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Gold: The Value of Liquidity

26 November 2015

It’s been another soft week for precious metals, with the price of gold trading just above USD $1072oz, down USD $10oz on last Friday’s London PM Fix. Silver has fared slightly better, essentially flat over the week.

Local investors have had a tougher time of it, with the Australian dollar climbing above 72 US cents, and pushing the AUD gold price back below $1500 an ounce. Silver has also pulled back in local currency terms, with the spot price back below $20 an ounce.

The strength in the Australian dollar has been unexpected, especially in light of the ongoing carnage in commodity markets, with iron ore, copper and the like all under continued pressure. Indeed commodity indexes continue to hit new lows, whilst the recently released private capital expenditure survey for Australia showed a 9% drop in the last quarter, and a 20% drop year on year.

Note this is with a car manufacturing industry set to close, housing construction set to peak, and a significant unwind in mining related investment yet to fully play out.

Bottom line, this recent rally in the AUD will prove ephemeral, and we are using it as an opportunity, and adding to our own metal holdings recently.

Gold: A Negative Trifecta?

It is no surprise sentiment towards precious metals is at all time lows. After all, we have a soaring US Dollar, with market consensus suggesting an imminent Fed rate hike will see even more US Dollar strength going into Xmas 2015 and next year. 

We also have the gold price itself trading at multi year lows, Gold ETF holdings back to where they were pre-GFC, and hedge funds either completely abandoning long positions, or going actively short on the gold market, betting on ever lower prices.

Finally, there is a perception out there that pro-cyclical demand from Asia will weaken in the coming months and years, due to the slowdown in economic growth we are seeing throughout the region.

This feeds into a supposed ‘negative trifecta’ for gold, with Bill O’Neill, a partner at Logic Advisors stating that “Throughout the Asian region with economies slipping, jewelry demand is going to be weak also”. This feeds into a negative outlook for the metal, with O’Neill noting that “Fundamentally, the gold market doesn’t look good, psychologically it doesn’t look good and the money flows don’t look good. So that’s a negative trifecta.”

We are not so pessimistic personally, especially over the medium to long term, with this recent weakness opening up a great buying opportunity for those of us happy to hold the metals for a period of three to five years or more.

Even short-term, we see an opportunity for the market to bounce. COT positioning highlights the almost extreme pessimism from the short-term speculative crowd, who are now net-short gold, like they were in August, just prior to gold’s last rally.

We also have a situation where almost everyone is long US Dollars, even though Fed interest rate hikes have typically marked US Dollar tops, not the commencement of further rallies.

That might sound surprising to some, but the following chart highlights it clearly, with the USD lower on every occasion 260 odd days after rate hikes that took place in 1994, 1999, 2004, 1986 and 1977.

HigherRates

Some of those dollar depreciations have been significant, especially those in the last 70’s and mid 80s, with the former also a period of significant precious metal price appreciation.

We are also further encouraged in our outlook for the metals due to the fact that we think any Fed rate hiking cycle, when and if it commences, will be relatively brief.

The reason for that lies in the relatively weak outlook for the US economy, which, for all of its relative strength (compared to the Eurozone and Japan for example), is still struggling to grow in any meaningful way.

Latest evidence of this can be found in the most recent update Atlanta Fed GDPNow forecast, which is now projecting a growth rate of just 1.8%, substantially lower than their prior forecast, which had growth running at 2.3%.

The chart below highlights how far this forecast has fallen since the beginning of November. 

EvolutionAtlanta

Lower rates of growth in the United States obviously dovetails in what is happening around the world, with a recent research note from Bank of America Merrill Lynch noting that year on year growth for World GDP has actually been declining since Q1 of 2014. 

In the coming months, we expect the market to realise more fully that;

• The global economy is weakening not strengthening

• Rate hikes will not necessarily mean a stronger USD

• The rate hike cycle (when/if it starts) will be short lived

• Gold often does well in environments where rates are rising

• Demand for physical gold remains robust, with continued buying from central banks and buyers from China, India and the Middle East

All of this will help support the precious metal market, whilst a likely decline in the AUD in the months ahead will add further upside potential for local investors. In light of this, our oft-repeated mantra around dollar cost averaging continues to make sense, and should set up investors nicely for the coming years. 

