The Fed Paves the Way for Running a “High-Pressure Economy” (Along with Higher Inflation)

Since the beginning of last year (see my February 4, 2015 commentary “U.S. Inflationary Pressures Remain Muted” and my March 1, 2016 Forbes commentary “Why Federal Reserve Tightening Is Still A Distant Event“), I have consistently asserted that the Fed’s ultimate tightening schedule would be slower than expected–from both the perspective of the Fed’s original intentions, as well as those of the fed funds futures market. Indeed, the most consistent theme since the beginning of the 2008-09 global financial crisis has been this: The tepid recovery in global financial conditions and global economic growth has consistently forced the Fed to ease more than expected; and since the “tapering” of the Fed’s quantitative easing policy at the end of 2013, to tighten less than expected. E.g. the October 2008 Blue Chip Economic Indicators survey of America’s top economists predicted the fed funds rate to rebound to 4.0% by late 2010. Subsequent forecasts were similarly early.

According to the CME Fed Watch, the probability of a 25 bps Fed rate hike on December 14 is now over 70%. I expect the December 14 hike to occur as the Fed has been prepping the market for one 25 bps hike for months; however–similar to what I asserted last year–I do not believe this rate hike will signal the beginning of a new rate hike cycle. Rather, the timing of the Fed’s third rate hike will again be data-dependent (more on that below). Fed funds futures currently peg the Fed’s third rate hike to not occur until more than a year from now, i,e. at the December 13, 2017 FOMC meeting. This is the most likely timing for the third rate hike, for the following reasons:

1. U.S. households remain in “deleveraging” mode. Haunted by the 2008-09 global financial crisis, record amounts of student loans outstanding (currently at $1.3 trillion), and a shorter runway to retirement age and lower income prospects, U.S. consumer spending growth since the bottom of the 2008-09 global financial crisis has been relatively tepid (see Figure 1 below), despite ongoing improvements in the U.S. labor market;


2. The developed world & China are still mired by deflationary pressures. While the Fed had not been shy about hiking rates ahead of other central banks in previous tightening cycles, the fact that all of the world’s major central banks–with the exception of the Fed–are still in major easing cycles means the Fed has no choice but to halt after its December 14, 2016 hike. Even the Bank of England–which was expected to be the first major central bank to hike rates–was forced to reverse its stance and renew its quantitative easing policy as UK policymakers succumbs to the rise of populism. In a world still mired by deflationary pressures, the U.S. could easily succumb to another deflationary cycle if the Fed prematurely adopts a hawkish stance;

3. The Fed is no longer in denial and finally recognizes the uniqueness of the 2008-09 deleveraging cycle that is still with us today. In a June 3, 2016 speech (titled “Reflections on the Current Monetary Policy Environment“), Chicago Fed President Charles Evans asserted why this isn’t a normal recovery cycle and because of that, argued why the Fed should foster a “high-pressure” economy (characterized by a tight labor market and sustained inflation above 2%) in order to ward off downside risks in both economic growth and inflation. Quoting President Evans: “I view risk-management issues to be of great importance today. As I noted earlier, I still see the risks as weighted to the downside for both my growth and inflation outlooks … So I still judge that risk-management arguments continue to favor providing more accommodation than usual to deliver an extra boost to aggregate demand … One can advance risk-management arguments further and come up with a reasonable case for holding off increasing the funds rate for much longer, namely, until core inflation actually gets to 2 percent on a sustainable basis.

President Evans’ speech was followed by similar dovish sentiment expressed by Fed Governor Daniel Tarullo in a September 9, 2016 CNBC interview, Fed Governor Lael Brainard in a September 12, 2016 speech at the Chicago Council on Global Affairs, as well as the September 2016 FOMC minutes. Finally, Fed Chair Janet Yellen explored the potential benefits of running a “high-pressure economy” after a deep recession in her October 14, 2016 speech at a recent conference sponsored by the Boston Fed. Quoting Chair Yellen:

If we assume that hysteresis is in fact present to some degree after deep recessions, the natural next question is to ask whether it might be possible to reverse these adverse supply-side effects by temporarily running a “high-pressure economy,” with robust aggregate demand and a tight labor market. One can certainly identify plausible ways in which this might occur. Increased business sales would almost certainly raise the productive capacity of the economy by encouraging additional capital spending, especially if accompanied by reduced uncertainty about future prospects. In addition, a tight labor market might draw in potential workers who would otherwise sit on the sidelines and encourage job-to-job transitions that could also lead to more-efficient–and, hence, more-productive–job matches. Finally, albeit more speculatively, strong demand could potentially yield significant productivity gains by, among other things, prompting higher levels of research and development spending and increasing the incentives to start new, innovative businesses.

