First: the facts. Gold prices have been on a tear the past week, with the price of the yellow metal climbing above USD $1240 an ounce, now up an incredible 18% in USD terms since the start of the year. Silver has come along for the ride of late too, currently trading at USD $15.70 an ounce. YTD it is now up 14%, with precious metals comfortably the best performing asset class of the year. 

In Australian dollar terms, the news is even better, with silver now trading above AUD $22 per ounce, whilst gold has just broken through AUD $1750 per ounce, up nearly 25% from the lows of late 2015, and within striking distance of its all time highs. 

In this week's market update, we are going to look below the surface, and ask what the latest movements in the price of gold suggest about the true state of the economy, financial markets, and the nature of money itself.

If we start with a look at the gold charts (taken before yesterday’s surge) we can see just how the market has changed since the start of the year. 

For so long unable to close above that down-trending channel that has capped every attempted gold break out since 2014, the gold price this time smashed through resistance. Volume has picked up too, with gold now above a number of key moving averages. 

Whether or not this proves that the bottom well and truly was made back in December 2015 remains to be seen, though it is increasingly likely that is the case. 

Despite that, a pullback from this rally should not be unexpected, as the last few days have seen the market get ahead of itself somewhat, and we for one are always nervous when we see too many positive articles about gold investment in the financial media, and there has been a noticeable uptick in the number of those lately.

But there is now no question that sentiment towards gold has changed from “why would you own it” to “would you dare short it”, especially amongst the more speculative end of the investment and trading community. That’s important, as speculative positioning was one of the things that capped previous gold rallies between 2013 and 2015, though it also needs to be pointed out that speculative positioning and trading added substantial upside in the 2009-2011 period that saw gold almost touch USD $2000 per ounce, a fact often overlooked by certain segments of the gold community.

In terms of how sentiment has changed, we were particularly interested in a note sent around by UBS this week, which noted that there was now more interest in gold than at any point in the previous two years, and the main buyers of gold were not traditional commodity players, but rather the wider macro community. Most important in that note was the comment that gold was once again being seen as “the final financial market hedge”, a point we will return to later in this missive.

Some employees at JPM clearly agree, with Bob Michele, global CIO and Head, Global Fixed Income, Currency and Commodities telling CNBC overnight that USD $1200 per ounce gold means; “in a flight to quality, in a safe haven, people have more confidence in gold than in bank deposits or paper money.”

So does this mean it’s all upside from here for precious metals? Possibly, and we’re glad to have been adding to our holdings the past few weeks, but it does need to be pointed out that gold has a rich history as a strong performer in ‘risk-off’ markets when equities fall meaningfully, as they are again this quarter.

Between 1972 and 2014, irrespective of whether we are looking at Australian or global markets, gold was the number one performing liquid asset class in the worst 10 calendar quarters for equity markets. Q1 2016 is shaping up as another win for gold in this department, though it does potentially suggest that any bounce in risk assets could see bullion prices ease back.

And in that sense, perhaps nothing has changed, and the recent savaging of bank stocks, commodity producers and risk assets in general really is a ‘buying opportunity’, rather than the beginning of the final, and potentially most damaging down-trend in equity markets whose origin can ultimately be traced back to the busting of the NASDAQ bubble.

If it is the former, and the next round of central bank magic tricks does once again save the stock market (which is apparently the role of central banks according to the image below), then we may have already seen gold’s best returns of the year, with the next few months seeing consolidation and an easing back in bullion prices.

Certainly there is still no official inflationary pressure to speak of, which is typically cited as a necessity for a sustained bullish move in bullion, even though market history comprehensively debunks the notion. 

And with macro data either already weak or rolling over in much of the developed world and China, it’s hard to see this changing meaningfully in 2016, despite the “best efforts” of central banks, who have now thrown QE/QQE/ZIRP/NIRP/TARP/TALF and every other letter of the alphabet at the global economy and her financial markets in this “post” GFC environment.

And in that sense, perhaps everything has changed, because the market appears to be questioning not just the effectiveness of the Fed and other central banks, but just where this road is going?

From benevolent omnipotence to………..

Janet Yellen must be wishing 2016 had never started. After raising interest rates in the lead up to Xmas last year, she must have headed off for her holiday break largely content with her work for 2015.

True equity markets weren’t hugely rewarding, and the US economy certainly didn’t fire on all cylinders, but the unemployment rate declined, and economic data held up well, on a relative basis at least.

Faith in the benevolent omnipotence of the Fed seemed to have hit an all time high too, with the market expecting a full four interest rate hikes this year, with higher stock prices, and an acceleration in the economic “recovery”. 

