Market Update: Final Thoughts for 2016!

Despite the price weakness and rapidly declining sentiment toward precious metals in the aftermath of the US presidential election, it is worth reflecting on the fact that as it stands today, 2016 has been a very profitable one for long-term gold and silver investors.
 
Starting the year below USD $1,100oz and USD $14oz for gold and silver respectively, the metals jumped out of the gate during January and February, with continued strong gains (for silver at least), through March and April. There were multiple drivers for this rally, with a combination of volatile stock markets, the introduction of ever more extreme monetary policy (most notably the introduction of NIRP in Japan), and a heightened sense of political uncertainty all contributing.
 
USD gold prices ended up peaking in early July, unable to push through the USD $1,400oz level, before easing back to the USD $1,250oz mark in late October, around the time a Hillary Clinton election win in the race for the White House was being priced into markets.
 
Today, it is trading at close to USD $1,175oz, some 10% lower than the levels it briefly hit when it became clear that it was in fact Donald Trump that was going to win the US Electoral College vote, and become the 45th President of the United States.
 
Were markets to stay steady between now and the end of December (no sure thing by the way), then gold is on track to record a 10% gain for the year, whilst silver is up by almost 25%, in USD terms. The gold price (in USD) and how it has moved across the course of 2016 can be seen in the chart below.

Australian dollar precious metal investors, which the vast majority of our clients at ABC Bullion are, have also seen an increase in their metal portfolios this year, with the AUD gold price on track to record a gain of just over 8%.
 
Silver on the other hand is up by almost 20% in local currency terms, currently trading around AUD $23 per troy ounce.
 
Whilst the price appreciation in the precious metals for 2016 is not quite as impressive as it would have been had markets held the levels they reached in July, it’s worth remembering that returns of circa 8% on gold are nothing to complain about, whilst a return of close to 20% for silver is also very impressive, on both an absolute and especially a relative basis.

Precious Metals – What Happens in 2017
 
Whilst gold has stabilised the last few days, and is set to record a strong gain for calendar year 2016, there is no question that participants in the market are particularly bearish when it comes to the next move in precious metal prices.

ETF gold holdings, which had grown strongly for the first three quarters of 2016, have been in free fall since Trump won, with GLD seeing a near 10% decline in tonnes held since November.
The trend in precious metal ETFs (both gold and silver) over the past few years can be seen clearly in the chart below, with the uptick in gold ETF holdings since the start of this year, and its correlation with rising prices, very noticeable.

Given the weakness in price action of late, it’s also been no surprise to see managed money shorts become more emboldened, whilst those betting on rising prices have largely exited the scene in the last few weeks. Indeed with net longs down another 2.6 million ounces in the 7 days ending 29th November, and net positioning now sitting at just 43% of its all time high, it’s safe to say that the vast majority if not all of the excess froth that we saw in the gold space earlier this year is well and truly gone.

Alongside the decline in ETF holdings, this is testament to the changed tone that we saw prior to the US election, when some analysts were so confident about the metals that they thought gold was due to rise, irrespective of who won the race for the White House.

Commenting on these trends, Bloomberg carried a note a week or so ago which featured a handful of precious metal forecasters who saw much further downside, with the article discussing the fact that gold was on track for its worst month in years performance wise, “with investors dumping bullion at the fastest pace since 2013”.

Comments like that do sound troubling, and we can understand why it would make many investors in the space a bit nervous, though we’d note the pace of outflows also looks suspiciously like panic selling, something that typically marks bottoms (and good buying opportunities) in any asset class, including gold.

Indeed selling any asset at a time when other investors are dumping that asset at the fastest pace in years (as people have with gold in the last few weeks) rarely works well, just as investing in an asset in the middle of a buying frenzy rarely works either.

On the subject of buying frenzies, and one can’t possibly talk about the prospects for gold in 2017 without also touching on the US dollar. No asset has been more popular in the aftermath of the Trump presidential election win than the mighty greenback itself, driven by the spread between US and other developed market bond yields, as well as the fear of what 2017 holds in store for the whole Euro project.

Almost everyone is bullish USD now, no surprise considering its recent sharp rally, which tops off a circa five year period of strength that has seen the USD Index rise from circa 80 to over 100 at present.

Impressive as this move has been, and as unstoppable as the dollar appears now, a look at the longer term charts suggests that we may be approaching an inflection point, with some serious potential downside ahead.

