Gold Investors: Let This Cycle Be Your Guide
June 14, 2014
by Frank Holmes
of U.S. Global Investors
U.S. Global Investors recently welcomed Doug Peta, an economist from BCA research, to our offices. He presented some interesting research regarding the Fed Funds Rate Cycle, and in turn, what that research could mean for gold. I wanted to share points from his presentation, as well as our own in-house research, to help you understand the positivity we see for the precious metal looking towards 2015.
Where are we now?
Below is a chart from BCA showing the Fed Funds Rate Cycle. In essence, this chart neatly illustrates what the interest rate cycle imposed by the U.S. Federal Reserve looks like. The red circle indicates where we are right now: Phase IV, also known as the “easing” phase of the monetary policy that was enacted in 2008 in the U.S., better known as quantitative easing (QE).
As we know, the Fed enacted QE to stimulate our nation’s economy. Right now we’re benefitting from our placement in Phase IV of this cycle because it is in this phase that the Fed is able to keep interest rates low, keep reserve requirements low and continue printing money. Similarly, when money is “easy,” businesses can find funding for projects and consumers have easier access to credit.
Historically, Phase IV (as well as the shift towards Phase I) are the best for equity investors because stocks usually rise during these two positions in the cycle.
Why these phases are good for gold, too.
We have been in Phase IV of the Fed Funds Rate Cycle for a few years now, and are expected to remain here into 2015. Eventually the Fed will have to start tightening again and raise rates, although the numbers should remain relatively low for a while. Once this begins, we will move into Phase I.
When it comes to the performance of gold and gold stocks, history indicates good times are ahead based on where we are in the cycle. Take a look at the tables below showing median returns during the cycle dating back to 1970 and 1971. You’ll see that for gold and gold stocks, Phase IV and Phase I both show the highest median returns.
| Spot Gold, From June 1971 | TSE Gold Miners, From July 1970 | ||
|---|---|---|---|
| Phase | Median | Phase | Median |
| Phase I (Easy, Hiking) | 11.8% | Phase I (Easy, Hiking) | 16.2% |
| Phase II (Tight, Hiking) | 2.2% | Phase II (Tight, Hiking) | -8.8% |
| Phase III (Tight, Cutting) | -4.3% | Phase III (Tight, Cutting) | -15.9% |
| Pase IV (Easy, Cutting) | 9.2% | Phase IV (Easy, Cutting) | 24.2% |
| Note: Excluding the two-month Phase II period spanning the October ’87 stock market crash. Past performance does not guarantee future results. Source: BCA, U.S. Global Investors |
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The reason for the high returns during these two phases is because of “easy money.” Tight money, which is what Phase II and III are based upon, is typically bad for gold investors. When money is tight, we don’t have inflation, and investors don’t need to turn to gold as a hedge against inflation. Without inflation there is no need to hedge.
Another reason we’ve traditionally seen gold investors benefitting during Phases IV and I of the cycle is that when money is easy, interest rates are low, meaning less opportunity cost for holding the precious metal. To help illustrate, imagine putting your money in a savings account and earning 5 percent on it. Well, the opportunity cost of keeping gold under your mattress would be giving up that 5 percent that you could be earning elsewhere. When your savings account yields next to nothing, some reason, why not just buy some gold?
This pattern is worldwide.
The trends we see in the Fed Funds Rate Cycle are not only U.S. specific. This same idea carries through to the stimulative policies of the European Central Bank and Japan. More countries around the world are applying monetary stimulus programs much like the U.S., while moving away from more restrictive policies. Remember that restrictive policies relate to tightening, which is bad for gold, and stimulative policies relate to easing, which is good for gold.
Right now, gold could use a pick-me-up, and here’s why. Over the last several years we’ve seen slowing money supply growth in many E7 countries. E7 refers to seven countries with emerging economies including China, India, Brazil, Mexico, Russia, Indonesia and Turkey. It’s these countries that drive the Love Trade for gold, primarily China and India, which purchase the metal for religious and cultural celebrations.
With less money being spent or borrowed, not only did the Love Trade begin to slow, global GDP growth also began to slow as you can see below.
