Since the bear market ended in December 2015, the price of gold and gold shares has been forming a base. We have yet to see a strong catalyst to propel gold off this base but this could be about to change.
Thus far in 2017, US dollar weakness and a general nervousness on many geopolitical fronts have provided solid support for gold as a currency alternative and hedge against risks. Gold ended the first half of 2017 with a modest gain of 7.75 per cent whilst gold stock indices underperformed physical gold as the Gold Miners Index (GDMNTR) gained 5.3 per cent and MVIS Global Junior Gold Miners (MVGDXJTR) rose 3.5 per cent.
We normally expect gold stocks to outperform gold in a rising market. The underperformance of the indices this year is likely due to:
- Mean reversion after stellar outperformance in 2016;
- Heavy net redemptions in the gold mining ETFs;
- Inability of stock indices to engage in fundamental stock selection.
The market is now in the midst of the summer doldrums, a time when physical demand is at its lowest, trading volumes can be light, and, as we saw in late June and early July, the bears come out to play.
The gold price is testing the $1,200 per ounce level for the third time this year. If $1,200 fails, then it will go on to test the $1,175 base of the uptrend that has developed over the past 18 months. Successfully holding above these price levels would be very positive technically and psychologically for the market.
Fundamentally, we believe the market is well supported around current levels because physical demand in India and China continues to improve, even though the People’s Bank of China (PBOC) has yet to buy gold in 2017. We believe the PBOC is on pause this year due to foreign exchange and debt issues in China.
Also supporting this price is the geopolitics in the Middle East and Korea—along with uncertainty surrounding the US political climate and policy—has created a pervasive nervousness globally that benefits gold.
Thirdly, the US dollar appears to be in decline. While it did not help gold in June, we expect the historically negative correlation to benefit gold in the longer term. Finally, the positioning in the futures market suggests there could be more buying ahead for gold.
We continue to be positive on the gold price in the longer term. Based on what we see and hear every day, all of us can imagine possible black swan events that might propel gold much higher. When we look at the economic cycle in the US, we find a more compelling investment case.
Back in March we highlighted many signs of a late cycle economy. In May we published an ominous looking chart of NYSE margin debt. Complacency is at high levels typically seen at market tops. Investors continue to pour money into ETFs, driving stock market indices to new highs, while volatility as measured by the VIX Index is at historic lows. Most Fed rate hiking cycles end in tears. Will this one be any different?
Gold would likely benefit from dollar weakness if the Fed is unable to raise rates later this year. In the longer term, when the economy and markets eventually see a downturn, the risks to the financial system will probably be substantial. Historically, excessive leverage is the core cause of financial upheaval. Student loans, automotive loans, and credit card debt are each over $1 trillion now.
The “elephant in the debt room” remains sovereign debt levels that exploded higher after the last financial crisis and has been growing ever since. A shrinking economy magnifies debt problems and, with interest rates still far below normal, would likely see the Fed again resort to quantitative easing and maybe more extreme intervention, such as debt monetisation. Gold as a sound money alternative can act as a hedge against such risks.
Joe Foster is portfolio manager and strategist for the Gold and Precious Metal strategy at VanEck