Gold Flies as Markets Crash!

Gold prices soared overnight, with the price of the yellow metal last trading at USD $1224oz, whilst silver is now sitting at USD $14.66oz, with the yellow metal now on track to close up for the week, after a sharp decline saw the price pull back below UDS $1185oz just three days ago.

In Australian dollar terms, gold has well and truly reclaimed the AUD $1700oz level, and last traded at AUD $1722oz, whilst silver is back above AUD $20.50oz, with the local currency fetching USD $0.71.

Earlier in the week, it looked like gold was at risk of suffering another precipitous fall, with the yellow metal declining by almost USD $20oz. As you can see on the chart below, prices fell from almost USD $1205oz on Sunday October the 7th down to USD $1185oz by October 9th.

Since then, it’s been upside only, with gold tacking on USD $40oz since over the last three days - a more than 3% move, which has helped any investor weather the storm that is beginning to rage in other markets.

The recent volatility in markets is being caused by a multitude of factors. Trade war uncertainty continues to simmer, with increasingly belligerent rhetoric coming from Beijing and Washington.

Political concerns aren’t limited to trade wars and Sino-American relations, with questions marks about the fate of the Euro again flaring, with Italy, the third largest economy the focus now.

The country is going through a budget crisis, as European bureaucrats and Italian politicians fight over a path forward for the Italian budget, and their aggressive spending plans. The impact on markets in Italy has been severe, with the Italian stock market now down more than 20%, whilst bond yields are soaring, with the spread between Italian and German 10 year bonds now more than 3%.

Rate hikes by the Fed are also a concern, not just for gold investors and broader financial market participants, but the White House, with US President Trump this week stating that: “The Fed has gone crazy”. He followed that up by blaming the Fed for the correction we’ve seen in the stock market his week, leaving no one in any doubt that the President would prefer more accommodative monetary policy, as have most of his predecessors to be fair, even if they were more elegant in communicating that message.

Rising bond yields are also starting to worry investors, with the US 10 year yield now sitting at 3.15%, down from just over 3.20% earlier in the week. That's still not a lot of return to lend to a US government with over USD $21 trillion in existing debt, and a rapidly deteriorating budget position which we’ll discuss in detail below, but its almost a full 1% more than you would have gotten buying a US 10 year bond just one year ago.

The chart below shows the movements in US 10-year yields since the 1950s.
 

Interestingly enough, for the first time in more than 30 years, US 10 year yields caught up with their 200-month moving average. The odds are building that the more than three decade bull market in bonds looks like it is coming to an end.

Higher yields are creating justifiable concern for investors when they look at the sheer volume of lower quality loans that have been made in recent years (see chart below).

Globally, there is now more than USD $2.5 Trillion in “leveraged loans”, with the Bank for International Settlements and the Bank of England warning of the building risks, with comparisons made with the junk-bond crisis of the late 1980s and early 1990s.

Unsurprisingly, all of these risk factors have finally combined to hit equities too, with substantial weakness starting to creep into risk assets. The Russell 2000 fell nearly 4% last week, whilst this week we saw an over 800 point drop in the Dow (more than 3%) on Wednesday night/Thursday morning Australian time.

More weakness was seen overnight in US markets, where the Dow fell another 500 points. It is now down almost 6% for the week, with almost all of the gains made YTD disappearing. The S&P 500 has seen similar declines, whilst the NASDAQ has fared even worse, falling by almost 7% for the week.

Locally, the ASX has now crashed back week back below 6,000 points, falling almost 3% yesterday. We will likely see more losses when the market opens today, with the substantial risks building in our housing market and our economy, which we’ll discuss in more detail below, likely to add further downside pressure in the months ahead.

Despite the ‘risk off’ environment we’ve seen in markets over the last couple of weeks, it is only in the last 24-48 hours that precious metals have found a meaningful bid.

Indeed up until then, sentiment toward gold had remained incredibly subdued, with the market for non-commercial traders still net short, as the chart below indicates.
 

As a quick side note, that chart comes from this great update on Livewire Markets looking at both gold and gold miners, subjects that were discussed in detail last week in Perth at what was another terrific Precious Metals Investment Symposium.