The good news is, as we see various countries applying monetary stimulus, including emerging markets, we can expect this to contribute to global GDP growth. In 2014, global GDP is expected to grow by 3.2 percent, according to the World Bank’s latest projections.
Similarly, the money supply of the United States has been a steady grower and the money supply in the E7 countries is also expected to reverse course; right now it is growing again but at a slower rate. The U.S. data suggests that a new easing cycle is starting in Europe, Japan and emerging markets. A pickup in economic activity in the E7, especially the big gold consumers, is yet another positive sign for the yellow metal.
Real interest rates are headed lower for most of the world as well. As money supply grows, countries eventually feel inflationary pressures. This will hold true in the U.S. as we move into 2015 and back into Phase I. All of these changes can lead to a declining confidence in paper money, yet another good sign for gold.
An interesting side note.
I have noticed that recent articles in both Money Magazine and the New York Times use an array of gold images to illustrate wealth. It seems that while some may debate whether gold is money, gold remains an enduring symbol of wealth.
Index Summary
- Major market indices finished lower this week. The Dow Jones Industrial Average fell 0.88 percent. The Standard and Poor’s 500 Stock Index dropped 0.68 percent, while the Nasdaq Composite declined 0.25 percent. The Russell 2000 Small Capitalization Index fell 0.22 percent this week.
- The Hang Seng Composite Index rose 1.44 percent. Taiwan gained 0.68 percent while the KOSPI fell 0.23 percent. The 10-year Treasury bond yield rose 2 basis points to finish the week at 2.61 percent.
Domestic Equity Market
The S&P 500 Index sold off this week as geopolitical events flared up in Iraq, sending oil prices higher and giving investors a reason to take profits after three weeks in a row of solid gains.
click to enlarge
Strengths
- The energy sector was the only positive performer this week as oil prices rose to $4 after an al-Qaeda-affiliated group took control of Mosul, Iraq’s second largest city. Observers fear the potential for a civil war, similar to what is currently ongoing in Syria, the key difference being a disruption to global oil supplies. The S&P 500 Oil and Gas Drilling Index and the Exploration and Production Index both rose by more than 3 percent this week in broad-based rallies.
- The technology sector was near breakeven this week as semiconductor and semiconductor equipment stocks were strong after Intel raised its second-quarter revenue forecast on improving business demand for personal computers. Intel rose 6 percent for the week.
- International Game Technology was the best performer in the S&P 500, rising 26.8 percent this week. The company, the world’s largest slot machine-maker, announced on Monday that it hired an investment bank to explore a sale, and by Friday multiple potential bidders and interested parties had been identified. Interest appears very robust.
Weaknesses
- The consumer discretion sector was the worst performer this week as homebuilding and auto-related groups sold off as higher oil prices caused concerns among investors that consumers would be forced to scale back activity. Homebuilders, home improvement retailers and automotive retailers were hit the hardest.
- The industrial sector was also an underperformer as airline stocks came under pressure on higher oil prices and Deutsche Lufthansa’s profit warning this week, citing tough competition for long-haul international flights.
- Tyson Foods was the worst performer in the S&P 500, falling 11.7 percent. The company won the bidding war for Hillshire Brands, but investors are concerned that the price may have been too dear.
Opportunities
- FedEx reports next week and is often looked at to provide a read on the direction of the overall economy. Hopefully FedEx will confirm the economic strength we are seeing in the macro indicators.
- We have several technology companies reporting next week, with bellwether Oracle the headliner, but also Adobe Systems, Red Hat and Jabil Circuit.
- The S&P 500 suffered its first loss in three weeks, and the winning strategy for the past 18 months has been to buy the pullbacks.
Threats
- Sell in May has not worked so far this year, but with a dearth of significant earnings or market moving economic data, a June swoon can’t be ruled out.
- At almost 18 times trailing earnings, the S&P 500 is not cheap. Valuation may be a headwind for future market gains.
- Any hawkish comments out of next week’s Federal Open Market Committee (FOMC) meeting could make the markets jittery and the inclination would be to sell first and ask questions later.