Bottom line: The Fed continues to back off from committing to an official tightening schedule. After the December 14, 2016 rate hike, probability suggests the next rate hike to not occur until the December 13, 2017 FOMC meeting. Until the year-over-year PCE core rate rises to and maintains a rate of 2.0% or over, the Fed will not recommit to a new rate hike cycle. This also paves the way for higher U.S. inflation; as such, clients should continue to underweight U.S. long-duration Treasuries and overweight gold.

Revising Our Price Target of Gold to $950-$1,100 an ounce

We first became bearish on gold prices in August 2011, when gold traded at $1,848 an ounce.  Even though we understand systemic risks in the Euro Zone were real, we thought gold was highly overbought at the time. We subsequently became even more bearish on gold prices in late 2012, when it became apparent to us that the year 2013 was shaping up to be an “anti-climatic” year as global and European systemic risks began to dissipate. We articulated our bearish views on gold in our January 25, 2013 global macroeconomic issue–when gold traded at $1,660 an ounce–sticking our neck out with a 12- to 18-month $1,100-$1,300 price target. Our call was made several weeks ahead of similar calls by Goldman Sachs and Credit Suisse.

Over the last 18 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 as gold production remained high despite the decline in gold prices. Recent developments suggest that deflation and increasing production efficiencies remain alive and well in the gold mining industry. As such, we are lowering our price target range for gold yet again to $950-$1,100 an ounce. We believe this target will be hit over the next six months. Figure 1 below shows our calls on the price of gold during and post the 2008-09 global financial crisis.


From a classic economic standpoint, gold production should be declining given the decline in gold prices over the last 18 months. But this has not happened in the gold mining industry, for two reasons: 1) almost all gold miners had a bloated cost structure going into the recent price decline; as such, many gold miners were able to cut production costs and stay marginally profitable even as gold prices declined, and 2) some gold miners–post production cost cuts–had to produce and sell more gold to stem cash flow problems.

As the cost of production declines, miners are able to produce more gold at lower prices. According to the World Gold Council, mine production hit 765 tonnes during Q2 2014, a 4% year-over-year increase from Q2 2013, despite an average market price of $1,288 an ounce, or a decline of $125 an ounce from Q2 2013. Figure 2 below shows that global supply of gold has remained steady despite the decline in gold prices in the last 18 months.


Interestingly, at the September 15-17, 2014 Denver Gold Forum, some gold miners are indicating a higher allocation of capital for development projects, such as Goldcorp (Cerro Negro, Eleonore, and Cochenour), Newmont (Merian), New Gold (Rainy River), and Eldorado (Skouries). With the exception of the Eldorado project, all of these projects are expected to come online with an all-in-sustaining-costs (AISC) of $1,000 an ounce or below. This means almost of these projects will remain profitable (taking into account regular future capex and maintenance costs) even if gold falls below $1,000 an ounce in the long-run. At the same time, many gold miners indicated that cost-cutting remain their main objective. The combination of more ambitious expansion plans and ongoing cost-cutting initiatives suggest that mine production (i.e. gold supply) will continue to increase even if gold prices continue to fall. We thus do not believe gold miners will curb production significantly until gold falls to below $1,100 an ounce and stays there for at least several months.

Finally, we assert that from a sentiment and psychological standpoint, gold is oversold but still not sufficiently oversold for us to buy. In our July 7, 2013 commentary–when gold traded at $1,220 an ounce–we stated 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.

One sentiment indicator that we track is the change in the holdings of the gold ETF, GLD. Holdings in GLD are highly indicative of marginal/short-term demand given its daily liquidity and the types of speculators it attracts. As shown in Figure 3 below, GLD holdings peaked at 45 million ounces (orange line; right axis) in early January 2013, and have since declined to 25 million ounces, a drop of 44% over the last 18 months.

