Gold: What to Make of the Pullback

Gold: What to Make of the Pullback
 
For the first time in 2016, precious metal investors are on the back foot, with gold and silver declining from early May. After closing out April at USD $1274.50 and USD $17.85 per troy ounce respectively, the two precious metals eased 5% and 10% respectively.
 
With gold closing out May at USD $1210.50 per troy ounce, and silver at USD $16.06, the gold silver ratio has also increased back to 75:1, a not unexpected development considering the overall trend in the market the past four weeks.
 
In Australian dollars, the metals are now trading at AUD $1673 for gold and USD $22.27 for silver, with the decline in prices across May slightly cushioned by the local currency.
 
Whilst this pullback may worry some, we see it as a relatively healthy correction within a broader uptrend. Indeed, most of the better analysts and followers of the precious metal market have been expecting a pullback like this.

There are a number of reasons for this, including:

• The surge in ETF gold holdings, which had helped propel prices higher in January through April was always going to have to take a breather

• Hedge fund positioning was at its most bullish, which is typically a sign the metals market is about to pullback

• There has been a decent rally in the USD index, with the DXY rallying from 92 to 96 in the space of a month.

We’ve also had a massive re-set of expectations regarding the next interest rate hike by the Federal Reserve. A month or so ago, the market was not pricing in any imminent interest rate hikes at all.
 
Some decent (though far from spectacular) economic data, and a series of Hawkish tones from the Fed have totally changed that, with it now seen as more of an odds on bet that the Fed will raise rates again in either June or July.
 
Over the medium to long-term, we see little threat to gold prices as a result of another small move higher in US interest rates, but short-term, we aren’t surprised to see these developments in futures markets for interest rates contribute to the recent precious metal weakness.
 
Other factors that some market commentators have mentioned include the sale of gold by Venezuela, who are rumoured to have liquidated in the vicinity of 80 tonnes recently, a desperate move to raise funds in a nation of the brink of a total economic collapse.

Technical View for Silver
 
With both precious metals declining, we thought we’d ask our colleague Nick to run a chart on silver, as it often holds some clues as to where the next move is for the entire precious metal complex.
 
Silver has reached the Weekly Standard Line and a trend line extending up from the Jan low. The price also made a low at the 50 % retracement of the up move from the US$13.65 low in December.
 
The band between US$15.83 and US$15.32 could prove decent support, although it would be preferable to see support right here.
 
Technically, the charts tell us that the next move in silver could be a move to the upside, with USD $16.55 a likely destination, providing the market holds its current levels. Were further weakness to occur though, then it looks like we could see the market ease as far back as the US$15.33-15.35 range, which would be a roughly 60% retracement of the entire 2016 rally.
 
In short, dollar cost averaging, a point we have made repeatedly for years, still seems the best course of action, as the markets remain uncertain.
 
As a quick aside: We’re making some further refinements to our Investor Centre. Within the next month, we’ll have a dedicated area for technical analysis, which Nick will update regularly. I’ll refer to these in our market updates from time and time, and link them in as well.
 
Our views regarding the recent correction in precious metal prices appear to be shared by a handful of the banks, and their analysts following the metals market.

UBS were out with a note this week stating that, as regards Gold: “The May set-back in gold has worked off its previously overbought situation in our momentum work and in terms of price, the yellow metal has retraced 38% of its rally off from the December low and it hit 1200 on Monday, which represented in May the lower end of our correction target. What we can't rule out is a little more consolidation/short-term bottoming or even another dip towards the 50% retracement at 1175. However, we do label the May correction as a healthy set-back within a new gold bull market and the weakness represents another opportunity to accumulate for those who missed the Q1 rally.”
 
They were even more optimistic on silver, noting that; “The most significant development in Q1 has been the break of the 2011 bear trend so that we do label the May correction as a classic pullback towards the formerly broken trend. The latter offers support at around 15.50 and which represents the short-term worst case scenario and the next buying opportunity.  In that context, keep an eye on the gold/silver ratio. Back in May the ratio hit historical extreme levels and which suggests that on a multi-month if not even a multi-year time frame, the odds are in favour of silver to outperform. After the most recent tactical bounce in favour of gold, a break of the May low in the XAU/XAG ratio would have a very bullish implication for the price of silver.”
 
Other forecasters have slightly differing opinions. Capital Economics noted that they see the silver price for example heading towards USD $19.50oz by the end of the year.

Whilst that is obviously a substantial move to the upside from there, they also stated that there is a possibility gold could fall as low as USD $1,000oz, but that it was not a base case scenario.
 
