Sprott’s Top-10 Reasons Gold May Shape Up For A Surprisingly Strong Performance In 2016 by Sprott Asset Management
December 2015 produced little movement in prominent asset classes. In this tepid environment, spot gold was virtually flat, declining three-tenths-of-one-percent to $1,061.42 per ounce. While December’s small increments of change seem to imply relative stability in market fundamentals, we would suggest that a confluence of underlying developments have actually increased probabilities for elevated market volatility in early 2016, especially in precious-metal markets.
After posting annual increases in U.S. dollar terms for 12 consecutive years through 2012, spot gold (measured in dollars) has now declined for three straight years. As investors look forward to 2016, the relevance of gold as a portfolio diversifying asset is facing legitimate debate. Do declines of the past three years represent logical correction of prior strength, or a signal that gold’s bull market since 2000 has indeed reached conclusion. In this report, we review our three suggested litmus tests in assessing gold’s ongoing portfolio relevance, and then present our “top-ten” reasons gold may be shaping up for a surprisingly strong performance in 2016.
- We would suggest the most powerful litmus test for gold’s ongoing relevance is an assessment of whether the U.S. financial system could endure normalization of interest rate structures. Should the Fed raise fed funds to 3%-to-4%, or should 10-year Treasury yields trade back to 6%-to-8%, without significant negative impact to the U.S. financial system, we would concede constructive progress might have been achieved in rebalancing U.S. financial markets. We would assess current probabilities for either of these developments as somewhat remote. In such an environment, gold remains a productive portfolio asset.
- We believe gold will remain a productive portfolio-diversifying asset until the process of debt rationalization is allowed to proceed in the United States. Since 2000, the Fed has now interceded to forestall this rebalancing process on three prominent occasions. To us, normalization of the relationship between claims on future output and productive output itself will eventually return ratios such as debt-to-GDP and HHNW-to-GDP to historically sustainable levels, say below 200% and 350% respectively. Because prevailing GDP levels would imply (respectively) $20 trillion and $30 trillion in either debt defaults or depreciation of financial asset prices, we suspect the Fed will do everything in its power to postpone this rebalancing. Given implications for declining intrinsic value of U.S. financial assets, as well as ongoing Fed efforts to debase outstanding obligations, gold remains a productive portfolio asset.
- Should the U.S. economy resume a GDP growth rate between 3%-to-4%, with a net national savings rate in the 8%-to-10% range (now roughly 1%), there would no longer be a need for the $2.0 trillion-or-so in annual U.S. nonfinancial credit growth now necessary to service outstanding debt and drive consumption. In such an environment, gold would hold limited investment utility.
In short, we would suggest litmus tests for gold’s ongoing relevance continue to register strong positive readings. However, given gold’s weak performance for now three years running, are there any fundamental factors which might lend urgency to a portfolio commitment to gold at the current juncture? We have collected for quick consideration our “top-10” reasons that the performance of gold is likely to surprise in the coming year. We will utilize this framework of salient fundamentals to assess gold’s prospects throughout 2016 and look forward to continuing the gold conversation with all Sprott clients.
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1.) U.S. Dollar is a Crowded Trade
U.S. dollar sentiment among western investors has become close to unanimously bullish. The Bernstein Daily Sentiment Index for the U.S. dollar registered a 90% bullish reading on 1/5/15. MacroMavens reminds us in Figure 1, below, that combined net speculative longs for the euro, yen and pound have almost regained their January 2015 all-time high. Somewhat counter-intuitively, examination of Fed tightening cycles since 1986 reveals that, without exception, the date of first rate-hike marked an effective six-month peak in dollar strength. Figure 2, below, demonstrates that average troughs for the trade-weighted dollar index during the six months following “liftoff” measured 5% to 10% declines. We would suggest global trends including central bank F/X liquidation and declining importance of the petrodollar float help to explain why the DXY dollar index has now stalled four times since this past March in rallies toward par.