Back to speculative positioning in the market and whilst this is a theme we’ve discussed over the past few months, it remains very relevant to the outlook for the yellow metal, even if nots a ‘new’ phenomenon. No doubt part of the rally we’ve seen in the last few days is simply speculative traders who have been short gold choosing to unwind their positions, which obviously acts to support prices.

Quite apart from the short volatility in stocks and gold catching a safe haven bid, there are other positive signs for precious metals bulls, including on the inflation front. Despite the decline over the past couple of weeks, oil prices have moved meaningfully higher this year, whilst the entire commodity complex looks like it may be on the verge of a multi-year breakout.

The following chart, which comes from this interesting read on commodities, highlights movements in the Reuters/Jeffries CRB index since late 2015, with a clear uptrend developing, as well as series of higher highs and higher lows seen since the start of 2016.

On the physical side of things, whilst trade remains somewhat subdued, there are pockets of support. Central banks are still in acquisition phase, whilst this recent article quoting State Street Global Advisors (SSGA) highlights the continued bid from Asia, with SSGAs Robin Tsui noting that; “Asian high net worth individuals that are served by private banks, in most cases, allocate to physical bullion as they love to literally see the gold in a tangible state.”

Recent data looking at demand from Chinese consumers backs up the above statement, with demand up 5% in the Q218 versus one year ago, with almost 145 tonnes of buying.

Putting this all together, and the backdrop for gold is definitely starting to improve. Even putting to one side the price action over the last day or so, the almost record lows in sentiment, extremely stretched futures market positioning and the third fastest pace of ETF outflows on record over the past three months speak to a market that is extremely oversold.

The fact that gold also held up above USD $1180oz over the last couple of weeks, despite the occasional sharp pullback is also a positive sign.

Banks like ABN Amro clearly see the potential upside from here, with their latest report highlighting a strong conviction in higher prices. This report has a December 2018 forecast for gold of USD $1250oz, which would make for a very happy Christmas for gold bulls. They see continued strength next year, with and a USD $1400oz forecast for gold in December 2019, whilst should their forecasts come to pass, silver will be trading at USD $18oz in 15 months.

On a more cautionary note, it has to be stated that there are still multiple tailwinds for the USD, which often though not always acts as headwind for gold. The Fed is still hiking interest rates too, and stocks, despite the recent sell offs, are still the flavour of the month for investors, though this could soon change.

For gold to really move higher, we’ll need to see the Fed take on a more dovish tone, more volatility in stocks, and ideally a declining USD, though should any one of these developments come to pass, it will be enough to support the precious metals market.

No Digital Gold Here!

Cryptocurrency markets have failed in their role as ‘digital gold’ over the last 24 hours, with the price of Bitcoin falling below USD $6,300 per coin, down over 4% for the night, with its status of ‘digital gold’ increasingly coming into question.

Whilst Bitcoin has fallen, as is often the case when crypto markets decline, it was the relative outperformer within the sector, with the below image from coinmarketcap highlighting the more than 10% fall in Ethereum, Ripple, Bitcoin Cash, EOS and Stellar over the past 24 hours.

 
The Bloomberg Galaxy Crypto Index has tumbled more than 10%, with Ryan Rabaglia, the head of trading with cryptocurrency dealing firm OSL in Hong Kong stating that: “The days of crypto being the safe-haven play and having a high degree of detachment from the rest of the world are seemingly diminishing”.

Indeed!

How Bad is the US Fiscal Outlook?

Ever since US President Donald Trump launched his fiscal stimulus plans, concerns have built regarding the size of the US deficit.

This week, we came across this short note from Tocqueville Asset Management, which highlighted a few incredible statistics about the parlous state of the US financial situation, including;

• The August monthly deficit was the fifth largest on record, with CBO estimates for the entire years deficit already surpassed, with a month to spare.

• Interest expenses on the federal government debt have now topped USD $320 billion.

• The average maturity of US government debt is 65 months, with over 40% maturing in two years or less, highlighting the sensitivity of interest expenses to rising yields.

• ‘Automatic’ expenditure on items like social security, health care, veterans benefits and of course interest owed to lenders exceeded individual income tax receipts by 28%.

