Markets bounce as inflation comes in hot

In this week's market update:

• Gold prices have fallen back below USD $1,700 per troy ounce (oz) this week, as markets reassess the outlook for monetary policy in the United States

• Silver has also pulled back, falling by 8%, and is again trading below USD $19oz, with the gold to silver ratio (GSR) rising from 83 to 88 over the past five trading days

• Equities have again been hit, with the S&P 500 down 2%, and is now down almost 25% since the start of the year, though markets did again bounce hard overnight

• Commodity prices have also fallen, easing by 1%, though oil rose mildy, and is again threatening to push above USD $90 per barrel.

• US and Australian 10-year government bond yields have continued to rise, with both now trading near 4%, with long-term bond prices falling 3%

• Markets have been driven by stronger than expected employment, and higher than expected inflation data over the last week, with the Federal Reserve now almost certain to increase rates by at least 0.75% at their next policy meeting

Well, that was quick!

Markets have been in correction mode for most of this week, after stronger than expected jobs data out of the United States on Friday 7th October, which showed the unemployment rate dropping to 3.5% strengthened market expectations for a 0.75% interest rate by the US Federal Reserve when they meet next week.

The news, which sparked an intra-week rise in the value of the US dollar (the dollar index was  +2% earlier in the week) also led to a sell-off in risk assets, bringing to an end a short-lived rally that had seen equities surge by several percent in the week prior.

Despite a strong bounce overnight, US equities remain down 2% in the last five trading days, and almost 25% for the year so far.

The equity market correction, combined with a pullback in bonds that has seen some longer-term bond prices down 30% or more in the last year, now means that diversified portfolios are seeing their worst ever drawdown in 2022.

This can be seen in the chart below, which plots the return for 60/40 portfolios (i.e. portfolios made up of 60% equities and 40% bonds) over the first three quarter of the year.

Indeed, so poorly have markets performed, that 2022 represents the first year on record that both the S&P 500 and 10-year treasury bonds are both down more than 10% for the year.
These numbers are of course made all the more problematic by current inflation rates, which mean the ‘real’ loss suffered by investors is worse than the chart above indicates.

Speaking of inflation, data released overnight out of the United States showed that price pressures are showing no real sign of abating, with consumer prices rising by 8.2% in the year to end September, which was above market expectations.

While the headline rate has fallen from just over 9% per annum, which it hit in June, core inflation (i.e. less food and energy), as well as median and mean CPI figures all continue to rise on an annualised basis. They hit 6.6%, 7% and 7.3% per annum respectively in September, as per the table below.

Source: Cleveland Federal Reserve

My colleague Nicholas Frappell, Global Head of Institutional Markets at ABC Refinery discussed the outlook for monetary policy in the US in his latest Pod of Gold episode, where he touched on the Taylor Rule, why Fed policy was still ‘easy’ in many respects, and that there was no real reason to expect a Fed pivot anytime soon.

That analysis was vindicated by the overnight inflation results, which make it all but certain that the US Federal Reserve will hike interest rates by at least 0.75% at their next meeting, while there is some talk that they may go a full 1%.

Bond yields have also continued to rise, with US 10-year government bonds approaching 4% (Australian 10-year government actually exceeded 4% this week) while real yields on US 10-years are now up by 0.65% in the last month, and a staggering 2.59% in the last year.

Precious metals have not been immune to the turmoil in broader markets over the past five trading days. Gold is off 3%, though it is still holding above USD $1,650oz, while silver has fallen by 8%, paring most of last week’s rally that had seen the two metals briefly trade above USD $1,700 oz (gold), and USD $20 oz (silver).

Things you see at the top!

When the history books look back at the movements in financial markets that have taken place this year, 2022 is likely to be remembered as the year of the US dollar (USD).
Since the start of the year, the USD has soared, having risen by almost 20%, based on the performance of the dollar index (DXY).

It’s not hard to understand why the dollar has been so strong, or perhaps to be more accurate, why other major developed market competitor currencies, from Sterling, to Yen, to Euros, have been so weak.