The Economy and Bond Market
Short-term treasury yields rose this week as Bank of England Governor Mark Carney indicated that interest rates might rise sooner than markets currently expect, which caused similar thinking to cross the pond. The three-year Treasury rose 10 basis points this week, and on an intraday basis hit the highest level since September. The long end of the yield curve was relatively flat, causing the yield curve to flatten. Economic data has generally been good here in the U.S. and optimism continues to build regarding growth for the rest of the year. The National Federation of Independent Business’s (NFIB) Optimism Index, which measures small business sentiment, rose for the third month in a row and hit the highest level since September 2007.
Strengths
- May retail sales data was the “big” number to watch this week and on the surface disappointed. May retail sales rose 0.3 percent, which was below expectations, but this was driven by the fact that April’s numbers were revised significantly higher, making for a much higher base to grow from. The key takeaway is retail sales data point to a second quarter rebound that many have been talking about after GDP contracted in the first quarter as weather disrupted activity.
- Another positive sign of economic recovery came in the Job Openings and Labor Turnover Survey (JOLTS) report, which showed that employers posted 4.5 million job openings in April, the most in seven years.
- Eurozone industrial production rose 0.8 percent in April, twice the consensus estimate which reinforces the European recovery story that is unfolding.
Weaknesses
- As mentioned above, the UK is moving closer to raising interest rates as the central bank is concerned that housing has become overheated and easy policy risks have created another bubble.
- The preliminary reading for the University of Michigan Consumer Sentiment Index came in below expectations and below May’s level.
- Short-term bond yields are heading higher and the market is becoming more anxious regarding the Federal Reserve’s quantitative easing (QE) exit plan.
Opportunities
- Housing starts and building permits for May are scheduled for release next week. This is a crucial time for the housing market. If we don’t see an uptick soon, we probably won’t see one this year. This could actually be a positive for the bond market as a weak housing environment likely keeps the Fed from shifting to a tighter policy.
- The Consumer Price Index (CPI) is also scheduled to be released next week, and with the Producer Price Index (PPI) showing a disinflationary trend this week, CPI should reconfirm for the Fed that easy monetary policy remains appropriate.
- With key global central banks back into easy policy mode and inflation trending lower in many parts of the world, the path of least resistance for bond yields is likely down.
Threats
- The Federal Open Market Committee rate decision and QE adjustment will be announced on Wednesday. Any deviation from the prescribed $10 billion in QE reduction toward a quicker reduction in QE or a more hawkish tone would be a negative.
- Bonds have posted strong returns so far year to date and with economic data looking supportive a modest sell off wouldn’t be surprising.
- While the European Central Bank (ECB) is moving toward easing, UK policy makers at the Bank of England are considering raising interest rates as the housing market has been very strong along with retail sales.
Gold Market
For the week, spot gold closed at $1,276.89, up $23.64 per ounce, or 1.89 percent. Gold stocks, as measured by the NYSE Arca Gold Miners Index, rose 6.65 percent. The U.S. Trade-Weighted Dollar Index rose 0.25 percent for the week.
| Date | Event | Survey | Actual | Prior |
|---|---|---|---|---|
| June 9 | U.S. Fed’s Bullard Speech in Florida | – | – | – |
| June 13 | China May Retail Sales | 12.1% | 12.5% | 11.9% |
| June 13 | Germany May CPI | 0.9% | 0.9% | 0.9% |
| June 13 | U.S. May Producer Price Index | 2.4% | 2.0% | 2.1% |
| June 17 | Germany ZEW Survey Expectations | 35.0 | – | 33.1 |
| June 17 | U.S. May CPI | 2.0% | – | 2.0% |
| June 17 | U.S. May Housing Starts | 1030K | – | 1072K |
| June 18 | U.S. Federal Reserve FOMC Rate Decision | 0.25% | – | 0.25% |
Strengths
- Gold had one of its best weeks of the year, aided by a slew of data from China on Friday showing that the economy is stabilizing, supported by targeted stimulus measures from Beijing. May retail sales rose 12.5 percent on year, above analyst expectations for a 12.1 percent increase, while industrial output increased 8.8 percent. China, the largest global gold consumer, nearly doubled its first-quarter gold imports relative to the same period last year, according to a recent study by data provider Global Trade Information.
