Gold: The Barbarian Is Back

by: Sami J. Karam
 
 
Summary
 
- Gold has risen nearly 20% in six months.

- The usual reasons do not explain the recovery.

- Trust in institutions may play an important role.

 
Last fall, around the time we updated our comment on the ratio of gold to the S&P 500, the price of gold (GLD, IAU) fell to a six-year low of $1,049 per ounce, representing a decline of 45% from the September 2011 peak of $1,895. As is customary near the end of each year since 2011, there were at the time several bearish analyses, assuring us in this case that the next level would be below $1,000. But gold was recently near $1,300, having risen over 15% since January 1st.
 
None of this is reason for cheer except among the sort of people who, self-sidelined in a bull market, like to sit around pontificating about everything that is wrong with the world while waiting for the economy to run into one of its periodic crises. In the universe of worthy holdings, gold is the unwashed barbarian who starts to have a good time when all others enter a depressive funk.
 
 
As a barometer of something gone wrong, the price of gold deserves some scrutiny. Why is it up nearly 20% in five months?
 
Usual Reasons
 
The usual suspects among plausible explanations are fear of inflation, a weak dollar, negative real rates and a rising budget deficit.
 
Taking each in turn, the risk of inflation does not appear greater now than it did last December. If you judge by recent decades, fear of inflation is very unsatisfying as an explanation for gold price movements. Inflation was a good reason for the rise in gold in the 1970s and early 1980s. But it is difficult to discern how inflation or fear of inflation pushed the price of gold from under $300 to $1900 between 1999 and 2011 when in fact, inflation was no higher in the 2000s than it was in the 1990s. It does not seem plausible that gold was bid up year after year because of inflation fears while there was little sign of actual inflation.
It is true that the dollar has weakened against the euro and yen since the beginning of 2016, but it strengthened more in 2014 with no corresponding weakness in the price of gold. In recent history, the correlation of gold and the dollar has had a patchy record. The dollar index (DXY) was at the same level in April 2008 and April 2011, but the price of gold doubled in those three years. The dollar strengthened against the euro from 1999 to 2002, then weakened from 2002 to 2008, then strengthened again from 2008 to 2011. Yet, in all of these periods, the price of gold rose, whether the dollar was rising or falling.
 
Real rates are still negative as they have been for years, the same years in which gold rose and fell. Here too, the correlation with gold did not work for long periods before 2005 and after 2011. Real rates continued to fall in 2012 and well into 2013 long after gold started its decline.
 
After its surge to top a trillion dollars during the financial crisis, the Federal budget deficit has fallen and is now around $500 billion, a level it is expected to retain for several years before starting to climb again in 2020 and beyond. Given the current forecasts for stable 2016-18 deficits, we cannot attribute the recent recovery in gold to the budget deficit.
 
So is this another false recovery? Absent an explanation from the above factors, will gold retrace its gains back down towards $1,000? Not necessarily. In addition to the measurable factors already mentioned, there are some more nebulous drivers.
 
Question of Trust
 
One of these drivers is trust in the strength of institutions. The idea here is that gold will rise if trust in institutions of government or of business is eroding.
 
In the 1970s, there were the end of the Vietnam War, Watergate, high inflation, the oil shocks, recession, malaise, and the Iran hostage crisis. Trust in effective government was not as strong as it had been in earlier decades and gold rose from $35 in 1970 to $512 by the end of 1979. It spiked to $850 in January 1980.
But then things turned around and trust entered a big bull market in the 1980s and 1990s. In the 1980s, the government beat inflation and won the Cold War while the economy and stock market boomed. And in the 1990s, it fixed a real estate bust, managed a quick victory in the first Gulf War, handled a recession, ended the war in Yugoslavia and balanced the budget deficit while the US emerged as the world's sole superpower and the economy continued to boom. In 1999-2000, the Nasdaq bubble crowned in euphoria what had been the American Century. On the back of these successes, gold had collapsed from a high of $850 in 1980 to a low of $253 in July 1999.
 
But then things turned again. The End of History proved more elusive. In the late 1990s, the bailout of LTCM and the repeal of parts of Glass Steagall seeded future crises. In 2000, the outcome of the presidential election was in dispute for several weeks. In 2000-02, the market crashed and former high fliers Enron, WorldCom and others went bankrupt. In 2001, it was the horror of 9/11.
 
Then the Afghan and Iraqi wars, and the financial crisis, bailouts and multiple rounds of Quantitative Easing. Abroad, there were questions about not found weapons of mass destruction, and at home, there were charges of rising cronyism. Trust took a hit and was in a bear market for over a decade. As if on cue, gold soared from below $300 to $1,900 in twelve years, massively outperforming the stock market.
 
The year 2011 saw the beginning of the end of the financial crisis, at least in its most immediate worrisome form, and the withdrawal of the last US forces from Iraq. Both of these events bolstered trust in the effectiveness of the Fed and of the US military and gold started its multi-year decline in September. In 2013-14, the US stock market jumped 50% (incl. dividends) and gold plunged 27%.
 
Some measure of doubt returned in 2014 when ISIS declared its Caliphate straddling Syria and Iraq.
 
War also came to Ukraine, damaging the West's relationship with Russia. Adding to the new anxiety, the mass movement of migrants from the Middle East, Central Asia and Africa into Europe accelerated in 2014 and 2015. Meanwhile, the slowdown in China and crash in commodity prices damaged emerging market economies.
Today in the US, both political parties are close to nominating candidates with high negative ratings.
 
The rise of unconventional candidates like Sanders and Trump certainly underscores the feeling among many voters that all is not well with the country. GDP growth remains sluggish while education and healthcare costs continue to spiral out of control. In many cities, the price of real estate is beyond the reach of most middle-class families. Recent terror attacks in the West have further eroded trust in the future course of events.
 
This reversal in trust goes a long way to explaining the incipient recovery in the price of gold.
 
Of course, there may be other factors at play such as jewelry buying in China and India or the return of some central banks to the gold market. However, whether gold continues to rise from here or whether it rolls over again depends on answers to the following questions:
  • What actions will the next US President and Congress take to restore trust?
  • Will GDP growth improve in the US and other developed countries?
  • Will cronyism be beaten back in the US and Europe?
  • Will there be more terror attacks in the West?
  • Will US tensions with Russia and China subside?
  • Will the war in Syria reach a settlement? Will ISIS be defeated?
  • Will the wave of migrants into Europe continue and how will it be handled?
  • Will China continue to deliver 6-7% GDP growth?
Depending on your sense as to the answers, you could target gold at $1,700 or $800.

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