Short-term Deflationary Pressures Mean More Downside for Gold Prices

We became bearish on gold prices in late 2012, and first articulated our $1,100-$1,300 price target in our January 25, 2013 global macroeconomic issue–when gold traded at $1,660 an ounce. Over the last 14 months, we have reiterated our bearish views on both gold prices and gold miners; in our July 7, 2013 commentary (“A Technological Revolution in the Making – The U.S. Giant Awakens“), we further lowered our price forecast to $1,000-$1,200 an ounce, and asserted that the price of gold will hit bottom by the end of the 1st half of 2014.

At the time of our July 7, 2013 commentary–when gold traded at $1,220 an ounce–we asserted that the two most reliable indicators for at least a tradeable bottom were absent. Quoting our July 7, 2013 commentary:

The two most reliable psychological indicators for a tradeable bottom in any asset class are: 1) Panic, or 2) Indifference. The best time to invest in any asset class is after years of investors’ indifference. That–along with other screaming buy indicators–was the reason why I invested in physical gold and unhedged gold miners at under $275 an ounce in late 2000.

In this commentary, we reiterate our $1,000-$1,200 price target, but are pushing our forecast to 2Q-3Q this year. In addition, we are revising down our absolute bottom from $900 to $850 an ounce, as the marginal cost (both all-in-sustaining and pure extraction costs) of production has come down substantially over the last 18 months (the price of gold traded at the marginal cost of extraction various times during the 1990s bear market). Here are our reasons:

After nine more months of trading, gold investors have neither panicked nor capitulated. While gold ETF holdings have declined from a peak of nearly 85 million troy ounces in late 2012 to just 56 million troy ounces today, COMEX gold net speculative long positions remain elevated at more than 15 million troy ounces (see Figure 1 below, source: Goldman Sachs).

Figure 1: COMEX Gold Net Speculative Position (Left, million toz) vs. 10-year TIPS Yield (right, inverted)

COMEXGOLDSPECSWe believe the trend for gold prices thus remains down. This is further compounded by short-term, but significant global deflationary forces, some of which we have previously discussed.

Those that are Gold Miners Specific

All extremes eventually become their opposites.” – Plato, and later Carl Jung

A bull market inevitably builds excess, and nowhere is this more evident than in the evolving marginal cost curve of gold miners. At the bottom in 2002, the marginal cost of extraction was approximately $300 a troy ounce. Despite technology improvements, the marginal cost of extraction steadily rose to nearly $1,000 an ounce by 2011 as gold miners exploited lower-grade mines and as mine workers enjoyed higher wages. Since the peak in 2011, the marginal cost of extraction has come back down to $850 an ounce (see Figure 2 below, courtesy Goldman Sachs). Deflation has set in within the gold mining industry–and given that it is a commodity industry, it is a race to the bottom. Ironically, some gold miners are producing even more gold in an attempt to stem cash flow problems–thus increasing supply and depressing gold prices even as demand remains anemic. So far, there have been no major mine closures; nor major bankruptcies in the industry. We believe that neither the price of gold nor gold mining stocks will bottom until the industry experiences a couple of major mine closures and/or bankruptcies. The gold mining ETFs, GDX ($24.26) and GDXJ ($36.66), could easily decline another 25-30% from current levels.

Figure 2: Real Gold Prices vs. Marginal All-in-Sustaining Cost of Production vs. Marginal Cost of Extractionrealgoldprices

Those that are U.S.-centric

As we discussed in our March 30, 2014 commentary (“An Imminent Correction in Risk Assets“), the outlook for U.S. monetary policy is not conducive to higher prices for risk assets, including gold–at least not in the short-run. While the price of gold continued to rally for three more months after the end of QE2 (peaking in September 2011)–gold has failed to rally despite the implementation of QE3 (which resulted in $1.5 trillion of agency MBS and Treasury purchases). As QE3 is scheduled to end by the October 28-29 FOMC meeting, it is likely that the price of gold will be pressured even further, unless: 1) U.S. commercial banks overcome their regulatory burdens and start lending more freely, or 2) the Euro Zone threatens to fall apart and the ECB is forced to monetize a substantial amount of peripheral debt and/or Euro ABS securities. Note the chances of either of these scenarios occurring are next to none (Spanish 10-year yield is trading at just 3.18%, or 50 bps above the 10-year Treasury).

