The number of comparisons between the current market conditions and the 2008 financial crisis continues to rise, but one expert has pointed out some big differences. One key point is the lack of a gold bubble this time, as momentum investors have not yet been drawn to the metal.
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Will gold keep rising or take a hit?
Daniel Oliver of Myrmikan Capital noted in his March update that the volatility in gold stocks and the rest of the stock market hasn't been this high since the 2008 financial crisis. He said the standard deviation in returns for the VanEch Jr Gold Miners ETF since inception was 2.8%. However, for the 18 days leading up to March 12, it was 5.3%. Since then, the volatility has continued, with the ETF falling 10% on Friday and another 8% in premarket trading this morning.
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He added that there has been talk about whether gold and gold stocks would be hit when the credit bubble pops like they were in 2008 or whether the Federal Reserve would print so much money to prevent the next crash that gold would "run without dipping." Although gold and gold stocks have been plunging lately, he argued that the answer to that question is still unclear.
What will happen to gold when the credit bubble pops?
Oliver pointed out that on one hand, it doesn't seem like things should be different this time around. He noted that the credit bubble was formed by banks issuing credit in dollar terms. When all that debt is called in at the same time, a major short squeeze on dollars erupts. He said the monetary base sits at around $3.4 trillion, but about $90 trillion is owed around the globe.
"When the debts become due, everyone dumps whatever assets they can to raise currency to ward off default and foreclosure, which includes gold and gold stocks," he explained.
However, there are some differences between now and then that suggest gold could run with very little interruption when the credit bubble pops, unlike in 2008. For example, he said the gold price participated in the bubble between 2001 and 2008, quadrupling from about $250 to $1,000 an ounce. However, he said the gold price remains about $300 per ounce below its peak in 2013.
He added that the tremendous increase in the gold price back then attracted momentum investors. Then when those investors received margin calls and redemptions, they had to unload their positions at any price, no matter what the value. As a result, many junior gold mining companies plummeted 90% or more. Some fell all the way to half a penny on the Toronto Stock Exchange.
In the current credit bubble, "managed money" has been largely short gold, according to Oliver. He also said there is virtually no generalist capital in gold mining stocks, especially not in the junior section.
The Fed can be more reactive now
He also said that in 2008, the Fed didn't learn that major banks were teetering on the edge until The Wall Street Journal reported on it. However, he believes the central bank now keeps "moles inside the big banks to stay ahead of the information curve." Thus, he argues that a deflationary debt collapse is less likely now.
Oliver also noted that the debt markets have undergone structural chances since the financial crisis, offering other ways for the Fed to be more "proactive" to situations. Banks once issued debt directly and then securitized their debt products. Then "when the music stopped, they were stuck with an inventory of toxic loans." Today non-bank lenders originate much of their debt with credit borrowed from money center banks, which protects banks from first losses.
Additionally, the Fed can watch funding conditions through the repot market and learn about credit issues before big banks can fail. He noted that funding issues arose in September, and the Fed was quick to offer "temporary" liquidity programs through the repot market. The Fed beat back market forces that "attacked" the credit bubble, which made it seem like "nominal prices were safe no matter how much overcapacity the market was enticed to construct due to the artificially low rates," he added.
"Gold investors were left wondering when inflation would finally rise to cause a decline in asset values in real terms (i.e. stable asset prices and a rising gold price, the 1970s stagflation)," he wrote.
How COVID-19 is attacking the credit bubble
Oliver explained that while 2001 to 2008 was a housing bubble, 2010 to 2020 has been a corporate debt bubble. He said the coronavirus caused supply chains to grind to a halt in China as many workers were placed under a travel ban after they had traveled away from their home and work for the Chinese New Year. Factories remained shut down after the holiday ended. Even those that didn't remain shut down were impacted by COVID-19 due to shortages of components made on other supply lines that were still shut down.
"Lose access to one component, no matter how cheap its price, and production stops," he wrote. "Just-in-time inventory systems make production chains brittle."
This has a ripple effect on companies with a lot of debt. Corporations have been taking on debt to buy back shares, increasing their earnings per share to "juice" their stock prices and the value of stock options for management. Between 2011 and 2016, $3.7 trillion in share repurchases were conducted, amounting to 91% of net income during that period. Forty-six percent of companies deployed more than 100% of their net income into buybacks and dividends.
All that additional leverage makes companies' capital structure brittle as well. Thus, when their supply chains are interrupted, so are their cash flows.
"Frozen supply chains and collapsing sales (and cash flow) is [sic] why the stock market has fallen so far so fast in the wake of the Wuhan virus and likely has a lot further to go," Oliver said.
Why printing money won't help this time
He believes the Fed's policies of virtually printing money won't work this time around.
"The normal transmission route from Fed printing to higher asset prices is that Fed liquidity provides banks with more reserves, upon which they create credit, to lend money to businesses, which construct new assets/collateral," he explained. "Companies demand components and labor to build their new projects, driving raw materials and labor prices higher, a sugar-high of activity. Only later does overcapacity reduce cashflows, which brings about economic distress."
Since COVID-19 froze supply chains, he believes businesses won't be able to borrow more no matter how low interest rates go. The result is that fiscal stimulus is the Fed's only remaining tool, although the federal deficit is already more than $1 trillion per year. Any stimulus will only increase that deficit.
As a result, he believes the next round of quantitative easing will be different from past rounds. He argues that instead of adding reserves for banks to create more credit, which was negative for gold, the Fed will have to create new money to pay for current expenditures.
"It is sheer debasement, it is the helicopter, and gold should fly when it takes off," he wrote.
Why gold stocks will move higher when the credit bubble pops
Oliver said gold stocks are trading "in sympathy with" the rest of the markets. He added that the gold price climbed $4 per ounce while oil prices plunged 25% on March 9. That means good things for the gold mining industries because revenues are climbing while costs are falling.
However, as the S&P 500 plunged, so the HUI Gold Bugs Index also fell. The next day, the gold price fell $30 per ounce while oil climbed 10.4%. Meanwhile, the S&P rose 4.9%, while the HUI climbed 0.4%.
He predicts that gold stocks will continue trading in line with the broader markets in the short term, but eventually, he expects them to rise as "liquidity determines prices in bubble markets" and "discounted cash flows determine value in a depression.
He believes that as the credit bubble slowly pops, the gold price in terms of oil and other mining input costs will keep rising, taking mining margins and cash flow along with it.
"There is no better environment for gold miners," he wrote.