins tripling between July and October, which is now on track to either match or exceed sales from January this year, back when gold started its 2016 rally in earnest.
 
These figures can be tracked here.

Probably the key area of concern right now on the physical side is gold ETF flows. For most of this year, including during the corrective periods, gold demand from ETF buyers has been very robust, and is no doubt one of the factors that has helped fuel the price gains we’ve seen.
 
Last week though there was a net outflow of some 518,000 ounces, the largest daily decline in over 3 years. Whether this huge outflow is a one-off, or the start of a new trend remains to be seen, but it is obviously a risk to the market, as a continuation of outflows from this sector would add downside pressure to prices.
 
Shorter-term, one can’t discount the impact of higher yields, and a continuation of the move higher in the USD, both of which could encourage further liquidation, especially if the odds of a December rate hike (which are near 80%) strengthen any further.

Australian Economic Update
 
Whilst markets are busy digesting the latest CPI print, which came in higher than expected, we have no doubt that the bigger news took place last week, with a genuinely poor employment result.
 
Touching on the former briefly, and whilst the headline CPI rate rose by 0.7% quarter on quarter (which all but rules out any chance of a Melbourne Cup day rate cut), the underlying trend in core inflation is still weakening, best exhibited by the following graph from Business Insider. 

The article that the graph came from can be found here.

As you can see, core CPI has been broadly declining for years now, as a stagnant domestic economy with negative real wage growth all but rules out any meaningful uptick in non-tradable inflation.
 
Meanwhile, the rally in the AUD this year has also helped limit any imported inflation, contributing to a picture that will worry the RBA, who, like most central banks, are desperate to see official CPI levels increase meaningfully from current readings (not that we agree with this line of thinking by the way).
 
As such, whilst we don’t think another rate cut will occur next week, it really is still just a matter of “when” not “if”, particularly with the outlook for the labour market as poor as it is.
 
Evidence of a continued deterioration in the employment outlook was contained in the latest set of employment figures, which showed a drop of circa 10,000 jobs in total last month. More worrying was the plunge in full time jobs, with some 53,000 Australians losing a job last month, whilst the participation rate dropped by 0.2%.  Employment growth has all but come to a standstill, and with the closure of the car manufacturing industry likely to coincide with a peak in building construction, it may well get worse before it gets better.

Given the benign inflationary outlook, the deteriorating employment picture, and an Australian dollar comfortably north of USD $0.75, we are very confident that the market is wrong on how low interest rates are heading in this cycle (the below chart shows where ASX 30 day cash futures are currently sitting), and are still comfortable with our earlier prediction that the RBA will ultimately bring rates down as low as 0.50% in this cycle.

As the weakness in the local (and indeed global) economy becomes more apparent, and markets begin to more fully price in lower rates from the RBA, we can’t help but think that the AUD will soon turn tail and head south again.
 
The fact that there is so much bullishness out there regarding the AUD, including from a handful of analysts like Greg McKenna who I have great respect for (his bullish view can be seen here), possibly means I’m a bit early with a bearish AUD call, but I think the broader concerns re low official inflation and a deteriorating labour market will end up winning the day, with the next major move for the Aussie being to the downside.
 
That is obviously bullish for gold, and indeed the entire precious metal complex, good news for Australian investors with money in the sector.
 
Global Trade, US Recession Risk, Cash flow, Capex and (Excess) Capacity
 
Before finishing this market update, I wanted to briefly discuss a handful of other developments and interesting data I’ve come across in the past month. None of it is gold specific per se, though it obviously relates to precious metals in that the factors I will discuss collectively suggest a coming era of slower growth, higher levels of uncertainty and likely lower returns of financial assets.
 
The first chart I wanted to highlight actually comes from a presentation given by Andrew Staples, who spoke at the recently completed LBMA Gold Conference that took place up in Singapore.

As you can see, growth in global trade volumes has been declining for some time, and is nowhere near the levels seen back in late 2010 and 2011. In some way, this chart illustrates the utter futility of the beggar thy neighbor currency war currently taking place between Europe, Japan, the UK and the United States, as it does nothing to help grow the overall economic pie.
 
The full slide deck that contains that chart can be found here.

With growth in trade volumes weak, its also not surprising to see a continued deteriorating in the rate of GDP growth in developed market nations, including the US, which has been a relative shining light.
 
Indeed the latest figures for GDP and GDI suggest that the USA, which is late cycle now that it’s in its eight year of expansion, may be dangerously close to rolling over into a recession, something neither candidate running for the White House will be particularly keen to confront.
 