With regards to the U.S. short-term inflationary outlook, the two following indicators (one leading and one coincident) come to mind:

1) The highly respected ECRI’s monthly U.S. Future Inflation Gauge (a leading indicator) remains depressed. For example, the rise in U.S. home prices (owners’ equivalent rent makes up approximately 25% of the U.S. CPI) has recently stalled due to anemic growth in U.S. wages and the rise in U.S. interest and mortgage rates. Unless U.S. wages experience a structural uptrend (not likely anytime soon), CPI inflation will likely remain low. Note that one of the best predictors for future CPI readings is actually today’s CPI reading, as the CPI reading is fed into variables that could cause future inflation, such as Social Security cost-of-living adjustments, union wage adjustments, and some private defined benefits pension plan cost-of-living adjustments.

2) The Cleveland Fed’s expected inflation yield curve as imputed from TIPS yields is still low, despite the Fed’s purchases of $4 trillion of agency debt, agency MBS, and Treasury securities over the last five years (see below chart). As of March 2014, the ten-year expected inflation rate is 1.74%. With the Fed beginning to shift to a tightening mode, we expect the Fed to begin raising the Fed Funds rate by the middle of next year, and for U.S. real interest rates to be definitively positive by the end of 2015.

While we are bullish on gold prices over the next 5-10 years (due to what we believe will be heightened political will to inflate out of our future pension/healthcare and student debt obligations), the next 6-12 months remain a very bearish period for gold prices.

clevelandfedcpi

Those that are Global in Nature

1) The annual growth rate of foreign reserves on the Fed’s balance sheet–an important global liquidity indicator–turned negative earlier this year–the first time since early 2012. Global deflationary events beginning in the 1980s (1994 Tequila Crisis, 1997 Asian Crisis, 1998 Russian/Brazilian/LTCM crises, etc.) have always been preceded by a year-over-year decline in the amount of foreign reserves on the Fed’s balance sheet. This is not surprising, as the vast majority of global trade is still settled in the US$. As the U.S. current account deficit shrinks (due to higher domestic oil production, “on-shoring” of U.S. manufacturing, etc.) global US$ liquidity will continue to decline–putting further pressure on the balance sheets of countries that are dependent on exports to the U.S. Since many of these countries are net purchases of gold, we believe declining foreign reserves will act as a deflationary force for gold prices over the next 6 months;

2) On April 1, Japan raised its sales tax from 5% to 8%. This act–which is felt instantaneously–is deflationary for the Japanese economy. The Bank of Japan is now expected to ramp up its quantitative easing policy (which will take several quarters). Domestically, this will counteract the deflationary effects of the sales tax increase by exporting deflation around the world. This deflationary shock will be felt mostly by Japan’s trading partners, as well as its trade competitors (South Korea, China, etc.). Since China is traditionally the second largest net buyer of gold, we expect Chinese demand for gold (whether as an investment or inflation hedge) to subsequently decline. In addition, while the Japanese economy will experience some inflation due to the Bank of Japan’s actions, this will have little effect on gold as Japanese demand for gold is effectively zero (most likely, the Japanese will purchase domestic equities/real estate as an inflation hedge).

3) India’s official gold imports hit a peak of 162 tonnes in May 2013. Indian gold imports made up 28% of the world’s demand in 2012–ahead of Chinese gold imports at 26% of the world’s demand. At the peak, gold imports were the biggest contributor to the Indian current account deficit. Since the Indian government took more proactive steps to curb gold demand in summer 2013, official gold imports have dropped substantially (see Figure 3 below, courtesy Goldman Sachs). Official Indian gold imports (which excludes imports via smuggling channels) are expected to be only 550 tonnes or lower in 2014–down from as high as 863 tonnes in 2012. The raising of gold import tariffs has resulted in a two-thirds reduction of the Indian trade deficit since May 2013! We do not believe the Indian government will reduce the import tariff substantially over the next 6 months. As such, Indian public policy suggests an ongoing deflationary pressure on both Indian gold demand and gold prices in general.

Figure 3: India’s Gold Imports have Collapsed Due to Higher Import Tariffs

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