That much is made clear from the following chart below, which comes from an early December update from the Felder report (accessible here), with the author noting that; “On a long-term time frame there are some significant bearish momentum divergences at play in the greenback. These are very similar to what we witnessed at the 2002 peak in the dollar. In fact, that 3-year analog is 92% correlated to the last 3 years’ trading in the greenback. Furthermore, this comes just as the Dollar Index tests the 61.8% Fibonacci retracement of its long-term decline since then. Technically, it looks ripe for a major reversal."

Source: The Felder Report

A decline in the USD would no doubt add some wind to the sails for precious metal bulls, with gold almost always performing strongly when the USD is falling.
 
The opposite does not necessarily hold true, something we’ve long commented on when discussing the asymmetric nature of the relationship between the USD and gold, with a stronger dollar (should this bull market rally in the greenback last a little longer), no guarantee that the yellow metal will continue to decline in any meaningful way throughout 2017.

This is not to say that it’s going to be all smooth sailing for precious metals next year, as bond yields, and spreads could easily continue rising, whilst stocks (though they are already expensive in the US when using metrics like CAPE or Market Cap to GDP) could also rally further.
 
On the physical side, we may also see a continuation of subdued demand (relative to the last few years) out of India and China, with attempts to crack down on the ‘black economy’ in India causing chaos across the country, no doubt contributing to a near 30% year on year decline in demand for bars, coins and jewellery, according to the latest update from OANDA, with data sourced from the World Gold Council. 
 
From a personal perspective, we’re happy to dollar cost average into the market around these levels, which we do on a weekly basis, reallocating some of our dollars, which we hold in a variety of currencies, into the real physical metal.

Short-term that may well add to the volatility of our overall portfolio, but considering the monetary extremism we see occurring around the world, including the latest announcement from Mario Draghi and the ECB overnight (see image below from Bloomberg capturing the essence of it), we feel very comfortable with our strategy.

As best as we understand things, it would appear that in the real world, paper most certainly does not beat rock!

Gold to Silver Ratio
 
One other signal worth looking at now is the much watched, (amongst precious metal investors at least), gold-to-silver ratio, or GSR. For those unfamiliar with it, the GSR simply measures how many ounces of silver one requires to buy one ounce of gold.
 
So if for example the price of gold was $2000 an ounce, and the price of silver was $20 per ounce, then the GSR would be 100:1, as one would require 100 ounces of silver to buy 1 ounce of gold.
 
Obviously a rising ratio is indicative of gold outperformance relative to silver, whilst a falling ratio tells us that silver is outperforming, which it often does during bullish periods for the entire precious metal complex.
 
Since the end of February this year, the GSR has declined meaningfully, from a high of over 83:1 to a low of just 66:1, before heading back to near 75:1 in mid November 2016, in the aftermath of the US Presidential election victory by Donald Trump. Interestingly though, in the past 2 to 3 weeks, silver has started strengthening again relative to gold, with GSR falling to just 68:1 today (8th December 2016).
 
A look at the longer-term chart, which you can see below, is even more interesting, with the below graph representing the GSR over the past 30 years. 

Source: MacroTrends
 
The first and most obvious thing that one can tell from looking at the above chart is that anytime the GSR hits 80:1 or close too it, silver is very cheap relative to the price of gold.
 
Indeed the only time the GSR went substantially higher than that was back in the early 1990s, when it went all the way toward 100:1, before halving across the course of the next decade. A troy ounce of gold could be bought back in those days for well below USD $400.
 
If one assumes that what will happen in 2017 mirrors what has happened in the past, and that a GSR of 80:1 or thereabouts represents a very expensive level for gold relative to silver, then it is likely that silver will outperform gold in the coming years, with the GSR falling as that occurs.
 
Given silver often outperforms gold in environments where the price of both metals is rising, this is a sign that the entire sector could prove quite profitable next year, and indeed for the several years to come.
 
To help picture what kinds of gains may be possible in the period ahead, we’ve created the following tables, which looks at the past two times the GSR pushed up toward the 80:1 level, back in the 2003 and again back in late 2008, as well as what happened to the price, and the returns for both precious metals in the subsequent years.

Note that all the price gains are relative to the original date, so for example, the 79.35% price gain for gold that you can see for 31/05/2007 represents a 4 year return, comparing the USD gold price of $659.10 per ounce on that date to the USD gold price of $361.40 per ounce, which is where the gold price was trading at on January the 31st of 2003. Note that back in May 2003 the GSR was nearly 78:1.