2.) Foreign Demand for U.S. Treasuries is Declining
Foreign demand for Treasuries has collapsed in recent quarters, despite persistently wide spread-premiums to competing global sovereigns. During the past twelve months, net foreign Treasury demand fell below zero for the first time since 2001 (Figure 3, below). Perhaps more ominously, net transactions by foreign central banks during the same span amounted to an outright sale of $203 billion (Figure 4, below), the worst 12-month sum in the history of this series (initiated 1978). The PBOC reported 1/7/16 that Chinese F/X reserves fell by $107.92 billion in December, the biggest monthly drop on record. During 2015, China’s F/X reserves fell by $512.66 billion, the largest annual decline on record. With global F/X reserves having doubled to $12 trillion during seven years of Fed QE programs, we expect dollar-denominated reserve assets to endure consistent pressure during the next few years as foreign central banks draw down F/X reserves in an effort to offset reversing capital flows.
3.) U.S. Recessionary Warnings are Flashing
Growing numbers of economic indicators in the United States are beginning to flash red. The Cass Freight Index, Association of American Railroads carload and intermodal statistics, and orders for trucks and rail cars have all experienced sharp declines in recent months, traditionally reliable recessionary indicators. Recent readings for industrial production, construction spending, factory orders, retail sales, housing starts and existing home sales have disappointed consensus. The Atlanta Fed’s GDP Now forecast for Q4 GDP now stands at 0.8% (1/8/16). As shown in Figure 5, below, the ISM Manufacturing Index has declined to contractionary levels during the past two months, matching the lowest levels since June 2009. While weakness in the ISM Manufacturing Index is frequently dismissed due to the limited contribution of manufacturing to U.S. GDP calculations, we would point out that all ten of the past ten instances of a rapid PMI decline in the context of flat U.S. equity markets correctly identified recessions, with zero false signals. As MacroMavens points out in Figure 6, below, the largest inventory build of the past 50 years is just beginning to unwind, and will burden GDP significantly in coming quarters. Even more ominous, rising revolving credit during periods of decelerating retail sales has generally been a reliable recessionary indicator. As shown in Figure 7, below, the slopes of the current divergence between revolving credit and retail sales are startling. And finally, even credit-fueled car sales appear to have hit a wall this past week.
4.) U.S. Credit Cycle is Turning
Valuations of high-yield debt and leveraged bank loans have been deteriorating since this past summer. At year-end, $482 billion worth of U.S. corporate bonds traded at distressed levels (yielding 10% or more). Contrary to consensus views, rising credit stress is not contained within energy sectors, but is actually spread over the entire continuum of industries. As shown in Figure 8, below, the majority of economic sectors have experienced during the past year a more than doubling of the percentage of bonds trading at distressed ratios. One of the byproducts of Fed liquidity programs has been abnormally low corporate default rates. Credit Suisse suggests in Figure 9, below, that the soaring percentage of North American companies operating in the red is likely to boost default rates significantly in coming quarters. Prominent short-term liquidity measures are also flashing stress readings—junk spreads, TED spreads and LIBOR OIS spreads are all trading at four-year wides.
5.) U.S. Equity Markets are Richly Valued and Breadth is Thin
By many prominent measures, U.S. equity markets are historically overvalued. Figure 10, below, depicts the current status of the venerable Buffett indicator—the ratio of U.S. corporate equities to GDP. After hitting a high of 129.8% in 2015 (87% above the 65-year historical mean of 69.5%), the ratio has now dropped swiftly to 114.4%. From such rarified heights, the two prior corrections since 2000 have returned this measure all the way to mean levels. The S&P 500 CAPE ratio (cyclically adjusted price earnings ratio during the past 10 years) now sits at 25.5. During the past 135 years (Figure 11, below), the CAPE ratio has only been higher on three occasions: 1929, 2000 and 2007. By the same token, breadth measures are registering strong warning signs. Amid these doubly strained market conditions, U.S. equity averages posted this past week their worst performances in an opening calendar week in history.
6.) Gold Complex Experiencing Bullish Divergences
Since the onset of gold’s bull market in 2001, the interplay between spot gold, gold equities and broad U.S. equity averages has proved volatile. As demonstrated in Figure 12, below, the cumulative advance of the S&P 500 (dividends reinvested) totaled 107.56% during the past fifteen years, virtually identical to the 106.24% increase in the GDM Gold Mining Index during the same span (w/dividends). Spot gold has outperformed both equity indices handily, increasing 286.19%. Throughout the past decade-and-a-half, gold equites have generally performed well during years in which spot gold has posted double-digit gains and the S&P 500 has stalled. At seminal inflexion points along the way, gold equities have traditionally proved to be an effective harbinger for spot gold’s future prospects. During the past three months, important technical indicators in the gold complex are signaling the most important divergence of the past 15 years. Since late-November, spot gold has set three separate closing 52-week lows unconfirmed by all broad gold equity averages (GDX, GDXJ, XAU, HUI), a development which has not transpired since 2001. Should this emerging divergence hold, especially now that spot gold has regained the $1,100 per ounce level, a new leg of appreciation for gold equities may have begun. Prior cycles have proved explosive.
