What the Fear of Recession Brings to Gold

Includes: DGL, GLD, IAU
by: Boris Sobolev

What are the major concerns on the Street today? Market analysts are starting to pronounce “recession,” that nasty “R” word once again. But most are saying that the US economy is going to avoid it for now. Here are their arguments:

1. The wise and powerful Federal Reserve is keeping a close eye on the markets and is ready to react at any moment. The FOMC has already lowered the discount rate which is starting to help the financial institutions. Inflation remains under control, and if the credit crunch continues, the Fed has a number of levers that it can use to avoid a full blown recession. In an attempt to restore liquidity, the Fed has already allowed banks to pledge asset backed commercial paper as collateral.

2. The global economy remains exceptionally strong. China’s growth has only been accelerating and the economies of Japan and Europe appear to be on solid footing. In addition, major corporations have very strong balance sheets. The weaker dollar is helping corporate profits. Most recessions are caused by deterioration in corporate spending and we have yet to see any signs of that.

3. The stock market correction was relatively shallow for the magnitude of the events in the credit markets. Major indices are now appearing to make a bullish “W” bottom.

Market Whispers

But we do not hear much about the following:

1. The Fed relies mostly on lagging economic indicators and there is a risk that it will not drop the fed funds rate fast enough to prevent a recession. True, the Fed has lowered the discount rate in an attempt to restore confidence in the financial system. Yet, that does nothing to help the hurting consumer. The Fed is now behind the curve and the fed funds futures are predicting an immediate rate cut. As the stock market recovers, the Fed will feel less compelled to lower rates in a hurry. But it is a dangerous game to play. This is why a big rebound in stocks could be a setup for a large leg down in the coming months.

2. The fact that the global economy is strong now is not a good enough reason to say that a recession can be avoided. A strong economy now means we are at the top of a business cycle and there is a higher downside rather than an upside risk.

3. While most of the focus is on the financial sector, the consumer is starting to feel the pain from depreciating house prices. Lenders are being more selective and mortgage rates are rising. So far, the Fed has done nothing to help the consumers who make up 70 percent of the GDP, and it is questionable whether it can (read more on this here).

The retail sector has been underperforming the S&P 500 since mid-2005, another alarming signal for the health of consumer spending. Last week’s rebound in the sector was discouragingly weak.

The fact remains that the American consumer is much more sensitive to the decline in the housing market than in the stock market. Low mortgage rates and rising property values helped keep the 2001 recession relatively shallow and painless despite the crashing stock market. The coming recession may prove to be much more difficult to weather. Consumers have lost their source of cash from refinancing. Many will now have much higher mortgage payments as a record number of ARMs get readjusted at the end of 2007 and in 2008. As a result, as many as 2 million foreclosures could occur in the near future.

Gold & Gold Stocks

With their piggy banks empty, consumers are looking to borrow even more but no one is willing to lend for cheap this time around. When bad economic news starts to filter in, the “R” word will be on everybody’s tongue. A recession is deflationary based on textbook economics. But the Fed has proven time and again that it will do anything to prevent a contraction in the money supply. It will attempt to inflate away all economic problems. In conclusion, while a deflation scare is short term bearish for gold and bullish for the dollar, the inevitable surge in the money supply is very positive for gold intermediate to long term.

Another major round of liquidation on the deflation scare is likely this fall. But we are not changing our outlook on gold, especially since the gold bugs sentiment has turned even more bearish while gold price has held up very well. Physical demand remains high as GLD gold holdings are at an all-time-high of 515 tonnes. The latest COT release is also very supportive of a short term rebound.

Most gold investors and traders tend to be pessimistic about the economy and the stock market. This is one of the reasons why gold stocks could be vulnerable to a second wave of liquidation related to the deflation scare this fall. We are urging caution, refraining from doing any more new buying and maintaining a cash position. Even though there is tremendous value in many junior producers and exploration companies, it is difficult to tell what the downside risk is to prices. We believe that highly bullish fundamentals on gold and the weakening economy will produce a significant rally in the next few months. But we do not know at which levels this rally is likely begin. Caution continues to be the name of the game for now.