In this week's market report:

• Following the Jackson Hole Symposium...

• Potential for a US Dollar correction

• Equity markets remain fragile

• Speculators have been betting on falling gold

• How about silver?

Dear Investor,

Spot Gold Price AUD [XAUAUD]

Source: Trading View
(Click to enlarge)

Following the Jackson Hole Symposium...

At last week’s Jackson Hole Symposium, Federal Reserve (Fed) Chair Jerome Powell took just 8 minutes to confirm that the Fed is unlikely to pare back the aggressive pace of interest rate hikes they’ve implemented in the last few months.

His opening remarks (captured below), set the tone.

The Federal Open Market Committee's (FOMC) overarching focus right now is to bring inflation back down to our 2 percent goal. Price stability is the responsibility of the Federal Reserve and serves as the bedrock of our economy. Without price stability, the economy does not work for anyone. In particular, without price stability, we will not achieve a sustained period of strong labour market conditions that benefit all. The burdens of high inflation fall heaviest on those who are least able to bear them_._

Powell was also explicit that the Fed would tolerate, and indeed expects a slowdown in economic activity, going on to note:

Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance. Reducing inflation is likely to require a sustained period of below-trend growth. Moreover, there will very likely be some softening of labour market conditions. While higher interest rates, slower growth, and softer labour market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.

Investors didn’t like it, with the speech setting the tone for a very soft week across asset markets. In the past five trading days, the S&P 500 has fallen by 5.50%, while the local ASX 200 has fallen by 3%. Bonds weren’t spared either, with 20-year Treasuries selling off by almost 2.5%, while a basket of high yield corporate bonds fared even worse, falling by almost 4%.

Precious metals have also been caught up in the market rout, with gold falling by 3% (USD terms) in the last five trading days, while silver is down 7% (USD terms). These declines, which in many ways are a continuation of the downtrend we’ve seen in precious metal prices since March 2022, saw the gold silver ratio (GSR) end August sitting at 96.

Year-to-date performance for the two precious metals in USD terms is now -7% (gold) and -23% (silver), with gold now trading below USD $1,700 per troy ounce (oz), while silver is back below USD $18 oz.

This correction also brings gold back to an important support, with the precious metal now almost exactly 20% below the all-time high it hit in August 2020.

Given this backdrop, it’s clear the precious metal complex faces headwinds, at least in the short-term, including

• The expectation of higher rates that have come through since Jackson Hole, alluded to above, with yields rising across the maturity spectrum in n the past week

• A still strong USD, which was up +0.6% in the last week, and +14% year to date

• Declining inflation expectations (the 10-year breakeven inflation rate, which measures what market participants expect inflation to be in the next 10 years, on average, fell below 2.50% by end August 2022. It was above 3% in April this year.

While these factors mean further downside shouldn’t come as a surprise, especially if we see a strong non-farm payroll report out of the United States, there are some signs we may be approaching an important turning point in the precious metal market.

These include:

1.    Potential for a US Dollar correction

As alluded to above, the USD has surged this year, with the Dollar Index (DXY) up by almost 15% in 2022. Compared to the Euro (EUR) and British Pound Sterling (GBP) it is trading at multi-decade highs, with EURUSD recently hitting parity.

While the DXY could push higher in the short-term, it is at risk of a serious pullback, especially if the energy situation across Europe and the UK (which is an unquestionable disaster, but likely a known disaster in terms of market pricing), improves even marginally.

If DXY were to weaken from here, it would likely support gold.

2.    Equity markets remain fragile

A proper bear market in stocks would typically be expected to have three components to it:

• A valuation reset, as investors no longer wish to pay an extreme price for a dollar of company sales or profits

• Earnings downgrades, as companies struggle to maintain their levels of profitability

• A psychology shift, as fear of missing out (FOMO) turns to fear

While markets are down this year (the S&P 500 is 17% YTD, while the local ASX 200 is -10% YTD), we’d argue only one of the above conditions is even close to being met. Valuations have declined, with the cyclically adjusted price earnings ratio (CAPE) now sitting at 30.