- Dundee Precious Metals rose nearly 17 percent this week following an analyst site visit to its Namibian operations. The impressions from attendees were very positive, and the strong price action this week highlights how misunderstood the stock has been. With its Tsumeb Smelter overhaul now complete and ramping up to full capacity, the financial performance is set to improve sharply, largely thanks to its low cost basis and solid operations.
- Pilot Gold announced results from its drill test of a new porphyry target at its TV Tower Project in Turkey. The drill hole assays show 153 meters of 0.99 gram per tonne gold and 0.39 percent copper. Similarly, TriStar Gold reported drill holes at its Castelo property in Brazil, with assays of 15 meters of 2.16 grams per tonne gold. Lastly, Platinum Group Metals announced a large increase to its inferred resource to a total of 287 million tonnes grading 3.15 gram per tonne 4E (Platinum, Palladium, Rhodium, and Gold).
Weaknesses
- Platinum dropped 1.15 percent for the week while palladium dropped 3.68 percent as investors anticipated an end to the 20-week-long platinum strike in South Africa. The Association of Mineworkers and Construction Union held mass meetings with its members to present the latest wage proposals developed over the last three weeks of talks. The result was neither a total rejection nor a total success, yet miners are not back to work and unlikely to do so as a whole in the next few days. Investors continue to ignore the fact that metal inventories are being depleted quickly, a situation that will not be resolved by ending the strike since it will take a number of months before miners can ramp up operations. As such, a much larger supply deficit should be on everyone’s books for the fall, but it doesn’t look like it is. Both platinum and palladium have strong fundamental prospects, aided by the supply shortfall expected.
- Canada will make it harder for miners to comply with its anticorruption laws after small- and mid-cap miners have been targeted by allegations of corruption of foreign officials. The amendment to the Canada’s Corruption of Foreign Public Officials Act (CFPOA) has increased its maximum jail term to 14 years with no limit on fines and allows for Canadian law enforcement to prosecute Canadian individuals or companies for bribery, regardless of where the alleged bribery took place. A Grant Thornton report shows more than 1 in 4 people have reported having paid a bribe in the last 12 months.
- South African police arrested 20 Sibanye Gold mineworkers this week for allegedly stealing ore at a processing plant west of Johannesburg after a six-month investigation. A spokesman for the country’s anticorruption unit declared this is the largest mass-arrest of mineworkers for gold theft in post-apartheid South Africa.
Opportunities
- Paradigm Capital is pounding the table for gold as the “stars are aligning.” The report highlights the strikingly seasonal aspect of the recent weakness, and expects gold equities “to fly” this summer as the seasonal trade kicks in. Gold stocks are “coiled springs” due to the high beta that lower gold prices cause in the producer’s balance sheets. In addition, ISI in its weekly note to clients argues the package of simulative policies around the world is likely being underestimated, noting that the Bank of Japan and Fed balance sheets over the past five years have increased a stunning $4.5 trillion. To complement, Bank of Montreal Quantitative Strategy argues junior gold stocks have broken above an underperforming trend, stating “[If] no one cares, you should.”
- The royalty companies were the big winners this week, rising anywhere from 5 to 17 percent as they take upon the role senior gold stocks were supposed to do for your portfolio: provide leverage to rising gold prices and better protection on the downside. On the same Paradigm Capital report mentioned above, the analysts quantified the different gold sectors’ beta to the metal. The analysis shows, year-to-date, royalty companies have the highest beta (7.0) to gold upside of any gold sector. In addition, over the last ten years, the superior business model of royalty companies has outperformed all other sectors by a mile, 423 percent versus the 90 percent average.
- Virginia Mines reported it has commenced, or will commence, a series of exploration programs mostly in Quebec as it seeks to discover new mining camps that could replicate its earlier success in Eleonore. Virginia holds a 2.2 to 3.5 percent royalty on Goldcorp’s Eleonore property after it led the efforts to the discovery of what will eventually turn out to be Canada’s largest underground mine.