7.) Physical Markets for Gold Establishing Durable Price Floor
During the past twelve months, offtake in the world’s leading physical markets for gold has been exceptionally strong. The Shanghai Gold Exchange, which has eclipsed the London Bullion Market Association as the world’s leading physical gold marketplace, reported 2015 physical withdrawals of 2,596.4 tonnes, a new annual record which equates to 80% of 2015 global mine production. Figures 14 and 15, below, outline monthly and annual physical offtake statics at the Shanghai Exchange. Roughly speaking, Shanghai withdrawals are composed of the aggregate total of Chinese imports, scrap recovery and domestic production, representing the broadest approximation of non-central bank Chinese offtake. Similarly, official Indian imports for 2015 are on course to exceed 1,000 tonnes, an 11% increase over 2014 levels (not including smuggling totals estimated in the hundreds of tonnes). Given prospects for extended volatility in both the yuan and rupee, we expect voracious domestic gold demand in China and India to set a durable price floor in future periods.
8.) Gold Price Should Reflect Bloated Fed Balance Sheet and Federal Debt Levels in 2016
Between 2009 and 2013, as shown in Figure 16, below, spot gold was closely correlated to growth in the Fed’s balance sheet. Between 2000 and 2013, as shown in Figure 17, below, spot gold was closely correlated to growth in U.S. Federal debt levels and limits. We have always regarded the gaping divergence since 2013 between these two series and spot gold prices as a great mystery. Nonetheless, we expect these traditional correlations to revert toward longstanding means. Because we expect the Fed’s balance sheet and the U.S. federal debt limit to prove “sticky downward” in future periods, prospects for reversion strongly favor higher gold prices.
9.) Gold is Diverging Positively from the Commodity Pack
During the second half of 2015, amid an accelerating slump in commodity indices, the relative performance of spot gold separated from the commodity pack. To us, gold’s positive separation from commodity indices is always noteworthy for two reasons. First, positive separation signals gold’s monetary characteristics are being increasingly coveted by the marketplace. We have never been enamored with gold’s commodity fundamentals – only the monetary characteristics justify portfolio allocation. Second, given the commodity-intensive nature of gold-mining, gold’s positive separation from the commodity complex can signal that earnings prospects for gold miners are set to improve. In Figure 18, below, we plot the ratio of spot gold versus the S&P Base Metals Index (as a proxy for miners’ input costs). The commodity collapse during the second-half of 2008, in a year in which spot gold posted a positive annual return of 5.78%, produced the huge surge in the middle of this graph. Few will recall that this surge initiated a three-year period (2008-2011) during which reported annual earnings for the entire XAU Index compounded at a 40.07% rate. While it is obviously too early to project where gold’s current divergence from commodity averages will lead, it is interesting to note that gold’s traditional role as purchasing power protector remains in full swing. As shown in Figure 19, below, the ratio of spot gold to Bloomberg’s comprehensive commodity index is breaking out to all-time highs.
10.) Extended CFTC Positioning Bodes Well for Short-term Gold Prices
Positioning of western commodity traders can exert short-term influence on commodity price-trends. In gold markets, commercial participants (jewelry manufacturers and bullion banks) are traditionally net short and speculators (hedge funds and money managers) are traditionally net long. Commercial participants in gold markets generally exhibit higher “threshold for pain” in short-term price movements because jewelry manufacturers are hedging existing inventories and bullion banks represent central banks and gold mining companies (with theoretically unlimited access to inventory). It is therefore significant that in recent weeks, commercial participants have reduced net short positions to the lowest levels in 14 years. Figure 20, below, highlights weekly CFTC positioning in gold markets since 2014 (light purple specs, dark purple commercials). Figure 21, below, depicts net commercial short positioning since 1999. Suffice it to say, when jewelry manufacturers and agents for central banks see little downside, gold prices are generally set to rally significantly.
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