GLD 9-26-14

While a 44% drop in GLD gold holdings is dramatic, keep in mind that all of this drop occurred from January 2013 to December 2013. Since the beginning of 2014, GLD gold holdings has actually remained steady–suggesting that retail investors have neither capitulated nor panicked into selling their GLD just yet. We do not believe that gold prices will bottom until there is another selling panic similar to that in April 2013 (when the price of gold dropped by $200 an ounce in just two weeks).

The combination of steady/higher gold production and the lack of investor panic in GLD suggest that gold prices have more downside to go. Bottom line: We reiterate our bearish stance on gold. New evidence suggests that gold production is more resilient and less sensitive to lower gold prices than we believed as gold miners continue to cut costs to achieve higher efficiencies . This is leading us to revise our target range downwards to $950-$1,100 an ounce over the next six months. Stay short gold.

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.


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



An Imminent Correction in Risk Assets

In our 2014 U.S. stock market outlook (published on December 22, 2013), we asserted that U.S. stocks will only return in the single-digits in 2014, due to: 1) a tightening Fed, 2) the reluctance of the ECB to adopt quantitative easing policies, 3) higher-than-average valuations, as well as 4) increasingly high levels of investor speculation (e.g. record high levels in margin debt outstanding). We stand by our 2014 S&P 500 year-end target level of 1,900 to 2,000.

Conversations with our clients suggest one overarching investment concern/theme. Investors are concerned with the unprecedented global monetary experiments, while most of Asia is concerned about runaway Chinese credit growth and the country’s shadow banking system. The shift from a unipolar investment environment (one dominated by U.S. policy and institutions) into a multipolar one–beginning with the fall of the Berlin Wall in 1989 and accelerating with China’s entry into the WTO in 2001–means an understanding of global macro is essential to understanding the main drivers of future asset prices (hint: it is not classical indicators such as P/B, P/E ratios, etc.). Going forward, monitoring the actions of the People’s Bank of China and Chinese credit growth will be just as important as monitoring the actions of the Federal Reserve.

We believe 2014 represents a transition year as the Federal Reserve definitively halts its QE policies/asset purchases and as Chinese policymakers adopt financial reforms (e.g. allowing companies to go bankrupt to prevent future moral hazard problems) in an attempt to alleviate investors’ long-term concerns. In many ways, these recent moves–including Fed Chair Janet Yellen’s surprisingly hawkish comments at the March 18-19 FOMC meeting–are reminiscent to the events of 1994, when the Greenspan-led Fed unexpectedly began hiking the Fed Funds rate in February 1994. The Fed Funds rate rose from 3.0% to 5.5% by the end of the year, while the two-year Treasury yield surged from 4.0% to more than 7.5%. The S&P 500 experienced significant volatility and finished down the year by 1.5%.

We do not believe the Fed will hike the Fed Funds rate anytime soon; however, we anticipate the Fed to halt its QE/asset purchase policies by the end of this year; and to begin hiking rates in the 1st half of 2015. That is, global liquidity will get tighter as the year progresses–further compounded by overbearing U.S. financial regulations, a hike in the Japanese sales tax this week from 5% to 8%, and the ECB’s reluctance to adopt a similar QE policy. The action in the S&P 500 in the 1st quarter of this year has so far proved out our thesis. The S&P 500 ended 2013 at 1,848.36 and as of last Friday, sits at just 1,857.62 for a meager 0.5% gain. We reiterate our year-end target of 1,900 to 2,000. In the meantime, we believe the S&P 500 is heading into a significant correction, i.e. 10-15% correction over the next 3-6 months–for the following 3 reasons.

1) Hot Money Action is Getting More Risk-Averse

Since the global financial crisis ended in early 2009, EM fund flows from DM countries have been highly positive. Fund flows to EM countries turned negative during the summer of 2013. Many EM countries never implemented much-needed reforms during the last boom (Russia leadership just proved it is still stuck in the 19th century), nor made much-needed infrastructure and educational investments (with the major exception of China). Investors have forgotten that EM growth (actual and potential) rates no longer justify such investment fund flows–and have continued to dial back risk-taking in general. Most recently–the stock prices of two of the hottest industries, i.e. Big Data and Biotech–have taken a significant hit in recent trading. We believe momentum investors are now leaving the stock market; and that there is a good chance this will turn into a market rout (i.e. S&P decline of 10-15%) over the next 3-6 months.