QE, seen by the market as a largely necessary evil, and a victimless crime, was thought to be a relic of history, at least in the United States. In the boardrooms of central banks and asset managers the world over, a collective sigh of relief must have been breathed. “It worked”, they seemed to genuinely believe. Then this happened!

A savaging of financial markets, banking stocks and almost anything commodity related, with the last week seeing serious question marks raised about the health of German banking giant Deutsche Bank, with credit risk soaring in a way we have not seen since the days of Lehman brothers. 

Indeed so loud are the warning bells ringing that we’ve had German Finance Minister Wolfgang Schauble go on record stating there is nothing to worry about when it comes to Deutsche, which is the kind of public reassurance the chairman of a English premier league football club typically gives a manger, about six days before sacking them.

The volatility has of course not been limited to banking stocks, or contained within Europe, with the Bank of Japan surprising markets in late January with their implementation of negative interest rate policy. 

This move from the BoJ is already a failure, with no noticeable weakening of the YEN. Indeed it has been the USD that has fallen, with the dollar index easing almost uninterrupted for the last two weeks, whilst the Japanese currency is trading at highs last seen in November 2014. 

Bond yields have fallen all over the world too, with the Australian bond market pricing in another rate cut soon, and no meaningful rate hikes until 2026. That is not a misprint. World equity markets are obviously in turmoil, with a Bloomberg article overnight now calling a formal bear market, with the MSCI All World index now down 20% from its May 2015 high.

What is different this time is that rather than being seen as a panacea, and a necessary evil, the actions of central banks are being questioned like never before.

Leo Grohowski (aptly named as no one seems to know how we can grow) the CIO of BNY Mellon Wealth Management summed it up nicely when he stated that, “central bank policies and the uncertainty around their effectiveness is the big macro concern right now.”   

Closer to home, AMP Capital Chief Economist stated that; “The markets are wondering, well, we’ve had these non-conventional monetary policy experiments for the last six or seven years and they haven’t caused a sustainable boost to global growth, so what will the latest moves do. It’s a reasonable question to ask given the events of the last few weeks.”

Questioning the effectiveness of central banks has gone from sacrilege to fashionable in the space of six weeks, with William White, OECD chairman of the economic and development review committee and ex chief economist of the BIS also openly stating the last few years central bank activity has not cured the global economy, and has likely set us up for a bigger fall.

Deutsche Bank even dared suggest that more monetary easing might be counterproductive, with the bank warning the ECB that more European QE could well push equities lower, not higher, though to be fair they blamed expected dollar strength for this, nothing a higher USD was not in anyone’s interest. That is a sentiment we think the Fed shares, not that the recent pullback in the dollar has done anything to assuage equity market investors.

So what happens next? It seems farcical now to think that the Fed really will follow through with the previously expected four interest rate hikes, with Chair Yellen admitting that negative interest rates are on the table in the US, with the Fed “looking at them again” though that is clearly not a base case scenario, at least according to the economic models so favoured by the PHDs at the Fed.

We are also likely to see “QE for the people” with direct stimulus spending by government, financed by central bank money creation. That will “work” in terms of stimulating aggregate demand, though we have no doubt it will still be a net negative, as we are beyond sceptical the money will be productively spent. The town of NOWHERE can expect a few fancy new bridges though.

Finally, and let’s all hope that this never happens, but the calls for a “cashless economy” are only likely to grow. If that happens, we will have well and truly crossed the Rubicon from financial repression to financial tyranny.

Either way, whether it’s more wasteful QE, NIRP, government funded boondoggles or the ultimate ban on cash, more difficult times are on the way, with increasingly desperate central bankers likely to lose further credibility, and make policy mistakes.

Declines in risk assets, and the open questioning of central ban policy suggest the market is increasingly aware of these trends, and is beginning to price it in.

This is why UBS, or their clients, are clearly correct when they’ve identified gold as the “final financial market hedge”. Not only will it protect investor wealth in the face of extreme sell offs in stock and bond markets (a shoe that is yet to drop), but it can’t be debauched or ring-fenced anywhere near as easily as currency can.

Considering the zero return/all risk nature of monetary deposits and many sovereign bonds, is it really so hard to believe that the latest gold rally represents the beginning of a major trend change, with portfolio allocations towards precious metals likely to see prices head much higher in the coming years?

We for one do not think so.