Subsequent Gold and Silver Prices Returns when GSR nears 80:1

The above table should encourage any precious metal investor, for it suggests the next year should see rising prices, whilst the entire period between now and the end of 2020 could well be highly profitable.
 
The last two times the GSR was as stretched as it is now, it marked a great buying opportunity, with gold prices rising by 7% in the 1 year ending May 2004 and 44% in the 1 year ending November 2009. Silver fared even better, rising by 25% in the 1 year ended May 2004, and an amazing 76% in the year ended November 2009.

Of course one can’t be entirely sure that the kind of market history we can see above will repeat, but it certainly does have a habit of rhyming. Therefore, if the next few years for the precious metal market look anything like previous periods have when the GSR has been sitting near 80:1, then it promises to be very profitable for gold, and especially silver investors.
 
Given the price history from the kind of environment we are currently in, it is not at all unreasonable to expect to see the USD gold price push back toward USD $1,475oz in 2017, whilst silver could easily push through USD $25oz.
 
Those would be wonderful returns, and would likely exceed the kind of returns on offer in traditional assets, which face a number of economic and political headwinds, not to mention their expensive starting point from a valuation perspective.
 
The situation could be even more rewarding for local investors, given the pressure on local interest rates and the Australian dollar, which we discuss in detail below.

Australia – Cash Rate Will Keep Falling!
 
Yesterday, Australia got a long overdue official wake up call, with the nation’s GDP declining by 0.5% in the September quarter. Whilst the number will almost certainly bounce back in the next quarter, and we are in no real danger of falling into an ‘official recession’ any time soon, the shocking headline figure should leave you in no doubt as to just how soft the Australian economy really is right now.
 
Indeed of the major contributors to GDP (government and household consumption, private and public investment, and net exports), only household consumption was a positive contributor for this quarter, as the chart below, sourced from an article in the Guardian, which you can access here, highlights.

What is truly astonishing in light of the weakness we are seeing across the economy right now is how ‘hawkish’ the market is regarding interest rates, with many commentators still clinging to the belief that the RBA is done cutting, and that the current cash rate of 1.50% represents the low for the cycle.
 
Indeed the ASX cash futures market (see image below), is not currently expecting any further rate cuts next year, and actually sees higher rates on the horizon, though not til 2018 it must be said. 

We think the market is as wrong now as it was a few years ago, when a market survey in late 2014 (carried out by Bloomberg from memory) found that 23 out of 23 economists thought 2.5% would be the low in the RBA cash rate.  
 
Rates have of course been cut a further four times since, and in our opinion, they have a lot lower to go. For despite their fear of stoking a property bubble on the East Coast, the RBA will end up being forced to cut.
 
After all, the Australian consumer is extremely leveraged, with record private debt levels. They also have little in the way of free cash flow (the household savings rate, which includes compulsory superannuation, is just 8% now, down from close to 10% in 2013), and faced with higher levels of underemployment and record low wage growth.
 
Australian businesses are also reluctant to invest, with further unwinds in mining capital investment to come, whilst we’ll also have to reckon with the pending closure of the car industry.
 
Finally, we have also likely the seen the peak for home building construction, which had been a major boost to the economy and to employment for the last few years.
 
Net exports will probably hold up, though the team at Capital Economics are not so sure, arguing that Australia may actually already be in a recession. Even if the volume (which is what counts for GDP) of exports performs reasonably in the years ahead, at the very least we expect the freakish rise in iron ore and coal prices that has taken place this year will at the very least run out of steam, if not completely turn around next year.
 
Those price rises in key commodity exports delivered a boost to nominal GDP this year, but one would need to be incredibly optimistic to expect the gains to continue, with out terms of trade, whilst well below the peak levels reached in 2011, still incredibly high by historical standards (see chart below).

This in turn will have negative implications for a Federal budget already creaking under the strain of lower than expected tax receipts, with the AAA rating almost certainly under further threat in 2017. 
 
If we don’t lose it, at the very least you can expect to hear a lot of warnings that it’s only a matter of time, whilst the already unbearable levels of political gridlock and the focus on trivial issues (think backpacker tax) that we see from Canberra will likely worsen if get any closer to a ratings downgrade or a formal recession.
 
Indeed, whilst it is easy to make far too much out of any one headline GDP reading, we think what we saw released yesterday merely revealed a long growing trend of domestic economic weakness.
 