2) The Federal Reserve’s Monetary Policy Tightening

Once the Federal Reserve wrapped up its “QE2” policy of purchasing $600 billion in Treasuries at the end of June 2011, the S&P 500 subsequently corrected by 14% over the next three months. The S&P 500 had already declined by 3% during May/June 2011, as the Fed did not provide a clear indication of further easing (i.e. QE3) until later in 2012. Prior to the end of QE2, the Fed purchased an average of $17.5 billion of Treasuries on a weekly basis. At the peak of QE3 (i.e. before the recent tapering), the Fed was purchasing an average of $20.0 billion of Treasuries and agency-backed mortgage securities on a weekly basis. The current tapering process is already having an effect on global liquidity, as foreign reserves held by global central banks have been declining over the last couple of months. Based on the current tapering schedule, the Fed will halt its QE policies at the October 28-29, 2014 FOMC meeting. The Fed’s balance sheet of $4 trillion of securities will take a decade to unwind (if ever). Unless the ECB chooses to adopt similar QE policies, we believe global central bank tightening (EM central banks are projected to tighten further over the next six months) will act as a significant headwind to equities and other risk assets for the rest of 2014.

Feds Balance Sheet

 3) A Record High in U.S. Margin Debt Outstanding

Our studies and real-time experience indicate significant correlation between U.S. margin debt outstanding and other leverage indicators, as well as major peaks and troughs in the U.S. stock market. We first discussed this indicator in our January 29, 2014 commentary (“Record Rise in Margin Debt Outstanding = Single-Digit U.S. Stock Returns in 2014“). We asserted that the record rise in margin debt outstanding (a 12-month rise not seen since July 2007–during the last major peak in stock prices) is indicative of significant speculation in U.S. equities. Since our January 29 commentary, U.S. margin debt outstanding has risen another $23.6 billion to a record high $502 billion. Meanwhile, the 6-month rise in margin debt outstanding hit $88 billion–again, a high not seen since July 2007 (when it hit $105 billion). More important, it is clear to us–based on the action in Big Data and biotech stocks over the last couple of weeks–that the willingness to speculate is declining. All of these indicators suggest to us that the S&P 500 will experience a major 10-15% correction over the next 3-6 months. We also assert that Emerging Market stocks will experience a significant decline, along with gold prices. We expect gold prices to bottom at the $1,000 to $1,200 an ounce level over the next 3-6 months. We will look for a buying opportunity in both gold and North American gold-mining stocks sometime in the next two quarters.

Our Revised 12-Month Outlook on Major Asset Classes

In our inaugural 12-month asset price outlook published on January 7, we rated Developed Equities a “7.” A rating of “5” suggests a return outlook close to its historical average (since 1926, the annualized total return of the S&P 500, with dividends reinvested, is just under 10%). i.e. We were relatively bullish on Developed Equities, as our rating of “7” in the beginning of this year suggests a higher-than-average return outlook. We were less bullish on Emerging Markets, however, as we believed countries like Brazil and India were: 1) experiencing inflationary pressures due to the lack of infrastructure and educational investments over the last decade, 2) the commodity bull cycle was maturing, and 3) China, the number one growth country in the world, was experiencing a structural growth slowdown (we projected a 5% to 8% growth rate over the next 5 years, versus a 8% to 11% growth rate over the last decade). As such, we rated Emerging Markets a “5” only.

Since January 7, the MSCI World Index (representative of Developed Equities) returned 11.8%, while the MSCI Emerging Markets Index declined by 10.4%. The return gap of over 20% between Developed and Emerging Market Equities (despite the ongoing troubles in the Euro Zone) over the last seven months is the largest running seven-month return gap between Developed and EM equities since month-end September 2000, and prior to that, the Brazilian/Russian crisis in fall 1998. Our constructive outlook on Developed Equities relative to Emerging Equities was thus prescient, although we did not expect Emerging Market equities to under perform so severely. Emerging Markets, in general, have been hurt by an overweight in the commodity and materials industries, as well as country-specific troubles such as the crash in the Indian Rupee, the slowdown in China (and domestic investors’ preference in Chinese real estate over Chinese stocks), and the near-recession in Brazil.