Brent Johnson, whose twitter address is @SantiagoAuFund and whose profile states “You either believe in magic or you believe in math. If you believe in math, buy dollars and & gold”, neatly summed up the challenge facing these other currencies in a tweet earlier this week which stated: “JGBs haven't traded in a week...the ECB is buying bonds on the periphery and is inceasingly likely to buy Bunds...all while the BOE is still supporting gilts.”

Given this environment, it’s obvious there are tailwinds that could well see the DXY continue to rise. The thing is, it’s obvious to everyone, which makes one wonder if its already in the price, with magazine covers like the one that appeared below in Barrons on October 10 potentially a warning sign for dollar bulls, and a welcome sign for gold and silver bulls.

This is exactly the type of magazine cover you’d expect to see after

• An asset has rallied significantly (which the USD has)

• Everyone expects it to continue rally (as most do with the USD)

• There are many good reasons it should continue rallying (as there for the USD)

When the outlook for anything is as good as the outlook for the dollar is now, one shouldn’t be too surprised if something bad (as in a major fall in value) ends up happening instead.

Things you don’t see at the bottom!

While equity market investors have been burned in 2022, and sentiment is bearish, there has been little in the way of the kind of panic selling that you typically see toward the final stages of a proper bear market.

Indeed, quite the opposite, with data from Bank of America (BofA), courtesy of Firstlinks suggesting that:

Last week, during which the S&P 500 rallied 1.5% off recent lows, clients were big net buyers of US equities ($6.1B; third largest inflow in our data history since '08 and the fifth consecutive week of inflows)

The overnight surge in equities, with the S&P 500 ending the day up by more than 2.5% despite originally selling off when the higher than expected inflation print was released, reinforces the idea that investors have in no way lost their faith in the stock market.

This is not the type of behaviour one typically sees at a proper market bottom. It suggests that investors are either

• still happy to allocate to equities outright, perhaps because they see the current market correction as a buying opportunity, or

• still believers in a “Fed Put”, where the central bank will ease policy if asset prices fall too far

• still unwilling to switch money into bonds, despite higher yields, perhaps due to inflation risk and/or because of the capital losses being seen in fixed income markets this year.

While it’s understandable that investors may hold one or more of the above views, there is little doubt current equity allocations, and the fact investors are seemingly willing to throw money into stocks at the first sign of a bounce, leave the market in a fragile position going forward.

A catalyst for gold market outperformance

While investors were willing to chase equity markets higher in the rally last week, gold got no such love, with a chart produced using Bloomberg data highlighting that gold ETFs have now seen net outflows for 17 straight weeks.

It’s the longest period of outflows for these products in 4 years, with this part of the gold market last seeing such a profound lack of buying interest back in mid to late 2018.

Back then, gold prices were at one point trading below USD $1,200 oz, before going on a 2-year rally that saw the precious metal increase by more than 70%, culminating in the gold price peak seen in August 2020 at more than USD $2,050 oz.

Futures market activity also continues to speak to the depressed sentiment in parts of the gold market, with net positioning in early October still negative, something that typically occurs in periods the gold market is bottoming.

And while it remains to be seen whether we have seen the low during this precious metal pullback, there is a definite catalyst at hand in terms of gold’s outperformance relative to equity markets, which dates back a year.

This can be seen in the below chart, which comes from an excellent article titled; “Major Catalysts Await Gold”, with the chart showing movements in the S&P 500, in the USD gold price, and in the ratio between the two from the mid-1960s through to present day.

The chart has two dotted vertical lines that appear on it, one around the end of the 1960s, and another in the early 2000s.

Those vertical lines mark the only two previous occasions, outside of COVID, that the S&P 500 closed below its 40-week moving average, up until the end of September 2022, when it occurred again.

This has the potential to be highly relevant for both equity and precious metal investors, for as the chart makes clear, the two previous times this happened,

• Equities fell into a secular bear market

• Gold began a secular bull market

That should serve as encouragement for gold bulls. For while it has pulled back in USD terms in 2022, the precious metal is clearly getting the upper hand on a relative basis.

Going forward, should gold continue to outperform equities, like it has for the over the last month and year, it would not be unexpected for silver to benefit as well, with both precious metals capable of surging as we head into next year.

Warm regards,

The ABC Bullion Team

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