ABN Amro are also optimistic, still on record stating that they see the gold price hitting USD $1370 per troy ounce by the end of the year, noting that the 200 day moving average for gold (currently around the USD $1163 level for gold) was a key line of support, and that an upward trend should be maintained if prices stay above this moving average.  
 
You can read more on there views here.
 
What Next for the Aussie Economy, Interest Rates and the Dollar
 
If you were just to follow the headlines, you would probably think the Australian economy is in some kind of mini-boom. The unemployment rate has declined from just below 6.5% to just over 5.5% over the past 12 months, inflation is as benign as it has ever been, and the latest set of GDP data suggests the economy grew by over 3% in the last 12 months, the fastest pace of growth in over 3 years.
 
Housing prices are surging too once again, a concern seeing the “China bid” is apparently vastly reduced, whilst APRA is also meant to be limiting investor demand. Obviously the rate cut earlier in the year helped, though we think the debate about negative gearing and potential changes to Superannuation might be a factor too.
 
Some see these rising prices as a major positive due to the “wealth effect” that higher housing valuations should have, with everyday Australians supposedly more likely to go out and spend. We remain almost entirely unconvinced of this thesis, a view that would appear to be shared by the team at Forager Funds, which you can read about in this piece here.

All in all though, and debates about the “wealth effect” aside, on the surface, the Australian economy would appear in relatively good shape.
 
But the truth is told more clearly through one different number, rather than the data above. That number is 1.75%. The official RBA cash rate, which has been cut once this year, and is likely to fall as far as 1.50% by Christmas 2016 (if not lower), which would make it a full 50% lower than what it was during the height of the GFC.
 
Indeed some see rates falling as low as 1% in by next year, a move that would cause no end of despair for those with money in cash and term deposits, though it will no doubt lead to an increase in demand for physical precious metals.

And the reason the RBA will cut rates further this year, is that despite the headline numbers, there is ample evidence the economy remains quite weak. After all, consider the fact that:

• Quarterly growth of 1.1% was essentially entirely reliant on net exports, which are getting a double whammy effect of much higher commodity exports (even though the prices are lower, hence declining terms of trade) and lower imports, as the ‘build phase’ of the mining boom is well and truly in the rear view mirror

• Domestic demand was basically non-existent, with consumption (+0.7%) offset by a huge fall in private investment (-2.2%), with the latter number indicative of the reluctance of businesses in the country to invest.

• Today’s retail sales figure (a key barometer for the health of consumer finances) came in at just 0.2%, not exactly weak, but not the kind of strength you’d expect if lower rates and higher house prices really were stimulating consumer confidence.

Clearly, the numbers beneath the headline paint a more troubling picture. On top of that, wage growth is at record lows, a notable rise in underemployment, record high personal debt levels and a federal budget that is deteriorating by the day.
 
To me the key factor was the real net per capita national disposable income figure, which fell (by just -0.1%), marking the 8th straight quarterly decline in what is probably the best representation of national living standards.

The trend of lower living standards and low growth fits in with a broader global theme, with the latest set of manufacturing data released by Markit continuing a down-trend that began in mid 2013.
 
Capital Economics suggested the latest set of global PMI data is consistent with a global growth rate of just 2%, a frankly awful result considering just how expansionary both monetary and fiscal policy is.

Delving further into the detail, the team at Capital noted that:

• The most concerning results were in China, where signs of a recovery from Q1 2016 failed to continue

• Other BRIC nations were also struggling, not a great surprise when you consider what is happening in Brazil, whilst India is also in a situation where industrial production might grow by circa 1-2%

Finally, Capital noted that manufacturing results for advanced economies were quite weak too, highlighting in total a worrying trend where the emerging economics (which were the key driver of growth from 2009-2011) are all struggling, with no real handover to the developed world.
 
The chart below captures these trends neatly.

Policy wise, one can’t help but think this means ‘lower for longer’ monetary policy, with RBA cuts likely to see the AUD head well below USD $0.70 in the coming months and years.
 
We will also likely see even more extreme steps from central banks in the coming years, though they are unlikely to work, as this article from Narrow Road, dealing with the failure of monetary and fiscal policy well worth the read.

We remain skeptical that more of the same from central banks will work, let alone what they might try next, despite some of the stronger than expected headline economic data we’ve seen around the world and in Australia of late, and the bounce in select risk assets.
 
Most importantly, we remain confident that maintaining precious metal ownership will be the simplest, least risky, most effective and potentially most profitable way of protecting wealth through the difficult period ahead.
 
For a final read of the week, and as a way of reinforcing the comment made in the above paragraph, we highly recommend you read the following report from one of our favourite analysts, Worth Wray over at STA Wealth Management.

Warm Regards
 
Jordan Eliseo

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