September Pullback in Gold as Markets and Dollar Rally

Precious metal prices eased in September, with the price of gold declining by nearly 2%, and silver easing by almost 4%. The month had started off strongly, with gold pushing up toward the USD $1,350oz level, but was unable to hold the gains, with continued strength in equity markets (which hit new all time highs), and a rally in USD contributing to the pullback we’ve seen over the last three weeks.

Markets have also largely faded the potential threat from tensions on the Korean peninsula over the last few weeks, as well as more or less ignoring (for now) the extraordinary developments in Catalonia, which looks set to push forward with a declaration of independence from Spain, irrespective of the Spanish governments determination to pretend the referendum never took place and/or can be ignored.

In Australian dollar terms, precious metal investors were slightly cushioned from the correction, with the AUD easing slightly to USD $0.7825 by end September, leading to a -0.80% decline for AUD gold, and a -2.85% decline for AUD silver.

The Gold:Silver ratio (GSR), which had fallen as low as 74.5:1 by early September, closed the month out back closer to 77:1, a level that would tend to indicate silver is cheap on a relative basis.

The potential for silver to outperform was recently addressed by Metals Focus, who expect the metal to outperform gold this quarter, and in 2018 as well. If that were to happen, it would suggest the entire precious metal complex (gold, silver, precious metals mining companies) is set to rally, as its rare for silver to outperform when the entire sector is declining.

Indeed this is the view of Metals Focus, who see a 2018 average gold price of USD $1,400oz, which would be a return of approximately 10% from current levels.

Continuing on with gold, and whilst the medium term outlook is solid, we may have some more volatility to deal with short term.

Jordan Roy-Bryne, an analyst well worth following, noted that the failure of gold to push higher after its early September rally suggests the entire sector is set to continue in its complex, multi-year bottoming out pattern.

Martin Armstrong was also largely expecting the recent correction, noting that gold had dropped away from their critical levels above USD $1,350oz, but that there is incredible support at USD $1,256oz and up to USD $1,269oz, basically where the metal is sitting now.

Whilst neither of these views sound hugely attractive for those looking to make a quick dollar, for longer-term buyers they should serve as encouragement to dollar cost average into the sector around these levels.

Looking at gold market dynamics, the last two weeks have seen significant long liquidation, with metals speculators reducing their bullish bets by over 40,000 contracts in the last fortnight.

Despite this reduction in speculative length, there is still room for more consolidation, as only 25% of the speculative bets that were added between July and early September have been unwound.

Developments in the ETF space have also been interesting for gold over the last month. Typically, ETF flows are highly correlated to the price itself, indicating a certain degree of ‘return chasing’ from ETF investors, who tend to have shorter-term time frames compared to buy and hold physical investors.

In September, this relationship broke down, with over 20 tonnes of gold flowing into ETFs around the world, despite the decline in price. You can see how unusual the last month was in terms of the relationship between price and ETF inflows/outflows on the chart below, which plots the two over the last several months.

Interestingly, according to data provided by the World Gold Council (WGC), North America was the region that dominated flows, with 36 tonnes flowing into ETFs. Europe and Asia saw outflows totalling close to 14 tonnes.

Cumulative flows since 2003 are seen in the excellent chart below, which also came from the WGC. It highlights clearly the perpetual inflows into gold ETFs from 2003 to 2012, the extraordinary divestment from seen in 2013, the gradual outflows seen in 2014 and 2015, and the substantial inflows seen again last year, as volatile equity markets, fears of Trump, Brexit and NIRP in Japan came to the fore.  

The bullish interpretation of this recent ETF phenomena is that the strong inflows, despite a declining price are evidence of a solid demand from US investors that has not been negatively impacted by the continued rally on Wall Street, and pick up in the USD.

The bearish interpretation of course is that this recent demand may not prove durable, especially if equities or the dollar continue to rally. This potentially sets the market up for imminent outflows, which would dampen if not contribute to further weakness in gold prices.

Only time will tell, but given the absence of physical buyers right now (its Golden week in China), a market that is starting to price in a Fed rate hike by year end, and a USD that has caught a recent bid, one can understand the caution in the market regarding the next move for gold.

From a personal perspective, we aren’t overly concerned, and think there will be considerable support around USD $1,270oz and especially just above USD $1,250oz, close to where the 200DMA sits.

Indeed given how oversold gold is currently looking, based on technical indicators like RSI and MACD (see chart below), a rally from current levels can’t be ruled out.

Debt Problems Everywhere

Since the onset of the GFC, there has been no shortage of warnings about the skyrocketing levels of government debt in the developed world, and the extraordinary monetary policy required to keep the financial system functioning. We’ve also seen plenty of commentary around the stretched nature of household balance sheets, something that is particularly relevant in Australia given household debt to income ratios are heading toward 200%.

This week, we came across a timely warning from the Bank for International Settlements (BIS) on the elevated levels of corporate debt, as well as the deterioration of corporate credit quality.
The report itself was published in the middle of September, and can be found here.

The charts below, which come from the BIS, illustrate the point.

Note that in the chart, GB refers to the UK, EA is the Euro Area, and US is the United States.

Chart 1 shows the share of covenant lite loans in the marketplace (which have risen substantially), as well as a covenant quality index, which has not surprisingly fallen. Jonathan Rochford, writing on Livewire Markets pointed out that; “Lenders are competing against each other by offering borrowers weaker covenants (which increases the probability and severity of defaults in the long term) as well as lower margins. Covenants have become so uncommon investors automatically assume that the borrower must have problems if their new loans include covenants.” Leverage ratios have also risen, which you can see in chart 2.

