Gold Is Ready For Pullback

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Includes: DGL, DGLD, DGP, DGZ, DZZ, GEUR, GLD, GLDI, GLL, GTU, GYEN, IAU, OUNZ, PHYS, QGLDX, SGOL, UBG, UGL, UGLD
by: Societe Financiers

Summary

China's manufacturing sector is starting to recover.

The US Dollar has no fundamental reasons to depreciate against other currencies in the mid-term.

The growth of the Yen has a positive effect on the growth of Asian economies.

The growth of the manufacturing sector in China negatively affects the growth in the price of gold.

The March Caixin Manufacturing PMI in China reached 49.7, significantly higher than the February 2016 value of 48. Unemployment continues to rise. However, inflationary pressures increased, indicating the presence of positive processes in the economy. The CPI index has also increased and totaled 102.3 in February 2016, instead of 101.8 in January 2016.

The Chinese government intends to reorganize the country's economic system in order to increase domestic consumption and make the country less export-oriented. This requires new ways of economic development, changes in fiscal policy, and adaptation of legal and financial institutions.

Most of the economic shock caused by reduced production has been successfully overcome. The first increase in foreign exchange reserves since October 2015 shows a decrease of currency and credit risks. This helps increase FDI, so a further stabilization of the Chinese economy will facilitate growth in the manufacturing sector and increase demand for crude oil.

Diagram 1. Manufacturing PMI. Click to enlarge

(Source: Tradingeconomics)

As you should know, there is a strong correlation between the value of the US dollar and the price of gold because of the significance of the US dollar in global trade. Accordingly, the devaluation of the US dollar should boost the price of gold due to the fact that the profitability of US imports drops significantly in the short term. This outcome greatly harms US importers and, with the current global macroeconomic weakness, is catastrophic to some countries.

The Fed's recent verbal intervention reflected a desire to ease the US monetary policy and inform the markets that the country's economy has not yet reached the necessary conditions for continuous rate hikes. However, we think that the Fed will likely raise rates before December 2016 because a rate increase will positively impact foreign capital inflows, the growth of long-term interest rates and, most importantly, will force US banks and other lending institutions to ease lending conditions in order to keep revenue growth.

The last year, in response to falling commodity prices, has passed under strong deflationary pressures. The current economic weakness and low inflation in advanced economies enables the rapid development of the manufacturing sector in emerging economies, increasing consumption and the recovery of crude oil prices. Global economic concerns stimulate the appearance of new economic development methods. These trends are vivid on the emerging markets.

The current growth in value of the Japanese yen will cause the expansion of the central bank's balance sheet and fuel an increase of the government's debt.

With the growth of the yen, Japanese manufacturers will face a decrease in liquidity, investment attractiveness, and other negative consequences. To minimize this, a series of monetary measures, such as quantitative easing, ensuring bank liquidity, and maintaining private sector lending, is required. These measures will lead to a significant expansion of the Central Bank`s balance sheet and growth of the government`s debt.

Considering the exports data for February 2016, most exported goods are transport equipment (1,455,974M Yen), machinery (1,128,741M Yen), and electrical machinery (956,116M Yen). The major importers of Japanese products are the region of Asia (2,882,625M Yen) and USA (1,218,392 M Yen). Most of Japan's imported goods are mineral fuels (1,013,240M Yen).

Considering the technological and qualitative superiority of Japanese products, a significant reduction in their demand is unlikely (i.e. inelastic demand is present). As a result, Japanese products will become more expensive in relative terms which leads to further increases in prices of final goods produced in Asia and the USA.

Alternatively, the deflationary spiral can ruin the Japanese manufacturing sector and spread deflation throughout Asia in the mid-term. This result is not advantageous to countries with developed and emerging economies, so we should expect definite actions from the Fed. Perhaps, we may expect faster-than-expected interest rate hikes.

Conclusion

Based on the fundamental reasons we explained above, we think that the investment attractiveness of gold will decline in the near future, lowering the price of the asset.

Societe Financiers is an investment research team focused on long-term, long- and short-only ideas. Our research objective is to cover equities in various regions, such as North America, EMEA, Asia, Australia, and Emerging Markets.
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