Three charts to finish

Before finishing this week’s market update, we wanted to share three charts that speak volumes about the disconnect between the real economy, financial markets, and money itself. They are:

• The oil to gold ratio
• Gold as a percentage of US financial assets
• The value of sovereign debt trading at negative interest rates

Each and every one of them is interesting and noteworthy in their own right, but it’s only when you put all three together that the troubling picture of how precarious the global economy truly is becomes clear.

Starting with the oil to gold ratio, and as you can see below, our most important energy source and the fuel that drives the global economy has never been cheaper relative to precious metals, with the ratio between the two now a staggering 46:1, a ratio that exceeds the previous peak of 41:1, that was last seen back in 1892.

Gold, relative to oil, is essentially three times the long-term average, which is just 15 times, with the blow out (caused mostly by the oil price crash), in the last two years evident in the chart below. 

The second chart comes from data produced by the World Gold Council, and Tocqueville Asset Management. It shows the value of gold, real money (a fact even central banks realise) as a percentage of US financial assets.

As you can see above, this number is near enough at its all time low, with the value of gold at current prices equal to just 3% of total US financial assets, barely one sixth of the level it was back in the mid 1930’s and early 1980s.

Combined together, we can see that oil, the lifeblood of the global economy has never been cheaper relative to gold, whilst gold has more or less never been cheaper compared to financial assets. 

And this is in a US economy that, despite the headline unemployment rate, is still mired in a quasi-recessionary state, with a dearth of real business investment, earnings goosed by over $2 trillion in stock buy-backs, and poor real wage growth. 

Indeed any balanced observation of the US economy could not help come to the conclusion that central bank stimulus and +$500bn a year federal deficits (remember those – they still count even if no one is paying attention) are the only thing keeping nominal GDP growth alive, even though that growth is not translating through to better living standards for 90% of Americans.

And here we come to our final graph, which shows the dollar value (in trillions) of negative yielding government bonds, which in the last week has gone above USD $7 Trillion, a staggering 29% of the Bloomberg global developed bond sovereign index.

The ‘real’ situation is of course worse, as the chart above makes clear, with a further $15 trillion in bonds yielding either 0-1% or 1-2%. In essence, that is the better part of $22 trillion in capital, wasting away with the ‘guarantee’ of a negative return.

Adding this to the mix, and we have real energy at an all time low compared to real money, real money near an all time low relative to financial assets, and financial assets now trading at negative yields, despite the fact they are in no way honourable in currency of real value.

Looking at this disaster, and that is what this is, we can’t help but think that if free market capitalism was a person, they’d be diagnosed with clinical depression. How can the global economy be so sick, and how can the opportunity for investment be so dire that USD $22 trillion, an entire year of American economic output (with Australia thrown in on top) be willing to accept guaranteed losses, rather than seek productive investment. 

I can think of no greater evidence that the entire “post” GFC experiment with QE, ZIRP, NIRP, and trillions in unproductive government spending has been a more or less complete failure, than the chart we see above. 

What comes next, which even broader market participants are starting to fear, remains to be seen, but is simply not credible to believe that more of the same will eventually work, with investors needing to bunker down and protect wealth in the coming years.  

Incidentally, with gold still priced at ‘only’ USD $1240 an ounce, there is nearly four times more money sitting in negative ‘real’ yielding government bonds than there is invested in the roughly 150,000 tonnes of readily investable gold in the marketplace, which is worth just over USD $6 trillion at today’s prices.

There is tens of trillions more sitting in other financial assets, which remain at the mercy of a weakening global economy and a financial experiment history will almost certainly condemn.

Critics will argue that gold too is unproductive, but it is highly liquid, has zero credit risk, is globally recognisable, and is a thing of beauty to boot.

We have no doubt the ratio between history’s greatest store of wealth, and financial assets underpinned by increasingly questionable currency units will change meaningfully in the years ahead, with bullion the likely winner of that rebalancing process.

As such, until this storm passes, I’ll be holding my existing gold and silver positions, and taking UBS’s advice to buy the dips. 

Until next week

Warm Regards

Jordan Eliseo

Disclaimer

This publication is for educational purposes only and should not be considered either general or personal advice. It does not consider any particular person’s investment objectives, financial situation or needs. Accordingly, no recommendation (expressed or implied) or other information contained in this report should be acted upon without the appropriateness of that information having regard to those factors. You should assess whether or not the information contained herein is appropriate to your individual financial circumstances and goals before making an investment decision, or seek the help the of a licensed financial adviser. Performance is historical, performance may vary, and past performance is not necessarily indicative of future performance. Any prices, quotes, or statistics included have been obtained from sources deemed to be reliable, but we do not guarantee their accuracy or completeness.