Gold Miners: Risks Of Being Long Are Too Great

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Includes: ASHR, EEM, FCX, FXI, GDX, GDXJ, GG, GLD, GOLD, PAAS, RGLD, SLV, UUP, WPM
by: Michael Roat
Summary

Potential strengths for gold prices include several years of extremely accommodative monetary policy and an increasing U.S. government deficit.

Gold prices could appreciate under a scenario of inflation exceeding target rate in the U.S.

Gold is primarily an inflation hedge and struggles to compete when interest rates rise because gold doesn't yield interest.

Rising real U.S. rates, and stronger GDP growth with muted inflation is a weakness to gold. A hard-landing in China is a threat to gold prices.

I think the risks for gold miners are tilted toward the downside. There is potential for gold prices to appreciate long term as inflation could overshoot the 2% target rate after several years of QE and prolonged low rates. In the near term, I continue to a expect a hard landing for China putting downward pressure on inflation expectations with the U.S. economy decoupling and leading the global cycle. This combination is a threat to gold prices. Oppositely, a period of high U.S. inflation, strong emerging market economies, global central bank policy convergence and U.S. dollar depreciation is an opportunity for gold.

Strengths and Opportunities

A recovering global economy and synchronized global growth has supported the position of an inflationary outcome. Government deficits are inflationary and the Trump administration with tax reform and a future infrastructure plan will likely increase the deficit. Why would inflation not exceed the target rate at some point after all this monetary easing and adding fiscal deficits when the economy doesn't really need stimulus? The Federal Reserve could easily be behind the curve on monetary tightening after failing to tighten financial markets throughout 2016 and 2017 despite raising the Federal Funds Rate. An outburst of U.S. inflation would be very beneficial to gold prices and gold mining stocks.

Weaknesses

Inflation has undershot the Federal Reserve target the last several years. The Federal Reserve though is continuing to lead global central banks through tightening preemptively and reducing their balance sheet while other central bank balance sheets expand.

The Fed has embarked on a yield curve strategy through dual management of short term rates and long end influence using their balance sheet. Markets and yields have not adjusted significantly to the announcement of quantitative tightening despite the roaring reaction when QE was implemented. The bond markets may finally be starting to understand and price in the idea that the U.S. economy is improving and on sound footing. This, in addition to monetary tightening, would exert upward pressure on treasury yields pushing gold prices lower.

Gold is not a safe haven asset as it failed in this use during 2008 Global Financial Crisis and 1997 Asian Currency Crisis. Gold prices are an inverse function of expected real yields or treasury yields minus market based measures of inflation expectations. Therefore deflationary shocks are usually gold price negative and this makes sense if one views gold as an inflation hedge.

Threats

The largest threat to gold prices is two-fold.

1. An improving U.S. economy with inflation expectations falling or staying muted. This could occur because the economy may still be mid-cycle. Economic growth (and subsequent monetary tightening) could preempt inflation.

2. Another factor is the direction of the Chinese economy. I believe a deflationary downturn in China and emerging markets is gold price negative.

If either of these threats occur, gold prices may decline. If both occur at the same time the downside for gold prices could be significant. In conclusion, I personally would either hold no position in gold or be short. I think the long entry point is still in the distance.

Disclosure: I am/we are short WPM, GG, ABX, RGLD, FCX. 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.

Additional disclosure: January 2019 put options.