GOLD MARKET
Investors were focused on emerging markets during January; growth concerns in China, scandals in Turkey and political unrest in Ukraine and Thailand. There was also concern about the impact of the US Federal Reserve’s actions on emerging markets. Over the past several years emerging markets have benefitted from easy money and ultra-low interest rates set by the Fed, with cash flowing out of the US in search of higher yields. Now, with the Fed’s first step to unwind its accommodative policies by “tapering” its bond purchases, the flow of money is beginning to reverse course. This potentially causes countries that are vulnerable to financial and/or political instability to have problems. As a result, stock markets plunged globally, as did many emerging market currencies. The complacency towards risk we saw in 2013 has begun to dissipate, as safe haven investments gained in January. Treasuries rallied and the dollar strengthened. Gold was up USD 38.90 or 3.2% to close January at USD 1244.55.
Gold stocks began the new year with handsome gains. The NYSE Arca Gold Miners Index was up 10.8%, while the Market Vectors Junior Gold Miners Index advanced 14.8%. There were several reasons for the strong performance. First was the safe-haven bid mentioned above. Second was a rebound from oversold levels in December, when year-end selling pounded the sector to multi-year lows. Lastly there was significant acquisition activity. Canadian major Goldcorp launched a hostile offer for fellow Canadian mid-tier Osisko Mining. The prize is Osisko’s world-class Canadian Malartic mine in Quebec. Malartic is a new operation that started producing in 2012. The mine is hitting its stride after several start-up problems caused it to underperform in its first year. It has been over a decade since we have seen a hostile offer on this scale in the gold sector. Goldcorp is taking advantage of depressed valuations in a bear market, which we believe is a great way to create value in the long-term. Osisko has declared the 15% premium Goldcorp has offered as inadequate. Investors are waiting to see if Osisko can attract a competing bid or whether Goldcorp is willing to pay more to win-over Osisko shareholders. The action caused othermid-tier and small-cap stocks to perk up in January.
OUTLOOK
In our view, the gold price is in the process of forming a base and the longer it remains above USD 1200, the stronger the base becomes. Net redemptions in gold bullion exchange traded products (ETP’s) continued into January, but stopped around mid-month for the first time since September. This should help gold stabilize, however, if net redemptions resume, then the risk of lower gold prices would rise.
Several other factors are likely to affect gold in the first half of the year. Economic data has been mixed lately, with positive GDP growth offset by weak data on payrolls and manufacturing. With Janet Yellen swearing in as Fed Chairman, the gold market will likely be sensitive to her first actions or statements. Gold could receive a boost if there are hints of further monetary accommodation. It could find further support as a safe haven if recent turbulence in emerging markets continues or worsens. Finally, we will see if strong demand for physical gold continues from China now that the Lunar New Year has passed. This demand has been critical in absorbing the heavy redemptions from the gold bullion ETP’s.
To gain a longer-term perspective on the gold market, we look at similar situations in past markets. There are two scenarios that remind us of the present. The first was the severe correction in the secular bull market of the seventies in which gold fell 43% from January 1975 to August 1976. In August 1976 Time Magazine published an article titled: “The Great Gold Bust.” Comments on gold in the New York Times in 1976 include:
“The fear that dominated two years ago has largely vanished, replaced by a (stock market) recovery that has turned the gold speculators’ dream into a nightmare” and “The most recent advisory from a leading Wall Street firm suggests that the price will continue to drift downward, and may ultimately settle 40% below current levels”. We now know that monetary policies did not change in the seventies, inflation was not dead, and 1975 - 1976 turned out to be a cyclical bear market. Gold rose to new heights over the next three years. In the current correction from September 2011 to June 2013, gold fell 36%. Similar comments are common in today’s press, for example UBS Global Research on 13 January said “Gold bulls are in a lonely place – after a disastrous 2013, few investors are willing to trust gold at this stage.” It paid to be a contrarian in 1976, will it again pay off in 2014?
The second scenario of interest is from September 1980 to June 1982 when gold fell 56%, marking the beginning of a secular bear market that lasted until 2001. For this we go to the Van Eck archives to see what our predecessors were thinking at the onset of a very long bear market. Quotes from gold fund reports published in 1981 and 1982 include:
- “If the Reagan program and the Fed’s monetary policies don’t show favorable results soon, the pendulum will swing back the other way and the demand for expansionary policies may prevail”
- “Management anticipates that the US Federal Reserve eventually will increase the rate of monetary expansion in this country during 1982 due to political pressures, rising bankruptcies and the requirements of the Full Employment Act of 1946. This upward cycle will be accompanied by a resurgence in inflationary expectations and commodity prices, including precious metal prices.”
It is clear that the fund management industry expected the gold bull market to resume based on experience with past fiscal and monetary policies. What they did not anticipate was the resolve and leadership of Ronald Reagan and Paul Volker to “stay the course”, subjecting the economy to considerable pain and suffering with tight monetary policies that ultimately succeeded in stamping out inflation and ushering in an era of prosperity.
We believe the current gold market is akin to the cyclical bear market of 1975 – 1976, not the beginning of the secular bear market in 1982. Why might we be right today, while our predecessors were wrong 32 years ago? First, our outlook is based on the premise that there will be unintended and highly undesirable consequences of the massive printing of money by the Fed to buy debt securities (QE), the prolonging of interest rates that are far below equilibrium, and the ongoing extraordinary build-up of Federal indebtedness. These are not sound monetary or fiscal policies in our view and are likely to bring unwanted inflation in asset prices (bubbles) and/or consumer prices and/or other dislocations in the global financial system.
Secondly, in 1982 inflation was a clear and quantifiable detriment to the economy and leaders could articulate a strategy to deal with it that the public could understand and support. In the case of the current situation, the costs of the monetary policies won’t be known until the Fed has completely unwound its balance sheet and returned interest rates to normal levels. Presently, the Fed is busy devising exit strategies and experimenting with new vehicles like “reverse repo transactions” to offset any ill effects. Our outlook again comes down to a belief that the Fed will not be able to financially engineer a peaceful withdrawal.
Finally, like our predecessors, we believe the government’s past record speaks volumes about how it will behave in the future. US politicians have a long record of approving more spending than the government takes in through taxes. They also have a propensity to avoid hard or unpopular choices that involve cuts in spending or benefits. It is likely, we believe, that debt levels will continue to increase as retirement and medical costs soar with age. Interest charges could then become overwhelming if and when rates normalize.
The recent history of the Fed shows a tendency to promote cycles of easing and excessive credit that generate disruptive episodes of asset price inflation. Since 1997, responses to the Asian financial crisis, the collapse of Long-Term Capital Management, Y2K, and the tech bust have all created over-heated markets that resulted in crashes in tech stocks and housing. In the wake of the most recent financial crisis, former Fed chairman Ben Bernanke doubled-down on accommodative strategies and current chairwoman Janet Yellen is expected to follow in his footsteps. We are afraid the Fed will again maintain policies that are far too easy for far too long.
