Pause game, not end game
Thoughts from Ani Markova, Vice-President & Portfolio Manager, AGF
Precious Metals Strategy
Following the U.S. election, the gold price has come under significant pressure, and recently broke the key
US$1,200/ounce support level. Ani Markova, Portfolio Manager, AGF Precious Metals Strategy, commenting on
gold’s recent performance says “the initial reaction was a flight to safety on uncertainty as to what a Trump
Presidency would mean for investors, but market sentiment shifted quickly on expectations that a Republican
sweep would bring corporate tax restructuring and support longer-term secular growth”.
Equity markets have rallied, buoyed by expectations that higher fiscal spending will drive growth. Government
bonds yields have also risen globally, alongside a rise in U.S. treasury yields on the back of prospects of a higher
term premium and higher inflationary expectations. As the market has quickly repriced expectations of U.S.
Federal Reserve (Fed) policy, the U.S. dollar has also strengthened. The key for gold has been that while inflation
expectations have risen (positive for gold), interest rate expectations have also risen, resulting in an increase in
real yields (real interest rates are the difference between nominal interest rates and inflation). This, coupled with
U.S. dollar strength has put pressure on the metal’s price, as investors are quickly selling their insurance and
chasing cyclical investments.
In our Investment Insight dated September 2016, we highlighted that there was a risk that expectations of a Fed
rate hike in December could cause investors to become net sellers. This is what has unfolded in recent weeks,
with investors pulling capital out of the gold Exchange Traded Funds (ETFs) and selling speculative positions on
the Commodity Exchange (COMEX) to channel monies back to U.S. equity markets on exuberance of U.S.
growth prospects.
Figure 1. ETFs and COMEX Speculative Positions
Figure 1. ETFs and COMEX Speculative Positions
40
70
35
65
Million ounces
30
60
25
20
55
15
50
10
45
5
0
Jan-2015
40
Jul-2015
Jan-2016
Net Speculative
Source: BMO Capital Markets, November 2016
Jul-2016
ETF
TWO STEPS FORWARD, ONE STEP BACK
While in the near term the gold price could remain under pressure, we expect that in the medium term, gold will
resume its uptrend for a number of reasons: 1) increased expectations of inflation driving down real rates; 2)
geopolitical uncertainty; and 3) a weaker U.S. dollar as a result of trade protectionism and debt deficits. Further, in
the current sell-off, investors have largely ignored the role that gold plays in the portfolio as insurance against
inflation and currency moves. Therefore any rotation back into the sector would be positive for investors.
INFLATION – WILL IT RUN AHEAD OF RATES?
We all wonder why we have not seen massive inflation on the back of ultra-easy monetary policies implemented
by central banks since 2008. About US$11 trillion has been printed by G4 central banks over the last eight years,
yet inflation levels today remain tepid. This is because most of that liquidity found its way onto balance sheets of
large financial institutions and into the capital markets. Banks were not lending and corporations were not
spending on capital investments, but were instead deploying cash to share buybacks and acquisitions. Consumer
deleveraging also resulted in less demand for credit. All these factors contributed to low velocity of money1. But is
this going to change? We believe so. After many years of declines, the money multiplier is finally starting to
rebound (Figure 2). With the money multiplier increasing in recent months, credit growth is accelerating and
bank’s deposit balances with the Fed (Figure 3) are starting to decline.
Figure 2.2.
M1M1
Money
Multiplier
Figure
Money
Multiplier
3. Bank
U.S. Bank
Deposits with
U.S.Federal
Federal Reserve
Figure Figure
3. U.S.
Deposits
withthe
U.S.
Reserve
$3,000
1.00
$2,800
0.95
$2,600
0.90
$2,400
0.85
$2,200
$2,000
0.80
$1,800
0.75
$1,600
0.70
0.65
2012-Jan
$1,400
2013-Jan
2014-Jan
2015-Jan
2016-Jan
$1,200
Jan-2012
Jan-2013
Jan-2014
Jan-2015
Jan-2016
Source: Federal Reserve Bank of St. Louis
U.S. President-elect Donald Trump has also promised US$1 trillion in fiscal spending over the next 10 years. If
implemented, this would be inflationary. The right fiscal policy would also increase business confidence and help
to accelerate spending. Further, as oil prices stabilize we will start to see a year over year positive change in the
energy components of the Consumer Price Index (CPI). As Figure 3 highlights, an oil price of US$50 per barrel
would drive the headline Consumer Price Index (CPI) number to close to 3%. However, we may not see the
impact of the year-over-year rise in oil prices until 2017.
Velocity of money is the rate at which money is exchanged from one transaction to another and how much a unit of currency is used in a
given period of time. Velocity measures how much money in circulation is used for purchasing goods and services and helps investors
gauge how robust the economy is, and is a key input in an economy’s inflation.
1
2
Figure 4. Annual change in headline CPI for various oil price scenarios
Source: Bureau of Labor Statistics (BLS), Federal Reserve St. Louis, Bawerk.net, Incremental AG, June 28th, 2016
Wage inflation is already emerging in the U.S. with average hourly earnings growing at above 2.6%. Additionally,
import prices are moving firmer and could continue to move yet higher were Trump to implement protectionist
measures (trade barriers would increase the price of imports and thereby contribute to inflation). There is also the
matter of China, which was previously thought to be exporting deflationary trends, but has now seen its producer
price index turn positive for the first time in 54 months. Unless Chinese exporters get help from a weakening
currency, they would need to pass on their costs to the end customers in order to protect their margins. That
means that the “Made in China” goods should become more expensive over time and contribute to inflationary
trends.