Developed and EM Return Gap

That said, Emerging Markets in general are in very good shape.  Balance sheets at most EM governments and corporations are flushed with cash, while EM’s dependence on US$ funding has declined substantially. Domestic ownership of EM equities has grown substantially–thus minimizing any potential fallout from a mass exit by foreign investors. SE Asian countries, in particular, have pooled their resources to create a $240 billion multilateral currency swap agreement. Dubbed the “Chiang Mai Initiative,” it was designed to prevent a repeat of a systemic fallout in SE Asia similar to the Asian Crisis. We think growth in EM countries and EM equities are poised to re-accelerate; and are thus overweight EM relative to Developed Equities over the next 12 months. We are raising our return rating for EM equities to “6,” while downgrading our return rating for Developed equities to “4.”

Our true value-add, however, was our highly bearish outlook on gold. On January 7, we gave gold a return rating of just “2,” with a very high risk rating of “8.” Our risk-reward outlook for gold was timely, as gold prices subsequently declined from $1,645.25 an ounce to $1,314.50 an ounce today–representing a decline of 20.1% in just under seven months. Gold is now hugely oversold in the short-run. We are thus raising our rating on gold from “2” to “3” (with a corresponding risk rating revision from “8” to a more benign “7”) despite our recent 6- to 12-month gold price target revision from $1,100-$1,300 an ounce to $1,000-$1,200 an ounce. Our 12-month revised outlook on major asset classes is published below. Any feedback or comments are welcome.

12-month Outlook July 2013

A Technological Revolution in the Making – The U.S. Giant Awakens

Note 1: We asserted in our June 18th commentary that WTI crude oil will definitively rise above $100 a barrel this summer, driven by the ongoing U.S. economic recovery, steady oil demand from China (the country’s short-term credit crunch is over), and pockets of strength in the Euro Zone. WTI crude oil is at $103 as I am writing this. And no, it is not due to unrest in Egypt, as Brent crude did not rise much on a proportionate basis. The narrowing of the spread between the price of Brent and WTI crude is also the best evidence of a U.S. economic recovery.

Note 2: In our late January newsletter, we asserted that gold was due for a major correction. We advocated a short position in gold. With gold at $1,660 an ounce at the time, we argued for a 12- to 18-month price target of $1,100 to $1,300 an ounce. Today, the price of gold sits at $1,220 an ounce. In just five months, the price of gold has hit our price target. Bottom line: We are revising our price target for gold. Our new position calls for a 6- to 12-month price target of $1,000 to $1,200 an ounce. 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. Of course–unless the U.S. mints a new currency–the price of gold will never see $275 an ounce again. So far, we haven’t witnessed much investors’ panic; nor indifference towards gold. With U.S. real interest rates (the ECRI Future Inflation Gauge just hit a 7-month low, even as long-term Treasury rates are spiking up) hitting new cyclical highs, we believe there is at least one more major sell-off in gold before there could be a tradeable bottom. The Dow-to-Gold ratio today sits at 12.4. I would only consider investing if the Dow-to-Gold ratio rises to 15, or above.  Avoid gold, for now.

Now, let’s get on with our main commentary. About 400 years ago, Descartes famously remarked “I think, therefore I am.” Descartes tried to prove his own existence by linking his thoughts to his consciousness. In other words, Descartes argued that because he cannot be separated from his thoughts–and because thoughts exist–therefore, he exists.

But Descartes was wrong. Equating one’s consciousness with one’s thoughts is mere identification with one’s ego–a path to endless pain and suffering. We are at our most enlightened state when we live in the present. A glimpse of a beautiful object, attending a concert, or seeing your loved one for the first time in a long time–these could all quiet our minds for just enough time to witness the beauty and truth in our own existence.  Unfortunately, human beings–just like Descartes–have equated our identities with our own, rigid set of thought/belief systems for thousands of  years. Such unconsciousness on a global scale has led to mass intolerance, discrimination and hatred, directly resulting in mass genocide, global wars, and witch-burnings–down to petty arguments over politics and household chores. It is sheer madness. A madness that many societies (e.g. the Middle East) still have not awaken from.

