While most economists, and especially the FED - who has a track record of being behind the curve - don’t see that major slowdown yet, the equity and bond market are pointing more and more to either a recession or a significant slowdown in 2019.
The following quarterly report addresses the Q4, 2018 and goes into details why consensus is underestimating the speed of the likely deceleration in the US economy and how important that and the resulting policy change from the FED is likely to be for gold and gold miners.
Review
As of December 31, 2018, gold bullion closed at US$ 1,282.45/oz., an increase of 7.5% QoQ. For the year 2018, gold decreased by 1.6% in USD. The FTSE Gold Index increased by 15.7% during Q4, 2018 (EUR). NESTOR Gold Fund decreased 0.7% in Q4, 2018. The underperformance is due to the fact that value and small caps lagged significantly. This happened as well in the early stage of the last two major bull markets (late 2000/early 2001 and late 2008), when the funds managed by Konwave AG lagged by 20-30% in the first few months, before significantly outperforming the benchmark and peers afterwards. Once it becomes clear that the action since the gold bottom in August and the bottom of large cap gold miners in September is the start of a genuine new gold bull market, we expect the small caps to significantly outperform the larger names again, as happened in the past (mid 2001 to 2007 and 2009-2010). In December, we have seen first signs of a turnaround to value and small cap names within the sector, which is positive. Also the end of the “tax-loss-selling” season is encouraging.
The gold market was developing positively in Q4/2018. Season strength (wedding season in India and start of buying for “Chinese New Year”), short covering at the COMEX and consistent inflows in gold ETF were supportive factors for the gold price.
While the earnings results were in line, the increased M&A action points to the major problem the bigger gold mining companies have. For many years, mine lives have been decreasing and given the weak gold prices in the last five years, the necessary replacement of gold reserves and resources will lead to more M&A activity in the future. The fund is well positioned for that, as it owns many attractively priced acquisition targets. The continued industry discipline combined with just slightly increasing costs should lead to a substantial leverage of gold miners relative to physical gold, once the gold price starts its next big upward movement.
Why the significant economic slowdown will probably happen in 2019 (and not in 2020/21, as consensus expects)
The consensus view is that the US and global economy will slow a bit in 2019 with a further deceleration into 2020/21. We struggle with that view, because the headwind for the economy is showing up in the next few months, while the outlook for the US/global economy in 2020/21 will depend on policy action, the US dollar, interest rates and oil price developments in 2019, i.e. it is far too early to make any assumptions given that the developments of these key economic factors aren’t known yet.
However, the shorter term outlook points to a much more significant slowdown than anticipated by the FED and consensus. But what makes us confident in that view?
1. Independent, proven models from highly regarded sources (Alpine Macro and Ned Davis):
Chart: NESTOR Gold Grafik 1
Sources: Alpine Macro, Ned Davis Research
The Growth Tax model (chart left) created by Chen Zhao, ex BCA strategist, shows that the “growth tax” (combination of the dollar, oil price and interest rates) can predict ISM manufacturing much more reliably than traditional economic forecast models. That model points to a major slowdown from 60 (high growth) to below 50 (recessionary trends in manufacturing) in the next 12 months. Also the Ned Davis “Global Recession Probability Model” (chart right) has a close to 50-year track record and currently shows an 80% probability of a major global slowdown.
2. Growth slowdown due to restrictive monetary policy (net “quantitative tightening” on a global level).
Wealth and consumption Coincident and lagged correlation1 1972 through Q3/2018
Chart: NESTOR Gold Grafik 2
While many market participants do neglect the effectiveness of the QE programs in the last 10 years, the fact that wealth effect and consumer spending have had a 75-90% correlation (!) since the financial crisis in 2008 shows clearly another picture. The recent equity market correction and the end of house price increases (due to higher financing costs) don’t bode well for consumer spending in H1, 2019.
3. Elimination of very positive growth contribution from fiscal stimulus to fade in the next 6 months due to the base effect. After a strong initial effect during the first half of 2018, capex growth is already slowing down significantly!
4. Inventory draw to have a major negative effect in early 2019:
Chart: NESTOR Gold Grafik 3
While investments contributed at first glance very positively to the growth during the 3rd quarter, it was actually inventory build. The reason was “panic buying” ahead of the potential import tax rise to 25%. After the G20 summit in Buenos Aires, the mentioned target to eliminate the 10% import tax will lead to a significant reduction of inventories, as delaying purchases can result in reduced costs. This will probably impact economic growth in December and early 2019 very negatively.
Based on all these facts, of which points 2 to 4 aren’t even in the models of Alpine Macro and Ned Davis, we expect a major slowdown of economic activity in the US starting in December 2018/early 2019! What gives us confidence in that earlier than expected slowdown is the fact that the equity market (correction and outperformance of interest rate sensitive sectors) and the bond market (declining yields and increasing credit spreads) are confirming our view.
Why is this key to the FED policy and gold mines?
While the FED reduced the “neutral rate” in the last two months (from far away to we are there now!) and is now guiding for two (instead of three) interest hikes in 2019 - i.e. is getting more and more dovish – its speed to adjust to the expected economic slowdown is fairly slow, as it has been in the past, such as in 2000 and 2007/8. The market, however, has started to anticipate a change in FED policy. Gold/gold miners tend to be the first asset class in most economic and monetary cycles to bottom and diverge positively from other asset classes (gold miners bottomed in Nov. 2000, equity markets in March 2003; resp. gold miners bottomed in October 2008, equity markets in March 2009).
Based on our economic view, the FED did finish its hiking cycle in December 2018 and gold probably bottomed in Aug. 2018, large cap miners probably in Sept. 2018 and juniors/developers probably in Nov. 2018. Why this is so important for gold and gold miners is seen in the charts below:
Chart: NESTOR Gold Grafik 4
Sources: Bloomberg, Konwave AG
The start of the monetary easing cycles (end of 2000 and 2008) was the reason for the last two big bull markets in gold miners. But it is also true that over the past 60 years, gold equities have often bottomed almost immediately after the peak in the Fed Funds Rate (FFR). In 10 of 12 rate cut cycles, gold stocks bottomed a median of one month after the peak in the FFR.
Conclusion
While 2018 was a big disappointment for precious metals investors, the recent equity and bond market action points more and more to a significant economic slowdown and an expected monetary change by the FED. This could represent a similar buying opportunity as in late 2000 and autumn 2008. Gold probably bottomed in Aug. 2018, while large cap miners made the trough probably in Sept. 2018. Junior producers and developer probably bottomed in Nov. 2018.
As in late 2000/early 2001 and late 2008, the funds managed by Konwave AG did also lag quite heavily in the first few months of a bull market in gold. Once it becomes clear that the action since the gold bottom in August and the bottom of large cap gold miners in September is the start of a genuine new gold bull market, we expect the small caps to significantly outperform the larger names again, as happened in the past (mid 2001 to 2007 and 2009-2010). In December, we have seen the first signs of a turnaround to value and small cap names within the sector, which is positive. Also the end of the “tax-loss-selling” season is encouraging and usually there is a reverse “tax-loss-selling-trade”, which should benefit the performance of the NESTOR Gold Fund.