Charts 3 and 4 are just as, if not more interesting. Chart 3 shows the percentage of ‘zombie’ firms in each market, with a zombie firm defined as one that is more than 10 years old and whose earnings aren’t even enough to cover the interest bill on their loans.

The lowest interest rates in several millennia are helping keep these companies afloat, but one can’t have a huge amount of confidence in their future, as, absent piling on yet more debt, they have little to no ability to invest in their businesses.

The problem is worst in the US based on the data, though post GFC, its been in Europe and the UK where things have deteriorated fastest.
Finally we have chart 4, which shows that the percentage of companies with a credit rating of A has deteriorated significantly in all three regions between 2000 and 2017 (with no improvement since the GFC).

As per the BIS report, “the share of investment grade companies has decreased by 10 percentage points in the United States, 20 in the euro area and 30 in the United Kingdom from 2000 to 2017. The relative number of companies rated A or better has fallen especially sharply, while the share of worst-rated (C or lower) has increased.”

The implications of this are quite clear. Record high debt levels debt sits like a sword of Damocles above every sector of the economy today, including corporates. At best, it will limit future GDP growth, unless it is inflated away, a cure that is arguably worse than the disease.
For investors, this portends lower real returns in financial assets in the decade ahead, and reinforces the importance of owning physical precious metals as part of a well balanced investment portfolio.

Time for Diversifiers?
Dovetailing in with the above, PIMCO released a report on October 2nd titled “Diversifying Assets: Poised to Outperform”.

The report, which includes the excellent chart below, highlights why ‘diversifying assets’ might be poised to outperform more traditional assets in the years ahead, and notes the attractive yields and prices on the former vs. the expensive valuations and historically high earnings levels of the latter. For reference, traditional assets are represented by the S&P500 and a US aggregate bond index, whilst the diversifiers include TIPS, commodities, REITS, emerging market stocks, bonds and high yield debt.

When looking at the chart, anytime there is a blue line (above zero), it means diversifying assets outperformed traditional assets, and vice versa, with a gold line representing outperformance by the traditional assets.

As you can see, in the three years from 2013-2015 inclusive, traditional assets outperformed by a significant margin, predominantly due to the continued rally in the S&P500 which continues to rack up all time highs. Prior to that, between 2001 and 2012, we saw sustained and significant outperformance by the diversifiers, owing to the volatility on Wall Street which held back traditional asset returns, and the strong returns in commodities and the like.

The suggestion that diversifiers are set to outperform in the years ahead is highly relevant for gold investors, as gold’s periods of outperformance have tended to align with the timeframes that diversifiers do well. The period from 2001 and 2012 is the most obvious, though it also occurred in the late 70s as well, the timeframe of the last great bull market in gold.

You can read the full PIMCO report here.

What is going on in Australia?
As expected, the Reserve Bank of Australia did nothing at this weeks meeting, keeping the cash rate unchanged, at 1.50%. On balance, they’re appear relatively happy with the pick up in employment levels, and growth levels more generally, noting in their latest statement that, based on their read of the economy; “there have been more consistent signs that non-mining business investment is picking up.”

Undoubtedly their primary concerns remain elevated levels of household debt, the lack of wage growth in the economy, and a stubbornly high AUD, though we think the substantial decline in the savings rate over the last few years is one to look at too, further evidence of just how stretched households are today.

Those ‘bearish’ factors, despite being widely appreciated, don’t seem to be causing the market as a whole too much concern, with the overwhelming view of market participants suggesting that the next move by the RBA will be to the upside. Indeed markets are now pricing in almost 2 full rate hikes by 2019, as you can see in the chart below. 

Source: ASX

We will have to wait and see how this plays out, though more warnings of a slowdown in the housing market, and a suggestion by UBS that up to a third of interest only borrowers in Australia don’t realise that that is the type of loan they have taken out adds to the cautious/bearish case, which suggests rates will be on hold, or indeed may continue to be cut in the years to come.

Given this backdrop, it was no major surprise to see Dun and Bradstreet warn that retailers are expecting a difficult Christmas trading environment ahead. They will not have been encouraged by retail sales data released today, which showed a -0.6% decline, bringing year on year growth to just 2.1%.

One final sign that all is not well in Australia is the stockmarket, which has been completely left in the dust by the US equity market in the last several years. The chart below shows the performance of the ASX 200 in Australia compared to the S&P500 (purple line), over the past 8 years since the GFC “ended”.

The start of the chart is 2008.

Source: Macrobusiness

Now admittedly Australian companies pay out much higher dividends, which would narrow the differential. It is also true that the S&P500 has been boosted by historically abnormal levels of buyback activity, which has made earnings look better than they otherwise would be.

Nevertheless the fact remains that the Australian equity market remains a developed market laggard, quite extraordinary when one considers we are the only ones that skipped a recession.

From our perspective, we remain firmly of the view that we have not seen the lows in the local cash rate, and still fully expect to see a cash rate of 1% or lower in the coming months and years. This will take some time to play out, but over the next few years, this should help push the AUD lower in due course, supporting precious metal values for local investors.

Until next time.

Warm Regards,
Jordan Eliseo

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