Gold suffered from rising trade war tensions and was shorted aggressively (highest short positions ever recorded!). ETF selling continued, but ended towards the end of the quarter. Unlike Q2, 2018 gold miners started to react to the falling gold price. The announcement that the largest asset manager in the world (Vanguard) was to change the mandate of its gold mining fund from 100% precious metals exposure to 25% precious metals exposure led to major capitulation selling. However, given the notoriously bad timing of these decisions by big entities, it can be considered as a very strong contrarian buy signal (the three largest asset managers in Switzerland announced the closing of their gold mining funds in January 2016, at the absolute bottom of this cycle). Q2 reports of gold miners were generally in line with expectations. Given the very low valuation (all time low based on price/cash flow, close to all time low based on P/B), operating and financial leverage, fairly stable costs and high industry discipline, we continue to consider gold equities to be in the sweet spot of the industry cycle. Therefore, they are expected to outperform physical gold significantly in a rising gold price environment.
The intensifying trade war led to widespread upheaval in the financial markets. CTAs, algorithmic trading systems went long on the US dollar and initiated huge short positions in treasuries, emerging market (Ema) currencies, base and precious metals. This led to a (likely unsustainable) situation that gold started to correlate more with Ema currencies than with US real rates (based on 10yr treasuries yields) and EUR/USD, which both have historically been a lot more important. While this hardly makes sense, we would point to a few facts regarding the situation in Emas. The recent weakness in Ema currencies led to a widespread belief that Emas could enter a similar crisis as they did in the late 1990s. We are struggling with that view for the following reasons: Most Emas have today freely fluctuating currencies, while most of them were pegged to the US dollar during previous crises. The FED policy has therefore today not the same impact as in the past (central banks in Emas don’t need to follow the FED policy anymore, as they had to in the past) and thanks to the depreciations, the Emas have become even more competitive recently. Current accounts look a lot better today in most cases than in the past, with 66% of Emas having a positive current account of at least 1%, while only 24.5% have a deficit of more than 1%. While commodities are still somewhat important (less than 15%, i.e. a lot less than in the past), the weight of Information Technology in the MSCI Ema is nearly double the weight of commodities today! To summarize, the current situation is very different from the past, based on much improved current accounts and lower dependency on commodities. In addition, most Emas do have a significantly better structural growth outlook than the US thanks to better demographics, lower debt and less consumer saturation.
Trade war: does the market action make sense?
After addressing the Emas, we suggest looking more closely at the expected real effects of a potential trade war. As can be seen in the chart below, the US manufacturers (40% of S&P 500 profits) have been the big winners of the globalization (tripling of margins since the globalization started in the early 1990’s).
Chart: NESTOR Gold Grafik 1
Bonds, real estate and consumers also benefited from the disinflationary effects of globalization. Net, net equities (higher margins, lower discount rates), bonds (lower inflation) and real estate (lower discount rates) have been the big winners of globalization. In a potential trade war, they are likely to lose relative attractiveness, while gold should actually be one of few winners. Gold would gain attractiveness not only as an alternative asset, but also due to lower real rates in a kind of stagflationary environment.
While we struggle to believe that Mr. Trump’s real attempt is a full blowout trade war (as this would sharply increase the cost of living of his voters), the reaction of gold and gold miners in the last few months is highly questionable and unlikely to be sustained.
Extreme positioning, lessons from the past
The COMEX reached in late August/early September the most extreme positioning seen in 17 years (net non-commercials), respectively the most extreme in history (net short managed money, total combined shorts of non-commercials), as can be seen below.
Chart: NESTOR Gold Grafik 2
Source: Bloomberg
In the past, similar positioning (late 2015, late 2001) has led to major rallies in gold, and given the potential triggers and the fact that August to February is seasonally the strongest period of gold, the recent trend change to rising gold prices should only be the start of a major upward movement.
Key trigger for a major upward movement
While often little is needed to create a major upward movement in such an extreme positioning as we witness currently (or as in 2016, when the fund tripled in 6½ months with little macro/market action), we would point to the most likely trigger in the next few months.
As the fear of further hike rates continues to be one of the key reasons why most investors have stayed away from gold (despite all the structural reasons to own gold/gold miners in a balanced portfolio), we expect that the FED will start to talk down further hiking expectations. It actually started in the minutes of early September, when the FED indicated increasing economic risks due to the trade war, Ema crisis, strong dollar and the big deceleration in the US housing market. Having underestimated the housing issues in 2007 (by continuing hiking rates) it is sensible to expect that the FED is addressing the recent weakness in the US housing sector with the necessary attentiveness. It is also interesting to know that previous Ema crises tended to be concurrent with the end of the FED tightening cycles! In last week’s statement, the FED eliminated the important word “accommodative” from its September statement, for the first time in many years. This is a signal that the FED considers the current interest rates as close to neutral. While they still guided for more hikes in December and 2019, it will be subject to the economic environment in the US, but also in the rest of the world.
But there will likely be more reasons for the FED to stop tightening the monetary policy as the benefit of the stimulus package starts to fade (base effect) while the best leading indicators for US industrial production (changes in oil price, interest rates and the US dollar) are posing serious headwind for the US economy. This development can already be witnessed in the US macro surprise index, which has fallen significantly in the last few months (chart below).
Citigroup Macrosurprise Index US (since 2016)
Chart: NESTOR Gold Grafik 3
Source: Bloomberg
Given all these challenges and the fact that neither inflation nor wage inflation seems to get out of control for the time being, we don’t see a reason why the FED shouldn’t start to change in the near term its language regarding future hike expectations.
Key questions to consider
The recent behaviour of gold and gold miners has been extremely frustrating and hard to explain, and has led to major investor capitulation. As a result, investors should ask the following questions:
- Are the structural problems in the industrialized world solved (over-aging, very high indebtedness, consumer saturation)?
- Is the US dollar - despite its massive twin deficit and record high debt - safer than gold?
- Is the threat of the US only a way to get an agreed massive dollar devaluation, as they did in 1971 (Nixon, end of Bretton Woods) and in 1985 (Reagan, Plaza Accord)? Trump has similar advisors as Reagan and he is following most policies of President Reagan.
- Haven’t we seen the similar macro and market environment before (later part of FED tightening, Ema crisis, technology overvaluation/bubble, long economic expansion, potential yield inversion)? Yes, at the end of the 1990s, and what happened afterwards?
- Could the recent massive inventory increase (Apple +89% yoy, Samsung +20%, Lenovo +30%, HP +20%) be a sign of deterioration in the IT sector, as was the case in 2000, when the then leading mobile phone producers (Nokia, Ericsson & Motorola) experienced an inventory build of around 50% since YE 1999? Could that be important given the love/hate affair between gold miners and Nasdaq since the 1970s?
Conclusion
We don’t see the ingredients for a broad-based Ema crisis, and we expect the speculators to cover their record high short positions, with positive implications for gold and even more pronounced for the gold miners. The combination of seasonal tailwind and increasing likelihood that the FED starts to prepare the market for the end of the tightening cycle is a perfect set-up for a major upward movement. Such a rally could easily break the multiyear resistance level at 1,370, which would open the door for much higher gold prices. The structural reasons to have a gold/gold miners allocation haven’t changed, but (unfortunately) gold mining investments became a lot cheaper.