Why The Downturn In Gold Does Not Reflect Long-Term Reality

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Includes: AGOL, GLD, IAU, OUNZ, PHYS, QGLDX, SGOL
by: Atlas Grinned

Summary

Gold is down on perceived economic strength in the US, but the coming rate hike is coming on the back of very low GDP and inflation statistics.

This indicates any rate hike will not be sustained and possibly quickly reversed, and when the market figures this out, gold will likely climb.

Gold miners continue to lose money, and at this rate most of the industry will go bankrupt, squeezing supply.

Over the past 30 days, the price of spot gold has fallen 7%. As is to be expected, the majority of gold ETFs have mirrored this decline. The SPDR Gold Trust ETF (NYSEARCA:GLD) traded for $105.37 at last close, having opened the month at a little over $111. The iShares Gold Trust ETF (NYSEARCA:IAU) currently trades at $10.62, again down from the $11.30 where we opened the month. The sharp decline comes as a culmination of a number of factors, including expectations of a Fed interest rate hike on the back of a perceived strong US economy, and a downturn in China, which has the potential to weaken global demand for most metals on the back of reduced manufacturing activity.

With all this activity, the big question is how hard is gold likely to fall, and is now the time to reallocate towards higher return assets. Judging by popular news media, the answer looks to be yes. However, for a number of reasons, things may not be quite so simple. From a global economic perspective, we are in something of an unprecedented situation, and the traditional capital flow between risk-on and risk-off assets in response to economic expansion/contraction might need a second look.

According to popular perception, the US economy has expanded over the last five years. The NASDAQ is up more than 130% since this time in 2010 while the Dow Jones Industrial Average up more than 70%, and the S&P 500 hit fresh highs on July 17 to chalk up gains of more than 92% across a five-year period. Further, unemployment is down at a little over 5% - its lowest level since Mid-2008. This activity has fueled expectations of a near-term interest rate hike. The US dollar has gained strength over the last few months relative to other currencies, and this strength has played a big part in gold's recent fall.

However, take a closer look at the US economy, and there are questions over whether a) it is ready for an interest rate hike and b) if such a hike could spark an economic downturn. Interest rates are normally used by a country's central bank to control inflation - when the target is hit, it will generally raise interest rates, with the reverse being true for a below target inflation levels at times of economic downturn.

The last CPI read, which measures inflation, came in at 0.1%.

This is the highest level of inflation we have seen this year. Back in April, inflation came in at -0.2%. Deflation is not generally associated with a booming economy and an interest rate hike. Similarly, quarterly GDP growth for March came in at -0.2%. The US economy actually contracted on a quarter-over-quarter basis. Again, an economic contraction generally does not precede an interest rate hike, and it is definitely not a sign of a stable and thriving economy. What is happening in equities markets does not seem to reflect the fundamental economic situation in the US.

Before we draw any speculative conclusions, let's move quickly on to China. Chinese growth keeps coming in at 7% - bang on target with the Chinese government's GDP expectations. Numerous questions exist as to the validity of the data we see out of China, but these questions aside, it looks as though the Chinese economy is slowing. China being a big gold buyer, it is this weakening that has contributed to the gold's recent decline. However, when we think bigger picture, a reduction in industrial metal demand may well translate to a medium-term reduction in the price of metals such as copper, iron and to some extent silver, but a reduction in the price of gold can only be a short-term perspective.

Why? Because if the Chinese economy is indeed weakening to the extent that its demand for industrial metals has a marked impact on the price of these metals, then there will likely be fallout on a global scale. The majority of Asian nations, as well as Australia and New Zealand are very closely tied to the Chinese economic prosperity, and could suffer as a result of a Chinese slowdown. The US is also not immune. A global economic impact would likely quickly alter sentiment, and initiate an allocation of capital back towards risk-off assets, translating to yellow metal strength. This is something akin to what happened in 2008, when gold initially sold off short term, but then flew to new highs for the next 3 years led by miners.

And what about Greece? Well, Greek banks reopened this week, and it now looks as though Greece will remain part of the Eurozone for the foreseeable future. Strict austerity measures are reported to be the answer to the nation's current fiscal crisis, and it is now just a case of hammering out a deal that suits both sides. But is it really this simple? With the Greek banks reopened, it is not unreasonable to suggest that cash reserves will quickly deplete. In fact, Greek bank stocks have been crashing limit down every day since the Athens exchange has reopened. If banks in your domestic economy closed for three weeks, how much longer would you leave your deposits sitting with them once they reopened?

The bank run that was only avoided through the closing of these banks could still take place over the next few weeks regardless of any political agreement between Greece and the wider Eurozone. What collateral effects might this have on banking systems across Europe? Further, austerity measures have repeatedly been shown as not being a realistic option for Greece. The country is in a position where it needs its debt written off entirely, and in the current negotiations, this is very unlikely to happen. The takeaway? That it is only a matter of time (likely short term rather than longer term) that we are again in a very similar situation.

So to bring this all together, we have the potential interest rate hike in the US, six years into a nationwide economic recovery, but imposed upon fundamental data that includes economic contraction and quarterly deflation. Further, we have a gold and industrial metal sell-off because shortsighted speculators see Chinese manufacturing weakening, without taking the global economic implications of a Chinese downturn into consideration. Finally, markets have seemingly reversed their bearish outlook on Greece and the Eurozone, based upon negotiations that fix only a very short-term problem in the single currency region, and fuel further and more serious problems down the line.

Moreover, this is looking at things from a macroeconomic perspective only. At current prices, gold mining companies cannot afford to keep processing ounces. The further the gold falls, the higher the loss each company shoulders per ounce, and the lower newly mined supply will become. Weak prices make it very difficult for junior gold explorers to attract investment, meaning not only do we have a reduction in the processing of current supply, but also a reduction in the exploration and identification of fresh unprocessed supply.

Gold may be down, but longer term, both macro and micro economic forces dictate that we must see a turnaround or we will simply run out of gold as bottom pickers buy existing supply and store it away. If suddenly, after 5,000 years of financial history, nobody else but the gold bugs care about gold anymore, then it won't matter. But if there is to be a supply of any kind, gold prices must rise, and soon.

Catching the proverbial falling knife is dangerous though, and the more conservative play is to wait for a breakthrough of around $1,170 an ounce.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in GLD over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.