Threats
- India’s gold consumption may be affected by a slow start to the monsoon season. Much of the country’s farmland depends on rain for their crops due to the lack of irrigation, leaving farmers concerned the late start of the monsoon season may reduce the size of crops. A reduction in crop volumes would be detrimental to the wealth of farmers, which could inhibit gold purchases in the country. In addition, rising oil prices due to the Iraqi conflict are putting pressure on Indian inflation and its current account deficit, as the country imports 80 percent of its crude needs.
- Central bank gold buying is set to decrease according to statistics revealed by the World Gold Council (WGC). According to its outlook, the WGC estimates central bank buying will reach about 300 tonnes this year, about one fourth lower than the
- 409 tonnes purchased last year. The WGC concludes the lower buying is yet another example of the gold market becoming more dependent on consumers, and less on investors.
- Human rights groups are pushing for urgent reforms to prevent gold from funding conflict in developing nations. According to the U.N. Group of Experts, 98 percent of artisanal gold, worth somewhere between $380 to $500 million per year, was smuggled out of Congo last year alone. This gold is allegedly funding armed actors and corrupt business and political elites.
Energy and Natural Resources Market
Strengths
- North American crude oil producers led resource stocks this week following a breakout in the price of West Texas crude to $106 a barrel. Accordingly, Suncor Energy, Devon Energy and Sanchez Energy all made fresh 52-week highs along with numerous other oil producers.
- Gold- and silver-related equities outperformed this week as bullion prices increased in response to geopolitical instability in the Middle East. Both Franco-Nevada and Silver Wheaton outpaced our natural resources benchmark.
- Oil and gas drilling stocks, with exposure to growing resource plays in the Permian Basin and Eagle Ford shale, performed well in the period. Patterson-UTI Energy and Xtreme Drilling and Coil Services breached prior 12-month highs.
Weaknesses
- Equities with exposure to Iraq and Kurdistan underperformed in response to the fall of Mosul to a militant Islamic group. Gulf Keystone Petroleum declined approximately 15 percent on the week.
- Copper-related equities and other base metal companies declined this week due in part to ongoing probes by Chinese officials related to the accounting of copper used as collateral for loans. Lundin Mining lagged our benchmark by approximately 100 basis points in the week.
- Food stocks declined over the past five days after the fallout from Tyson’s final bid for Hillshire Farms was accepted by shareholders. Tyson Foods and Archer Daniels Midland fell by roughly 12 and 3 percent during the week.
Opportunities
- Despite small-cap weakness in the broader equity market, the Toronto Stock Exchange (TSX) Venture Index of junior resource stocks outperformed the large-cap-dominated Morgan Stanley Commodity Related Index by approximately 40 basis points this week. Expanding market breadth may imply further strength for our natural resource stocks over the near term.
- The International Energy Agency (IEA) said in its monthly report that it had raised its estimate of the demand for OPEC crude oil in the second half of this year by 150,000 billion barrels per day (bpd) from its forecast last month to an average of 30.9 million bpd. That is almost a million bpd a day more than the group was producing in May. The IEA is forecasting global oil demand growth of 1.3 million bpd for 2014.
- The latest escalation in Iraqi tensions has introduced new event risk for global oil markets. However, current options market pricing suggests oil markets are still attaching a low probability to an oil price spike over the coming months. This could reflect the fact that major oil infrastructure has not (yet) fallen into the hands of the militant extremists, which is constructive for producers in the region.
Threats
- The stakes are high for the oil market as the security situation in Iraq has taken a sharp turn for the worse with al-Qaeda-linked groups seizing control of large parts of Mosul, Iraq’s second-largest city. Further turbulence in global markets could increase if extremist groups expand their attacks from the Kirkuk-Ceyhan pipeline to other energy infrastructure assets.
- This year global inventories for grains and soybeans are projected to be the second-highest on record. Moreover, global production for corn and soybeans is set to hit a new record. While demand may prove robust, bearish supply side developments could weigh further on soft commodity prices.
Emerging Markets
Strengths
- Brazil was the best-performing emerging market this week, rising 4 percent after voting intention polls show waning support for current president Dilma Rousseff. Investors were net buyers of Brazilian stocks this week on speculation that an opposition candidate can win the elections on a platform focused on revitalizing the nation’s anemic growth. All eyes are on Brazil for the next thirty days as the 19th FIFA World Cup kicked off this week.
