Last Friday, the Labor Department released the much-anticipated jobs report for the month of July. The jobs report threw a positive surprise. The economy added 255,000 jobs for the month of July, well above the consensus forecast. The probability of a rate hike in 2016 has increased significantly since Friday's report. As expected, it has also led to a pullback in gold prices.
What The Jobs Report Means For Gold
Ahead of the July jobs report, I had noted that there is a strong case to remain bullish on the SPDR Gold Trust ((ETF) (NYSEARCA:GLD)) and the Market Vectors Gold Miners (ETF) (NYSEARCA:GDX) although I would look at a lower entry point. The strong July jobs report has provided that opportunity. Immediately after the release of the jobs report, both GDX and GLD fell sharply as can be seen from the charts below.
The pullback in gold was expected as a strong jobs report has raised the possibility of a rate hike in 2016. The question still remains whether the rate hike will come at the next Fed meeting or the one in December. In its most recent FOMC, the Fed had hinted at a rate hike as well. I believe that the case for one has strengthened after the July jobs report. Remember that we have had two back to back strong jobs report. The interesting thing is that the strong jobs reports have come despite weak second-quarter GDP growth. The consumer side of the economy certainly appears to be strong given the improving labor market but GDP growth has been marred by weak business investment as the second-quarter GDP report shows. But the Fed's rate hike decision, at least in theory, is based on the state of the labor market and inflation. On the labor market front, there is enough evidence of improvement and a strong case for a rate hike.
According to Reuters, there is now a 46% probability of a rate hike in 2016. The probability of a rate hike stood at 34% before the jobs report was released. While the improvement in the labor market certainly justifies a rate hike, the Fed is still concerned about inflation. Inflation still remains well below the Fed's target rate. As a result the pace of rate hike is going to be gradual. The medium term outlook for gold therefore remains bullish even though the strong July jobs report has raised the possibility of a rate hike.
Another very important factor to remember here is that the Fed is importing monetary policy from other developed world central banks, which are still in expansionary mode. The expansionary monetary policy measures, including bond buying, by central banks in the euro zone, Japan and the UK have pushed yields on $10 trillion worth of sovereign debt into negative territory. As investors search for yield, they have poured money into Treasuries, pushing yields on 10-year bonds to record low levels. So any effort by the Fed to tighten will have minimal impact. The opportunity cost to hold gold remains insignificant and therefore I remain bullish in the medium term.
Calm Markets But For How Long
The strong jobs report also put the market into risk on mode, with the S&P 500 closing at yet another record high on Friday. At the same time, the VIX index, which measures volatility, dropped to its lowest level in the last one year.
The question is how long will the market stay calm. With nearly 90% of the S&P 500 companies now having reported their quarterly results, the earnings season can be called a disappointment. Certainly, based on how the earnings season has unfolded, the S&P 500's current valuation is not justified. The blended earnings decline, according to FactSet, is 3.5%. This was after 86% of the S&P 500 companies reported their earnings. Not since the financial crisis of 2008/2009, have we seen five straight quarters of year-over-year earnings decline.
The market remains due for a sharp correction and I expect a spike in volatility. It could be triggered by concerns over growth in China. On Monday, the world's second-largest economy reported disappointing export data. Remember that the last two sharp sell-offs in equities, the one in July last year and the one at the beginning of this year, have been sparked by concerns over China. Then there is the threat of a banking crisis in Italy. As we get closer to the constitutional referendum in Italy, I expect investors to take risk off the table. An unfavorable outcome in the referendum is going to trigger a huge sell-off in risk assets. The unusual calm in the markets is not likely to last for long.
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