Commodity Trade Mantra

Fundamentals in place for Gold with Fed Tightening amid Unjustified Stock Market Valuations

Fundamentals in place for Gold with Fed Tightening amid Unjustified Stock Market Valuations

Weak US dollar, economic and political stability support gold price recovery

The gold price changed very little in May, recovering towards the end of the month after early weakness brought on by the French presidential election and the FOMC (Federal Open Market Committee) meeting. From the first round of the French elections on 23 April to the final round on 7 May, markets became increasingly convinced that the pro-EU candidate Emmanuel Macron would win the election. This pressured gold as the risk of a Marine Le Pen-led Eurozone break-up lessened.

On 3 May, comments by the Federal Reserve (Fed) following its May FOMC meeting convinced the market that a rate increase following the 13 June meeting would be likely. Gold hit its low for the month on 9 May at $1,214 per ounce, but was able to regain lost ground to end the month up $0.65 (0.05%) at $1,268.94 per ounce. Weakness in the US dollar also added support for gold prices during the month. The US Dollar Index (DXY) fell 2.1% in May and appears to have entered a bearish downtrend since reaching multi-year highs in early January. Economies in Europe and Japan have stabilized recently and the Trump administration has indicated a desire for a weaker US dollar. Gold should benefit if the US dollar trend seen so far in 2017 continues.

Asian physical gold demand appears strong in 2017

Physical gold demand from India and China has also been supportive of gold prices. We believe healthy demand in March and April along with anecdotal comments from analysts suggest that 2017 is shaping up to be a much better year for gold in Asia. Last year’s liquidity squeeze caused by the currency transformation in India seems to have dissipated and people are again making gold purchases. In China, bond market turbulence associated with government efforts to rein in debt and speculation have spurred investment demand for gold.

Juniors and mid-tiers underperform but not based on fundamentals

Chart patterns for the gold equity indices mimicked gold bullion in May. The NYSE Arca Gold Miners Index gained 1.07%, while the MVIS Global Junior Gold Miners Index fell 3.66%. The juniors and some mid-tier gold miners have underperformed the larger producers over the past two months with no significant change in gold bullion prices. We find no fundamental reason for the underperformance, and therefore expect some mean reversion to favour the juniors in the second half of the year.

Is US equity market bubble set to burst?

Following the November presidential election the “reflation” or “Trump” trade took the markets by storm. Presumably, the belief was that pro-growth policies would ignite animal spirits in the markets that would stimulate business and prosperity. As President Trump has struggled to implement policies and his administration has been dogged by controversy, the Trump trade has unwound. Metals such as copper and iron-ore have given up much, if not all, of their post-election price gains. Gold has rebounded from its post-election losses. Interest rates have subsided and the DXY has fallen to pre-election levels. The one asset class that appears to still believe in the reflation trade is US equities. As we write, the S&P 500 Index has reached new, all-time highs. In the past year, the likes of Apple and Tesla have posted gains of more than 50%. A chart of NYSE margin debt is worth a thousand words.

NYSE margin debt continues to grow, reaches record high in April

VanEck Gold ETFs

Notice the peaks at the tops of the tech (2000) and housing bubbles (2007) compared with current levels. Each of these bubbles was accompanied by strong 3% to 4% economic growth and each was preceded by a Fed tightening cycle. While the current stock market does not have the same feeling of mania seen before the tech bust, in the context of an economy that struggles to achieve 2% growth, we struggle to justify current stock market valuations – and the Fed is tightening. At the other end of the spectrum are gold stocks, fresh off of the worst bear market in their history from 2011 to 2015. A chart in our April update showed gold stock valuations below long term averages. Secular market tops and bottoms are notoriously difficult to predict, however, we believe the signs are there to make such a prediction for S&P stocks and gold stocks respectively.

Industry’s current growth strategy reflected in corporate activity level

Acquisition activity has been subdued in the sector, while strategic positioning has become a frequent occurrence. In some cases, two producers have taken a strategic stake in the same junior developer. Not all gold properties become profitable mines and not all producers will have the same success that Eldorado has had with Integra. Gold production is no longer growing globally and many companies will face declining production in the years to come. To offset this, once the current phase of strategic positioning has run its course, we believe there will be another robust M&A cycle, possibly beginning in 2018. – VanEck

 

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