- Hong Kong was the best-performing Asian country this week, as China’s selective easing policy showed initial signs of success, reflected in the stabilization of May macroeconomic data. China’s fiscal spending grew 24.6 percent year-over-year in May, the fastest since August 2012 and accelerating from a 9.6 percent pace in January through April.
- Health care was the best-performing sector in the emerging market universe this week, largely driven by strong performances by Indian stocks. The Indian pharmaceutical industry reacted on speculation that global pharmaceutical companies are focusing their mergers and acquisitions efforts on emerging markets. Two of our funds’ holdings in the sector hit their 52-week highs this week: Straumann, a Swiss manufacturer of dental implants, and Krka, a Slovenian pharmaceutical manufacturer.
Weaknesses
- Turkey was a major underperformer this week, as the local Istanbul market declined 3.6 percent following the news of a rebel takeover of the city of Mosul in northern Iraq. Turkey has close dealings with the Kurds, who have recently declared commercial production out of their oil fields in northern Iraq, which have been assumed to be at risk by the current internal Iraqi conflict. The Kurds, however, stand to win politically from the current conflict as the West may increase support for their independence from Iraq to protect strategic oil production from the rebels.
- Dubai construction and property developers slumped as the United Arab Emirates Central Bank stated the country’s real estate market may be overheating. Average rental yields in Dubai and Abu Dhabi have fallen below historical averages as real estate prices rose, indicating market imbalances, according to the Central Bank. Property and construction companies have led an equities rally in Dubai, where the benchmark index has increased more than threefold since the start of last year, data compiled by Bloomberg show.
- Telecom services were the worst-performing sector in emerging markets this week, driven by Thai wireless carrier Advanced Info Service on fears of potentially intensifying industry competition after China Mobile announced a bid to acquire an 18 percent stake in another Thai-integrated carrier, True Corporation.
Opportunities
- The three German luxury car brands—BMW, Mercedes and Audi—have become ever more dominant as emerging markets growth has expanded global demand for premium cars, according to a recent article in The Economist. Together, the German trio now controls 70 percent of the market for fast, expensive and luxurious cars. The implications for Emerging Europe are direct, as German luxury car factories across these nations have taken over a large portion of the production and distribution for these manufacturers.
- The official start of the quadrennial FIFA World Cup may remind investors of further monetization potential from leading providers of the Internet, desktop and mobile, all the way from advertising, shopping and socializing to entertainment, as Chinese consumers spend even more time on the web than their peers in major developed countries thanks to the proliferation of mobile devices. Indeed, China’s mobile internet users reached 838 million as of January, or about 62 percent of the country’s total population.
- Cash deposited overnight with the ECB plunged to the lowest level since 2011 as a negative interest rate took effect, reports Bloomberg. Commerzbank, Germany’s second-biggest bank, was the first to publicly state it will no longer deposit surplus cash at the ECB. The measure is expected to result in banks offering additional lending to companies and households in an effort to fight declining inflation and spur much needed growth.
Threats
- Indian stocks dropped the most in four months on concerns that rising oil prices will spur inflation and widen the nation’s trade deficit. The rupee weakened to a four-week low and bonds declined. Bloomberg reports higher fuel costs may stoke inflation as the country buys about 80 percent of its crude from abroad. Higher inflation would undermine Prime Minister Narendra Modi’s efforts to curb consumer prices and revive economic growth from near the weakest level in a decade.
- China’s new home sales declined 10.6 percent year over year in May, and new home starts dropped 18.6 percent year-over-year in January through May. Deteriorating sentiment toward Chinese residential property oversupply in lower-tier cities, coupled with a peak in the maturity of wealth management products in the second half of this year, only add to volatility of property developer stocks in the near term.
- Estonian first-quarter GDP turned negative, highlighting the rippling effects of the Ukrainian crisis in Eastern Europe. Estonia’s transport industry, a key contributor to the Baltic economy, has been harmed by Russia’s conflict with Ukraine. Cargo volumes, mostly oil product shipments originating in Russia, have declined drastically. The Baltic nations are especially vulnerable to Russian trade with Europe, which threatens to continue its decline following the Western-imposed sanctions.
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