The Tocqueville letter ends by quoting Ray Dalio, who is a strong believer in owning gold, who stated that there is a risk of a “30% depreciation of the dollar” over the next two years, with a loss of confidence in the US currency now a credible risk.

Property Fears Building!

In Australia, the news about our local property market continues to deteriorate. Building approvals have plummeted, falling almost 10% in August, after an almost 5% decline in July, with approvals for units falling by a staggering 17% relative to a month earlier.

The latest Performance of Construction Index (PCI) declined as well, with falling levels of activity across houses and apartment construction, with engineering works the only bright spot, obviously assisted by publically funded infrastructure projects.

Given the falls in prices on the East Coast over the last few months, and the declining levels of activity on the construction side, it should be no surprise that confidence amongst property professionals in Sydney has hit its lowest levels on record, with confidence amongst property professionals nationwide hitting a 7 year low.

Auction clearance rates continue to suggest a faster pace of price falls is ahead of us, whilst the performance of our major banking stocks, if they are kind of any lead indicator for the housing market, suggests more pain ahead.

Clearly there are other factors at play when it comes to the banks, the Royal Commission being but one of them, but the chart below (form Macrobusiness), which tracks the prices of the big 4 since the late 1990s is fairly ugly, with the prices of the big four down approximately 28% (for CBA and ANZ), and 30% to 33% for NAB and WBC respectively.

Note: This chart was drawn prior to the ASX market open on the 11th of October.

Adding to the negative outlook is the disappearance of buying interest from Chinese property investors, with demand for property by foreign investors now just 8% of total demand for newly built properties, and just 4% for already established properties. Both of these numbers have more than halved since the halcyon days of late 2014/early 2015, and are currently at 7 year lows, according to the latest NAB quarterly property survey.

Worrying as all of these data points are, the real “headline” news this week regarding property comes from Australian Super, Australia’s largest industry superannuation fund, which manages approximately AUD $140bn in Australian retirement funds.

Australian Super have decided to make some fairly significant changes to the way they run the “Direct Property” option they offer their members, now limiting exposure to 70% of total assets. More importantly, they’ve warned investors that it may take up to two years to liquidate one’s holdings, should a member decide they want to sell their property exposure and rotate to another asset class.

Without wanting to add to the hyperbole, this decision by Australian Super is clearly not a vote of confidence in the outlook for the property market, though they should be commended for bringing this to their members attention and obviously trying to get ahead of the risks that are building.

For a more liquid alternative, Australian Super members may be better off looking at physical gold. The chart below, which comes from our early 2018 report: “Australian Housing – End of Boom?”, shows that gold priced in AUD, is extremely cheap relative to the local housing market, with over 400 ounces of gold needed to buy the average Australian home.
 

As to how far property prices fall, it of course remains to be seen. Morgan Stanley believes the market is on track to experience its largest and longest decline since the 1980s, with a 10-15% decline in real terms.

The report we wrote earlier this year suggested a nationwide fall of 20% would not be out of the question, an alarming number indeed, but well short of the 35% average decline in property prices economists Reinhardt and Rogoff noted in their 2009 study titled; “The aftermath of financial crises”.

For those interested in reading another perspective on the housing market, we’d recommend this article, published on Livewire Markets by John Abernathy of Clime Asset Management.

Amongst a handful of excellent insights and graphs which help illustrate the problem we are facing, we were particularly taken by the following table, which highlights the reduction in borrowing power that households now have, given APRA’s attempts to clamp down on riskier lending.

 
The numbers that stand out in particular are those for households on incomes between AUD $100,000 and AUD $200,000, as there are very few households that fall outside of this bracket, particularly above AUD $200,000. As you can see, within these household income brackets, at a minimum, households are looking at a reduction in borrowing limits of 28%.

In due course, these worrying trends in the Australian property market, and the impact they’ll have on our broader economy, will exert downward pressure both on the RBA cash rate, as well as the AUD, and support the reasons why local investors should feel comfortable incorporating physical bullion in their investment portfolios.

Until next time,

Jordan Eliseo
Chief Economist
ABC Bullion

Disclaimer
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