Figure 5. Import Prices Imply Upside To Inflation
Figure 6. Wage Inflation Setting In
Source: Haver Analytics, Renaissance Macro Research, November 16, 2016.
A key question is how aggressive the Fed will be in raising interest rates. Consensus is that the Fed will raise
rates in December, but the question is by how much and what will be the path of future rate increases. We
continue to believe that the Fed and Central Bankers from the major developed markets, will welcome an
environment where inflation is running ahead of nominal rates in order to avoid stifling economic momentum. This
is a scenario that gold has not priced in and represents an opportunity.
We also expect monetary policies to remain accommodative around the world. In the event that negative interest
rates do not drive the targeted economic growth expansion, there is increasingly talk of helicopter money, which is
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essentially fiscal policy financed by central banks. If implemented this would drive up inflation, with risks of central
banks overshooting on their inflation objective. In this regard, we are watching countries such as Japan, which is
targeting yield curve support at or above zero rates (essentially an unlimited bond-buying program). It is likely that
the European Central Bank will also modify its monetary policy away from negative rates, but given the state of
the European economies, it is very likely that it will continue to use quantitative easing through different forms.
Figure 7. Aggregate Balance Sheet of Central Banks Implementing QE (in U.S. dollars)
Figure
7. Aggregate Balance Sheet of Central Banks Implementing QE (in U.S. dollars)
Source: Ned Davis Research, September 30, 2016.
U.S. DOLLAR – WHERE DOES IT GO FROM HERE?
The U.S. dollar has historically been an important factor for the performance of gold and is therefore worth
addressing. While we believe the U.S. dollar in the near term is likely to be supported by prospects of higher U.S.
growth and higher U.S. rates, in the medium term, a strong U.S. dollar is a headwind for U.S. growth. Therefore,
achieving Trump’s objective of higher economic growth would require U.S. goods becoming more competitive
internationally, likely by way of a weaker U.S. dollar. Further, to the extent that the significant infrastructure spend
and corporate tax cuts are financed by debt, a higher deficit would put pressure on the U.S. dollar. This would be
positive for the gold trade. As we sit today, the U.S. Federal budget deficit is at about 3% of GDP. If Trump’s tax
plan is implemented, the deficit could more than double over a short period of time. And the question is, how
much debt are the Republicans willing to take on? Not to mention that negotiations on the debt ceiling are coming
in February 2017.
Figure 8.
the
Deficit
- U.S.
Deficit
as a share
GDPof GDP
Figure
8. Outlook
Outlookfor
for
the
Deficit
– U.S.
Deficit
as a of
share
Source: CBO, Tax Policy Center, and Cornerstone Macro, November 21, 2016.
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GEOPOLITICAL UNCERTAINTY REMAINS
On the night of the election, as the prospects of a Trump presidency increased, markets retreated and the gold
price increased to US$1,307/oz. However, this proved short-lived as markets quickly shifted to focus on the progrowth and reflationary nature of Trump’s policies. We believe the market is discounting the fact that there still
remains a great deal of uncertainty as to the policies that Trump will implement once in office. We also believe the
market may not be taking into account the risks associated with some of the proposed policies. For example,
Trump campaigned on an anti-trade platform, which has the risk of leading to geopolitical tension as well as
stagflation –high inflation but weak real GDP growth.
Further, the election of Donald Trump reflects the emergence of those dissatisfied with the current state of affairs.
There is a risk that it fuels further destabilization in Europe. Developments in Italy, Germany, France and
Netherlands, all that have upcoming referendums/elections could drive volatility and drive safe haven demand for
gold.
CONCLUSION
So what should investors do? Gold typically acts as hedge against systemic risks such as high inflation/deflation,
currency risk or geopolitical uncertainty and could therefore move higher as any of these risks get priced in. Even
if the Fed raises rates in December, it is the real interest rates that we will be watching – i.e. the level of inflation
that the market will start to discount. Geopolitical uncertainty and a weakening U.S. dollar could also contribute to
the metal’s strength.
It seems to us that the market is only pricing in the secular U.S. GDP growth and benefits of tax cuts/infrastructure
spending and this trade may last a few more months putting further pressure on the gold trade. We see downside
support levels in the US$1,100-$1,200/oz range. That said, uncertainty remains of the extent or timing of new
fiscal easing measures in the U.S. or their impact on global markets. We believe that once the market starts to
price in inflation, it is likely that we will continue to the upward move in the gold price to a new range of $1,4001,500/oz. Although the timing of the gold rally is uncertain, we continue to add on pullbacks to select gold
positions. We are defensive short-term.
For more information, visit AGF.com/Institutional.
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The commentaries contained herein are provided as a general source of information based on information available as of November
24, 2016 and should not be considered as personal investment advice or an offer or solicitation to buy and / or sell securities. Every
effort has been made to ensure accuracy in these commentaries at the time of publication, however accuracy cannot be guaranteed.
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Published Date: December 7, 2016
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