For the month ending July 31, 2016.
Gold's Resilience Continues in July
Following the June 23 Brexit vote when the U.K. chose to withdraw from the European Union, bond yields fell to record lows and gold rallied to two-year highs, reaching $1,375 per ounce on July 6. In the U.S., subsequent strong economic results in manufacturing, retail sales and housing created U.S. dollar strength and gold consolidated its Brexit gains, declining to $1,310 per ounce on July 21. However, as was the case throughout the post-crisis expansion, good economic news doesn't last long and the month ended with disappointing durable goods and pending home sales reports, along with second quarter GDP growth of just 1.2%. The U.S. dollar reversed course and the gold market demonstrated its resilience, advancing to end the month with a $28.80 per ounce (2.2%) gain to finish at $1,351 per ounce.
Silver is fulfilling its role as a leveraged proxy for gold with a new post-Brexit high of $21.14 per ounce and a monthly gain of 8.7%. The buying in silver was led by China with heavy volumes on both the Shanghai futures and gold exchanges.
As we have pointed out repeatedly this year, and discussed in detail in our June update, gold companies are well managed, and gold stocks provide leverage to gold since valuations remain attractive. Therefore it is no surprise that stocks enjoyed another surge higher in July. The NYSE Arca Gold Miners Index1 (GDMNTR) gained 10.1% and the MVIS Global Junior Gold Miners Index2 (MVGDXJTR) gained 16.8%. Strong equity gains are typical in the early stages of a gold bull market.
Low Rates Force Investors to Take on More Risk
We are beginning to witness, once again, the unintended consequences of monetary policies that have remained too easy for too long. Because of extremely low rates, bonds no longer fulfill their historic purpose of capital preservation and portfolio security. A Wall Street Journal article by Timothy W. Martin published on May 31 shows that the expected return of a portfolio made up entirely of bonds was 7.5% in 1995. To achieve the same return in 2015, a portfolio would have needed to hold only 12.5% bonds and 87.5% in stocks, real estate and private equity. This portfolio allocation would have carried nearly triple the volatility of the bond-only portfolio.
Ineffective Monetary Policies Creating Potential Future Issues
Policy makers seem to be focused on solutions to previous problems without realizing that excesses are going to create additional issues. For example, an odd thing happened after Brexit - stocks ignored the risks Brexit posed to the global economy and the S&P 500®3 advanced to all-time highs. Markets rallied in the belief that more central bank stimulus would be forthcoming. Bonds also moved to all-time highs. The traditional negative correlation between bonds and risk assets, including stocks, no longer applies thanks to meddling by central banks that has caused asset price inflation (or bubbles) in both these asset classes.
Negative yielding sovereign debt in Japan and Europe totals over $13 trillion now, according to a recent Bank of America Merrill Lynch analysis. We believe U.S. rates are not far behind; from a first hand experience, I recently received a CD rollover notice from my local mega bank branch with a yield of only 3 basis points (0.03%). Negative yields lock in a capital loss if held to maturity. The only way to come out ahead is when negative yields are accompanied by deflation in excess of the yield rate. However, deflation comes with its own drawbacks, namely, bank failures, job loss and depression. Without deflation, there is a limit to how much further yields can fall and for how long they stay in place before savers abandon the banking system to hold cash, despite the inconvenience that option brings. Or perhaps as an alternative, they look to hold gold since it exists outside of financial authority, cannot be a target of financial repression, and carries virtually no counterparty risk.
As central banks buy up more bonds and more bonds move into negative yields, investors search among a smaller pool of substitutes and trades get crowded for higher risk alternatives. According to the Wall Street Journal, higher prices for stocks, bonds and real estate have caused net wealth to swell to over 500% of national income in the U.S. This has happened only twice historically - just before the tech bust and just before the housing bust. By definition, black swan4 events are nearly impossible to predict. However, with the imbalances and extremes present in the markets today, we must assume that the odds are increasing for an unforeseen calamity. The further bond prices rise (and rates fall) the greater the risk is to bond values from even moderate increases in inflation and interest rates. One possible crisis scenario might involve higher than expected consumer price inflation that crushes negative yielding bonds, causing liquidity to dry up as investors rush for the exits and sell assets to cover losses.
Mervyn King, Governor of the Bank of England from 2003 to 2013, was interviewed in the World Gold Council's June edition of Gold Investor and said, "The risk is that we just muddle through with a prolonged period of very low growth. The longer that goes on, the more output we will have lost in the interim. And in the long run, it makes another crisis more likely because, if everyone is relying on monetary policy and it isn't the answer, we won't get back to a new equilibrium. We do need to make that jump at some point so the question is do we get there as a result of active, conscious policy decisions and cooperation between countries or will it only happen as the side-effect of another crisis."
Unlike 2008, Investors in 2016 are Acting Proactively
There was heavy investment demand for gold following the 2008 financial crisis. We are seeing a similar level of investment demand in 2016, as many are preparing their portfolios for the next possible crisis. Gold and gold shares declined with other markets in the massive selloff in 2008. However, both gold and gold equities bottomed in October 2008 and then made a strong recovery. The action in the current gold markets indicates that investors have become more proactive, buying gold as a hedge against future turmoil. This suggests that gold is now more broadly recognized as a hedge against financial stress. With this recognition, if there is another crash, perhaps gold will not see the same selling pressure as the broader markets.
With Selling Pressure Removed, Normal Gold Demand Trends May Reemerge
Historically, there is a seasonal pattern to gold prices dependent on physical demand trends. Often, there is weakness in the summer when jewelry demand, primarily from China and India, is low and trading volumes decline. Seasonal strength often occurs from August to January, beginning with the Indian festival season and ending with Chinese New Year. Gold demand from China has been weak and from India has been even weaker. The Indian Finance Ministry reported 218 tonnes of imports in the first half, a 52% decline from the first half of 2015. This is to be expected as Indian and Asian demand overall usually declines when the price is rising, as gold investors in these regions tend to wait for price weakness to restock. Changes to Indian demand may be coming though. The Indian monsoons have been good this year which boosts crop output and the ability of rural farmers to potentially increase their gold savings, and the Diwali festival begins October 30. In addition to the macro drivers, seasonal strength may provide a boost to gold prices as the New Year approaches. This summer, any seasonal price weakness has been offset by gold's appeal following the extraordinary Brexit rally which has delayed the return of the normal gold market pattern. This pattern has been absent for several years due to the relentless selling pressure during the gold bear market. However, shorting gold has been a very risky bet in 2016. Now that the gold bears are on the run, perhaps seasonality will again influence the market.
1 NYSE Arca Gold Miners Index (GDMNTR) is a modified market capitalization-weighted index comprised of publicly traded companies involved primarily in the mining for gold.
2 MVIS Global Junior Gold Miners Index (MVGDXJTR) is a rules-based, modified market capitalization-weighted, float-adjusted index comprised of a global universe of publicly traded small- and medium-capitalization companies that generate at least 50% of their revenues from gold and/or silver mining, hold real property that has the potential to produce at least 50% of the company's revenue from gold or silver mining when developed, or primarily invest in gold or silver.
3 S&P 500® Index (S&P 500) consists of 500 widely held common stocks, covering four broad sectors (industrials, utilities, financial, and transportation).
4 A black swan event is an event or occurrence that deviates beyond what is normally expected of a situation and is extremely difficult to predict; these events are typically random and are unexpected.
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