While that’s down from the high of 36 seen for the CAPE ratio seen in January this year, it’s still well above the long-term average (which is closer to 17), and way above levels seen at proper bear market bottoms, where the CAPE ratio has fallen below 10.

Earnings have also been resilient, as have operating margins, which are currently at their highest level in decades. However, as growth slows, and inflation eats into consumer discretionary spending capacity, we can expect margins to come under pressure, and downgrades on the earnings front start to come through.

As a guide to how big an issue this may become, consider that since the early 2000s, global stocks have seen earnings fall by an average of 27% in periods of major slowdown/crisis.
If anything like this occurs in the coming year or two, it will be a major headwind for shares.

Finally, despite investors saying they’re pessimistic, these been little in the way of the kind of mass selling you see in a market panic. Indeed, investor allocations to shares are still at/near the highest levels they’ve been in more than a decade, as the image below highlights:

Given this positioning, there remains substantial potential for equity market weakness. Should that eventuate, precious metals, especially gold, can be expected to find support.

3.    Speculators have been betting on falling gold – that is typically bullish

Given where sentiment is, it’s not a huge surprise that speculators have largely abandoned their bullish bets on the gold price. Indeed, by late July, speculators using the gold futures market were betting that gold prices would fall.

As per research from the World Gold Council (WGC) this is a rare event, having only happened five times since data measuring this positioning was introduced just over 15 years ago.
The chart below shows the net position in the gold futures market (long bets that gold prices will rise minus short bets that the gold price will fall) since 2006, as well as movements in the gold price over that time.

Source: ABC Bullion, LBMA, CFTC

As the chart highlights, it’s typically been a good time to buy (not sell) gold when there are more speculators betting the price will fall relative to those betting it will rise.
As the WGC state, “net shorts in gold futures have historically been associated with positive gold returns going forward. For example, on a three-month horizon, they have been positive 88% of the time, with this figure rising to 95% and 100% on a six month and 12-month forward basis, respectively”

How about silver?

Two years, gold was trading above USD $2,050oz, having rallied by some 70% in USD terms in the period between end Q3 2018 and end August 2020.

Sentiment at the time was also extremely bullish, which is unsurprising when one recalls the economic damage wrought by the pandemic and steps taken to limit its spread, uncertainty as to how long it would last (there were still no COVID vaccines) and the monetary and fiscal stimulus deployed showered on businesses, households, and investors in that period.

Today, the situation could not be more different, with sentiment toward precious metals far more depressed, while demand, at least from investors who use gold ETFs, has also receded, with the better part of 200 tonnes of gold flowing out of these products in the last five months.

The situation is particularly dire for silver, with the GSR back near 100, meaning you need almost 100 ounces of silver to afford one ounce of gold. Outside of a short spike in the GSR when COVID first hit, that is unprecedented, with silver almost never this cheap relative to gold.

The below chart, which highlights quarterly flows into silver ETFs (red line), as well as the silver price is also illustrative, as it shows silver investors, or at least those that prefer to use ETFs for their exposure, have largely abandoned the market.

As Callum Thomas of TopDown Charts noted in relation to silver (bold underline ours).

“In the past few months, we have seen a flood of outflows from silver ETFs, speculative futures positioning move slightly net-short from previous crowded longs, and sentiment collapse to the most bearish readings in recent history. We have seen what amounts to an outright capitulation by silver bulls. What’s also interesting is that silver now sits at a key technical support level. So, the question at this point is basically do you go with the bearish flow, or take the contrarian stance and be greedy while others are fearful on silver.”

That sums the situation up perfectly.

It can be hard to buy any asset (silver included), when it’s gone through the kind of correction it has recently, but from a sentiment and flow perspective, these are the perfect conditions for it, as well as gold, to find a meaningful bottom.

Inside our office this week...

This week we have seen a sharp increase in activity. In particular, there has been a surge in silver sales as clients take advantage of the dip in prices. Our best sellers have proven to be Pool Allocated Silver and ABC 1kg Silver Cast Bars, with investors continuing to accumulate precious metals.

Warm regards,

The ABC Bullion Team