Gold: The Importance of Liquidity

One of the most important characteristics of the gold market is its liquidity. Liquidity, or liquidity risk (the inability to sell an asset when you want to, or at a price near the prevailing market price) is typically the most overlooked risk when it comes to asset allocations and putting together a portfolio.

Most investors are aware of the risk of inflation, and even the idea of diversification (within a stock portfolio for example), but few worry about the ability to actually liquidate holdings when and if they want to.

We think this is a mistake, and one that may well be costly in the coming years, with even the most traditionally liquid markets suffering these days.

That much was made clear in an excellent article written by Ben Wright, Group Business Editor for The Telegraph. Titled “The World’s multi-trillion dollar bond market is circling the drain”, the article focused on the evaporation of bond market liquidity, an asset class that at the sovereign level at least, has always been amongst the world’s most efficient to trade in. 

It’s a problem that is worrying plenty of financial heavyweights, from Glenn Stevens, the governor of the RBA, to Jamie Dimon, the CEO of JP Morgan Chase, to Nouriel Roubini, to Stephen Schwarzman, the CEO of Blackstone.

All of them have warned about liquidity, and how the lack of it could be the cause of another financial crisis, with Deutsche Bank research noting that whilst the amount of outstanding corporate bonds had doubled since 2001, the dealer inventories of these same securities had fallen by 90%.

With the world drowning in debt, there has been no shortage of concern about the deteriorating credit quality of the issuers, corporate or sovereign, but the potential for these markets to simply freeze up is not one to overlook.

This is another reason why we love owning gold (and silver) in our own portfolio, for it is amongst the most liquid assets on the planet. Indeed daily turnover in the OTC gold market is estimated to be well north of USD $100bn a day, according to LBMA Liquidity Surveys, whilst the value of the physical gold market (even at today’s depressed prices), makes it one of the largest markets on the planet.

Indeed the value of the physical gold market dwarves the value of most sovereign debt markets, with the exception of Japan and the United States, as the following chart makes clear. 

LargestDebt

In time, this will also attract investors of all sizes to the gold market, for the simple fact that it is easily investable, even for those looking to allocate hundreds of millions, if not billions of dollars.

Of course, one of the other attractions, apart from liquidity and turnover in the gold market is that no matter how large the physical gold market becomes, there is no deterioration in credit quality.

This is not something that can be said for anyone lending money to Uncle Sam or those in charge of the public finances in the Land of the Rising Sun, all of whom are earning desultory yields for their ownership of an asset whose credit quality deteriorates by the day, and whose real value is eliminated over time by central banks, with the imprimatur of government.

For those who wish to read the full Telegraph article regarding liquidity, you can do so by clicking here.

RIP Richard Russell

Before finishing this week’s market update, we wanted to make mention of the passing of Richard Russell. For those who read ABC Bullion Market Updates and are not familiar with Richard Russell, he was the publisher of Dow Theory Letters, an investment newsletter service he began all the way back in 1958.

Writing or publishing more or less everyday for the past six decades, Dow Theory Letters was the longest newsletter service published by any one person.

Russell made some of the most legendary investment calls of his time. He recommended gold stocks in 1960, called the top of the 1949-1966 bull market, and the bottom of the bear market in 1974.

He was also a strong advocate of physical gold ownership, and the merits of including it in your portfolio. Indeed, as a tribute to the man, Financial Sense just re-posted this Financial Sense radio newshour, dated June 28th 2003, which was a ‘roundtable’ including Russell, where he talked about the upcoming gold bull market.

It is safe to say that gold was a completely ignored asset class back in those days. 

According to Russell, his most popular article ever was one titled 'Rich Man, Poor Man'. If you do nothing else this week, read it in full – twice. You can find it right here.

Rest in peace, Richard – they do not make them like they used to.

Until next week,

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. 

JE