For evidence of this long growing slowdown, consider the chart below, which was carried in a Business Insider article and produced by Dr Andrew Charlton, founder of economics consultancy, AlphaBeta.
 
The chart shows reported GDP figures for the last three or so years in the dark line, and what AlphaBeta called “Adjusted GDP growth”, which strips out anomalies, including a huge public spending boost in the June quarter, to give a truer picture of what’s happening in the economy.   

As you can see, “Adjusted GDP growth” has been declining for well over a year. Record low wages and the lack of growth in full time employment opportunities that we are seeing right now make a lot more sense if we look at the economy through this kind of lens.
 
You can find the article that the above chart comes from here.

Indeed, were it not for the property construction (and price boom) in much of Sydney and Melbourne, we have no doubt rates would already be much lower in Australia, something that the folks at SGS Economics and Planning would no doubt agree with.
 
They conducted an interesting study recently, which looked at all the major cities, territories and regions in the country, and tried to estimate what an appropriate cash rate for each area would be.
 
Not surprisingly, they found that the appropriate cash rate for Sydney (3.75%) was much higher than the official 1.50% cash rate, with the appropriate rate for Melbourne (2.25%) and the Northern Territory (3.50%), also above the current setting dictated to the nation by the RBA.
 
The chart below highlights where the team at SGS think rates would be set in various parts of the country, including Adelaide, Brisbane, Tasmania and Western Australia.

As you can see, according to SGS, US/UK style interest rates of less than 1% are appropriate for large parts of the country, with regional areas in every state needing rates as low as 0.25%.
 
Considering the likely peak in housing construction on the East Coast, and a potential plateauing (not crash) in property values in Melbourne and Sydney, we think there is a much greater chance that the ‘appropriate’ cash rate in these cities will decline to the levels already deemed necessary in other parts of the country that are seeing a faster pace of economic deterioration.
 
Certainly we see little reason to think that the economy in WA, SA or Queensland is set to pick up steam any time soon, which would allow for higher appropriate cash rates, especially with mortgage arrears across the country some 25% higher than they were a year ago, with these three states (WA/SA/Qld), the most severely affected, according to a study by S&P.
 
With that in mind, we are quite comfortable repeating our forecast of a comfortably sub 1% cash rate in Australia in 2017. Should this transpire, it is something that will no doubt lead to even higher levels of physical gold demand from risk conscious investors, especially if it coincides with a further decline in the Australian dollar.

Final Thoughts and Chart of the Year
 
Every week we look at hundreds of interesting charts, and articles which attempt to explain what is going on with financial markets and in investment markets. There have been some terrific ones and research notes that I’ve come across, but no one chart resonated quite as well as the one below did.
 
It came courtesy of Bank of America Merrill Lynch, and measures the record disparity that currently exists between financial assets (stock and bonds), and real assets (commodities, etc.), with the latter currently at all-time lows relative to the former.

Ultimately, no one can be sure what will happen to precious metals, or to bonds, or stocks, or property, or even cash, in 2017 and in the years ahead. But investing is about tilting the odds in your favour wherever possible.
 
Given that, even if one were not convinced that the economic, monetary and political headwinds that the world will face in the years ahead were reason enough to own assets that are entirely devoid of credit risk as physical gold and silver are, then the above illustration of relative value should be all the encouragement one needs to act today.
 
After all, physical gold and silver are the simplest and most liquid real assets that any investor can put into their portfolio. Given real assets have never been cheaper relative to financial assets, this makes the asset allocation decision to incorporate physical precious metals into a portfolio a no brainer for truly risk conscious investors.  
 
With that, it’s time to wrap up this update, thank all of you who’ve read them across the course of the year and provided such valuable feedback, and for me to wish you and your loved ones a very Merry Christmas period and prosperous 2017.

Until next year,
Jordan Eliseo

Disclaimer
This publication is for educational purposes only and should not be considered either general or personal advice. It does not consider any particular person’s investment objectives, financial situation or needs. Accordingly, no recommendation (expressed or implied) or other information contained in this report should be acted upon without the appropriateness of that information having regard to those factors. You should assess whether or not the information contained herein is appropriate to your individual financial circumstances and goals before making an investment decision, or seek the help the of a licensed financial adviser. Performance is historical, performance may vary, and past performance is not necessarily indicative of future performance. Any prices, quotes, or statistics included have been obtained from sources deemed to be reliable, but we do not guarantee their accuracy or completeness.