Review
As of March 29th 2019, gold bullion closed at US$ 1,292.3/oz., an increase of 0.9%. The FTSE Gold Index gained 8.2% (in USD), while the NESTOR Gold Fund increased by 10.7% (USD). The outperformance is due to stock selection, as junior gold miners were slightly lagging the benchmark. Positive contributors were Eldorado, Alacer, Newmont (no position), Semafo, Hochschild, Doray, St. Barbara (no position), Alamos and Wheaton Precious Metals.
Gold increased thanks to weak economic data, which led to an end of future hiking expectations. Gold miners published Q4 reports which were generally in line with expectations. Production guidance for 2019 was somewhat below expectations, which should benefit the gold price during 2019. Given the low valuation, operating and financial leverage as well as continued industry discipline, we continue to consider gold equities to be in the sweet spot of the industry cycle and therefore they are expected to outperform physical gold significantly in a rising gold price environment.
Why is a soft landing a low probability outcome?
Let's start with a look back at interest hiking cycles and how often a soft landing was actually achieved. Having in mind that the financial industry has generally a (biased) optimistic view and has in the past never forecast a recession adds to the evidence of the following chart. The fact that, in the last 100 years, 19 interest hiking cycles were followed by 16 recessions or, to put it in other words, that in only 3 out of 19 cases a soft landing was accomplished, puts the probability to a mere 16% that the currently priced in scenario will be the real outcome.
Chart: NESTOR Gold Grafik 1
Sources: Federal Reserve St. Louis, Incrementum AG
Certainly not a very attractive probability, especially for the equity market, while the return/risk-ratio (by buying a small insurance policy, i.e. gold miners) looks very attractive. Given that gold miners are trading currently at record low valuations, that looks like a very cheap hedge.
While there are some arguments that the US economy might stabilize in the next few months at a very low growth rate, i.e. not immediately fall into recession, we aren't seeing any reason why it could reaccelerate afterwards! Since the crisis of 2008/09, close to 100% of the growth in the US economy was thanks to rising consumption. Given that, at the same time, the correlation between wealth effect and consumption has risen to 75 - 90%, it becomes clear how much the zero percent interest policy and the different rounds of quantitative easing have contributed to the (low) growth exhibited in the US and Europe. Without the boost of rising real estate and equity prices, the US and all other parts of the industrialized world would have been oscillating around zero growth for the past ten years, something most strategists, analysts and investors often forget these days.
Given that the FED tightening cycles have initiated close to all recessions in the last 100 years, the obvious question is: what level of interest will lead to the next recession? The following chart from Barry Bannister, strategist of Stifel Nicolaus, does give some interesting insight.
The upper chart shows Fed fund rates minus neutral Fed fund rates since 1987. But what is the meaning of “neutral rate”? Interested readers will find the details on the internet, but to explain it without too much detail, it calculates what level of Fed fund rate is neutral to the economy, i.e. not boosting, but also not slowing the economy. The wording and calculation of “neutral rates” was created by two former FED governors (Williams & Laubach, 2003).
Chart: NESTOR Gold Grafik 2
The above charts reveal two important points:
- The upper chart shows that the trend (red dotted line) of the Fed Fund Rate minus the neutral rate has constantly been falling over the last 32 years. This shows that the US economy is less and less able to cope with rates above the neutral rate (most likely due to steadily increasing indebtedness and the worsening demographic situation).
- The second chart, which shows the movement around the (declining) 30-year trend line, reveals that the Fed funds have already reached a level where the Fed is at the maximum tightening level and if it doesn't start to loosen the monetary policy, it will create the next recession!
The fact that the US economy is slowing back to very low levels is unsatisfactory to Mr. Trump, as it is lowering his re-election chances. Given that the Democrats (who control the house) want to do everything to avoid a re-election of Mr. Trump, any big stimulus is very unlikely.
This explains Mr. Trump’s recent proposal to put Stephen Moore into the Fed instead of the candidate favored by the Fed chair, Mr. Powell. Mr. Moore has been highly critical of the Federal Reserve and is favoring a much looser interest policy, i.e. much more negative interest rates (positive for gold). If Mr. Moore joins the Fed (to be seen in the near term), the extremely dovish advocates of Mr. Trump would have the majority in the Fed. This, together with the economic slowdown and the need to stimulate the economy into 2020 (election year), will speed up the turn to significant interest cuts, which in the past have led to spectacular returns of our funds, as can be seen below.
By reading recent comments of the current Fed members, it becomes clear that the Fed will implement negative interest rates at the next major economic slowdown. This will likely result in even more negative real rates than have ever been seen in the last 35 years, which should lead to new all-time highs in gold and gold miners.
Chart: NESTOR Gold Grafik 3
Sources: Bloomberg, Konwave AG
Given the uncertain timing of the turn to falling Fed fund rates, it is worth taking a look at the positioning data of speculative money, i.e. managed money, at the Comex. Having failed so many times at the critical resistance range (1'350 - 1'370), we get the push back from interested, but not (yet) invested, investors to wait for the breakout, before committing capital to gold miners. While this behavior is understandable given the many failed trials in the last 6 years to break this key resistance, it might however not work as planned. A client reminded us recently how the key support level at 1'530 was broken in 2013 (after gold rebounded between 2011 - 2013 many times from that key support). Within two days gold fell by USD 190 (!!!), which triggered a much bigger fall in gold miners. Something similar would definitely not surprise us on the way up as well, i.e. a jump to USD 1'500 within a few days (maybe hours), while our funds could leap up by 30 - 50%. This seems not unrealistic in such a scenario given the focus on this multiyear resistance.
During the last few years, the Comex positioning was often stretched, when gold came close to the key resistance. In 2018, however, the situation looked much more promising, which gave us conviction that we are finally ready to break out. The hard to understand and hard to explain gold price reaction on the trade war tensions and the fact that the Fed was able to implement more interest rate hikes than priced in by the market (thanks to the better economy, which benefitted strongly from the fiscal stimulus package) were too much headwind for gold. While our outlook was wrong a year ago, we notice that the key headwinds of 2018 are gone (trade war de-escalation and no more Fed hikes, i.e. also no more support for the US dollar), which makes it much more likely that 2019 will be different and the patience of gold mining investors is finally rewarded handsomely.
Conclusion
After many years of disappointment the likelihood that we will start a major gold bull market is strongly increasing. The headwind of increasing Fed fund rates is most likely over and the classic economic and monetary cycles are the basis for a breakout through the multiyear resistance zone.
While many peers have been exiting from the junior/developer segment in the last few months, we are sticking to our long-term strategy. Given the record high valuation discount of these segments, we are convinced that our strategy will pay out and therefore expect that the fund will beat comparable active and passive products significantly, as it has done in previous bull markets.