Pivot to gold coming?

Dear Investor,

• Gold prices continued to fall this week, down 1%, with the precious metal again testing support near USD $1620 per troy ounce (oz).

• Silver also fell, down 3%, currently trading back below USD $19oz, while the gold to silver ratio (GSR) has climbed to 87 over the past give trading days.

• The continued pullback was part of a broader sell off in commodities, with oil off 5% for the week.

• Equity markets have stabilised, with the S&P 500 basically flat, while crypto remains under pressure, with Bitcoin still unable to get back above USD $20,000.

• The bond market has again seen heightened volatility, with US 10-year bonds falling 5% over the past five trading days, with yields now comfortably sitting above 4%.

How much lower for gold?

Gold prices have continued to fall in the past week, with the precious metal looking like it may test the USD $1600oz level at a minimum in this corrective cycle. Since the intra-year high hit in early March this year, gold has largely been in free-fall, and has now fallen by almost exactly 20% in USD terms.

This week’s price fall was largely yield related, with US 10-year bonds rising by 0.27% in the past five trading days, while real yields were also up another 0.10%, as the opportunity cost of holding the precious metal continues to climb.

Given the price action, the outflows being seen in the gold ETF space, and the still negative net short position in the managed money gold futures market, it’s no surprise that sentiment toward the precious metal remains depressed.

Evidence of that was seen in a Wall Street Journal article published on October 18. Titled “Only the Fed Can Return Gold’s Lost Luster”, it noted that gold had entered the year looking like a winning investment, especially after the war between Russia and Ukraine started. That’s obviously not how things have turned out, with market participants ignoring record levels of inflation and pushing the gold price lower in the last seven months.

In the short-term, it’s easy to understand why many market participants expect gold to continue falling. There are signs headline inflation rates are easing, while the Fed is expected to continue hiking policy rates, with these factors combined suggesting real yields should continue to rise.

The US dollar (USD), which this week climbed above 150 versus the Japanese Yen (a high that dates back to August 1990), and is now up 30% for the year vs the Japanese currency, continues to surge, noting the USD is also at multi-decade highs relative to the Euro and Pound Sterling.

Given that backdrop, “why would you be bullish or buy gold?” seems to be the question many in the market are asking.

We think there are several potential answers as to why gold may soon bottom

• All the above bearish factors are known knowns. They represent consensus opinion. To some extent, they are already priced by markets

• Inflation may not fall as fast as the market expects

• Several indicators suggest the entire precious metal complex (which includes silver and precious metal mining companies) looks cheap, which we’ll explore in more detail below

• A pivot from the US Federal Reserve, where they become more dovish with their monetary policy, is likely to be far more bullish for gold than it is for stocks.

We’d also note forecasts from the latest annual London Bullion Market Association (LBMA) precious metal conference, which was held this week in Lisbon. Delegates predicted gold prices would rise to USD $1830.50oz a year from now. Should that come to fruition, it would represent a price gain of 12% from current levels.

What if inflation doesn’t fall?

Despite the surge in headline inflation rates to multi-decade highs that we have seen across the developed world in 2022, investors by and large remain unconcerned about long-term price pressures, with market expectations about future inflation rates actually falling this year.

Indeed, both 5-year and 10-year breakeven inflation rates (what markets expect inflation to average over the next 5 and 10 years respectively) are currently sitting at close to 2.40%. That is a level that most policymakers would be comfortable with. It is also almost 6% below current headline inflation rates in the United States, which were sitting at 8.2% at the end of September.

While there seems little doubt headline inflation rates will fall in the next year, what happens if they don’t fall as much as the market expects, and instead settle into a range closer to 5% per annum?

This is exactly what market strategist and historian Russell Napier, who was a firm deflationist for decades, expects to happen going forward. In a long interview, Napier spoke of a return to capital investment on a massive scale, and that inflation, which is now being driven by structural, not cyclical forces, is likely to settle at somewhere between 4% and 6% per annum.
He also shared a view that we may be set for 15-20 years of financial repression.

From an investment perspective, Napier pointed out that bonds were set to suffer, while only select parts of the equity market may prosper.

Most importantly, he noted that gold “will do well once people realise that inflation won’t come down to pre-2020 levels but will settle between 4 and 6%. The disappointing performance of gold this year is somewhat clouded by the strong dollar. In yen, euro or sterling, gold has done pretty well already.

Gold equities suggest market may soon turn

While they have a different risk and return profile, there can be no doubt there is a link between the share price of gold mining companies, and the gold price itself. Given their higher risk nature, gold equities often outperform during gold bull markets, and then typically underperform during gold bear markets.

The chart below, which comes from a recently published Van Eck article on gold and gold equities, is a ratio of the share price of gold mining companies divided by the USD spot price of gold, with gold mining companies proxied by the NYSE ARCA Gold Miners Index.

If the ratio is falling, it means gold prices are outperforming gold mining equities, and vice-versa.

Clearly, since late 2020, gold, even though its fallen circa 20% in USD terms, has been outperforming gold mining equities, with the ratio falling from almost 0.9x to almost 0.6x in the last two years.

Indeed, the ratio is now approaching levels seen back in late 2015 and early 2016, when the USD gold price was bottoming out at close to USD $1050oz in a complete market capitulation that marked the end of that precious metal bear cycle.

The gold price has risen by more than 50% in the time since.

Careful what you wish for

Given the sharp sell off in almost every asset class that we have seen in 2022, and the slowdown in economic growth, many are expecting the US Federal Reserve (the Fed) to soon pivot, switching from very aggressive rate hikes to keeping rates on hold, or indeed even beginning to cut them.

The expectation that we will soon see a pivot is one factor encouraging investors to keep allocating more money to equities (despite dire sentiment readings, investors are still buying them). These investors believe that a stabilisation in, or the lowering of interest rates will help the stock market find its feet.

History suggests investors should be careful what they wish for, with the US equity market seeing average market falls of almost 30% between the time the Fed does pivot to dovish policy, and the time the market itself bottoms.

The biggest loss in a period the Fed was cutting rates was over 50%, which was when the GFC hit between 2007 and 2009, while time wise, the average length between the Fed pivoting and the market bottoming is 14 months.

Gold stands to do far better when and if we see the Fed pivot, as the table below highlights.

The precious metal has outperformed stocks in all but one of the above time periods (when they both fell by similar amounts) and has generated average returns of 16% from the time the Fed does pivot to the time the stock market stops falling. On a relative basis, gold’s outperformance has been an impressive 44% in these environments.

Historical observations obviously can’t guarantee future performance.

Nevertheless, many precious metal investors will likely be encouraged by data like this, which suggests that not only may we getting close to end of the recent pullback in both gold and silver, but that it may soon begin to outperform other assets going forward.

Inside the office this week

As we lead up to Diwali this weekend, ABC Bullion has seen a huge rush for our limited collectable range, including the 5g ABC Bullion Diwali Minted and the 1oz ABC Bullion Diwali Silver Coin. In addition, the new 2023 1oz Silver Britannia Coin is also flying off the shelves.

Warm regards,

The ABC Bullion Team

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