The chart below, which comes from an excellent article in the Telegraph (you can find it here), shows how these readings have evolved over the last 16 years, with a clear decline on display right now.

Discussing these trends, Albert Edwards, Soc Gen’s most famous bear, recently stated that; "The pronounced weakness of GDI relative to GDP might be an ominous omen, for it may well be indicating that a US recession is already underway - just as it was in 2007."

Whether that is true or not remains to be seen, but with such a poor outlook for growth, it is certainly difficult to see much in the way of rate hikes in the US over the next 12 months, even if the Fed does move in December.
 
Two further points that highlight the softness in the United States economy relate to the rate of new business creation, and investment at the big end of town.
 
Starting with the former, and whilst parts of the business media can’t seem to stop talking about Disruptors, Fintech and Unicorns, all of which would seem to suggest that more and more new businesses are being started every day, the truth is rather different.
 
Indeed the US today is creating new businesses at a very low rate, with the share of private firms that are less than a year old dropping to just 8% in the last few years, a huge reduction from the 1980s, when close to 12% of private firms were less than a year old.
 
Surprise surprise, the burden of bureaucracy is partly to blame, with Goldman Sachs economists blaming the cumulative effect of regulations brought in post GFC for reducing access to credit, and raising costs for small business, all of which makes them unpalatable to start, let alone operate successfully. How these trends have evolved in the past few decades can be seen in the chart below.

This dearth of new business has been plaguing the US for many years now, and is one of the major reasons the “recovery” post GFC is the worst seen since WWII.
 
Indeed back in early 2015, Jim Clifton, CEO of Gallup, went so far as to say that the US “economy is never truly coming back unless we reverse the birth and death trends of American business.”
 
You can read more about the trends in new business formation in the United States here and here.

The picture at the big end of town is similarly worrying, with businesses in the United States still exceptionally reluctant to invest. This unwillingness, despite record low borrowing costs, is entirely understandable, especially in an environment where capacity utilization rates, which seem to have been in a secular downtrend since the 1990s based on the chart below, continue to decline.

As a quick aside, this chart comes from an excellent report titled “The Flawed Logic of Inflation” which you can read here.

Despite their understandably cautious approach to investment, and the de-facto increase in hurdle rates, companies have been only too willing to borrow, utilizing cheap debt to buy-back stock and pay out ever higher dividends.
 
Indeed a recent article in Bloomberg pointed out that US companies are this year likely to dole out close to USD $1 trillion in buybacks and dividends alone, even though there has been no meaningful increase in free-cash flow generation to justify the largesse.  
 
US company spending on dividends and buybacks has actually eclipsed reported earnings for 6 quarters, something we haven’t seen since 2007, right before the previous market crash took place.
 
Scarily, some 34% of buybacks that have taken place in the past 12 months were debt funded, a more than 50% increase on the same figure a year ago, according to data from JP Morgan.
 
As the following chart from Soc Gen makes clear, company spending comfortably exceeds free cash flow generation, with net debt levels continuing to climb. The lack of growth in free cash flow generation can also be seen on the chart.

Discussing this trend, Andrew Lapthorne (one of my favourite analysts), noted that “US corporate balance sheets are a major risk going forward”. Most importantly for investors, he noted that “asset valuations are extreme; returns are poor, the probability of losses is high, and the ability to recovery any losses is low.
 
Whilst we can understand the desire of boards to reward yield starved investors with regular cash-flows, and the reticence to invest in a low-growth world with little demand and growing excess capacity, we can’t help but be concerned about the broader implications of these trends, both for employment and economic growth rates going forward, as well as stock market returns.
 
The worrying trends in corporate decision making regarding investment vs. payouts is something I’ve written about before, with this encouragement to sacrifice the future (for want of a better term) the least discussed negative side-effect of QE, ZIRP and NIRP. For a more detailed explanation on this, and the seven things a business can do with the money sitting on its balance sheet, click here.

The logic of owning gold is fairly easy to understand when one ties together the worrying trends on display re economic growth, trade volumes and business investment.
 
Collectively, these trends portend an era ahead which will almost certainly see much lower real returns for financial assets, and a greater focus on truly defensive assets, that have a track record of preserving wealth through the most challenging market, economic and political environments.
 
Despite the day to day price volatility, physical gold and silver of course remain assets without peer in this regard.
 
Until next time,
Jordan Eliseo

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