On a more practical level, an individual cannot invest successfully unless he awakens from such unconsciousness. Just like the natural laws of the universe, there are certain axioms any investor needs to follow; however, these axioms only provide the larger framework, and as of today, are not yet complete. Sir Isaac Newton explored the meaning of gravity, but lost his entire fortune in the aftermath of the Great South Sea Bubble. Investors are taught from an early age to follow benchmarks ranging from valuation ratios, cash flows, inflation, and GDP growth, to central bank policy, energy policy, technological breakthroughs, and finally to more esoteric indicators such as the VIX, various investment surveys (useful from a contrarian perspective), and sentiment data via Twitter feeds and Google Trends. An investor who is unconscious–i.e. one who follows a rigid set of thoughts and belief systems–cannot make outsized returns, since most investors follow such rigid thoughts, and by definition, most investors cannot beat the market. Sir Isaac Newton tried to follow such physical laws whilst speculating in South Sea stock. Both the final run-up and the subsequent collapse would catch him completely off-guard. Later on, he would remark “I can calculate the movement of stars, but not the madness of men.” The final exponential run-up in technology stock prices in early 2000 offered yet another example. Investors who failed to acknowledge this “New Era” missed the bull market in 1996, 1997, 1998, and 1999; many blue-chip funds under performed and numerous money managers lost their jobs because their rigid set of belief systems prevented them from owning technology stocks (at the peak in March 2000, the NASDAQ Composite traded at a P/E of 260). Of course, they were eventually proven right. But being “early” in the financial markets is just a nicer way of saying one was wrong. Similarly, many investors who were caught in the 2001 to 2002 bear market did not realize the rules have changed yet again.

I made this same mistake when I began investing in college. I tried to predict stock prices with factor models using linear regression analysis. I studied modern portfolio theory and was fascinated by real options valuation models. I thought the bull market in technology stocks would go on forever. I was unconscious. Thankfully, I did not remain unconscious for long. I managed to catch the tail-end of the technology boom; sold all my technology stocks in early 2000 (and warned others to do the same), and was 100% short the NASDAQ by late March 2000. The lesson I learned: Regimes come and go; belief systems are overturned (even thousand year-old systems such as the Chinese dynastic system in 1911); and something faster, crazier and more unbelievable will always come along.

A study of human history yields an endless chronicle of conflicts, wars, famines, mass slaughters, rape & pillage, and general misery. For sure, such a dismal record has been punctuated by glimpses of human goodness and progress in mass consciousness. e.g. The unprecedented prosperity and the promotion of peace during the “New Kingdom” period in Ancient Egypt, the export of Greek culture during the Hellenistic period, the harnessing and control of new technologies during the Han Dynasty in China, and of course, the European Renaissance and the Enlightenment. But it was not until the adoption of the United States Declaration of Independence–inspired by the writings of John Locke, and documents such as the Magna Carta, the Petition of Right, and the English Bill of Rights–did a major society finally begin to embrace the concept of human equality, freedom, and other basic, “inalienable,” rights.

In my opinion, the 56 delegates who debated and signed the Declaration of Independence as part of the Second Continental Congress represented the gathering of the most talented, progressive, and yet pragmatic, men in all of history. The Declaration of Independence–riding on concepts clarified by Enlightenment philosophers such as John Locke, Voltaire, and Rousseau–is the definitive document which defines the United States of America to this day. Yes, the U.S. falls short in many places; that is to be expected as the U.S. represents an ideal–an ideal that all of us should continue to strive for. It is thus no accident that the U.S. remains the most attractive center for entrepreneurs, hard-working immigrants, innovators, and the world’s best and most creative minds–despite our shortcomings.

In the wake of the Pearl Harbor Attack by the Empire of Japan, Admiral Yamamoto is alleged to have remarked: “I fear all we have done is to awaken a sleeping giant and fill him with terrible resolve.” Ever since the collapse of the technology boom and subsequently, the events of September 11th, the U.S. has been rudderless. Over the last 12 years, both the U.S. political and corporate leadership have failed the world, and reneged on too many broken promises. However, not all was lost. There have also been flashes of brilliance. e.g. the completion of the Human Genome Project in 2003, D-Wave’s progress in the development of a quantum computer, the advent of 3-D printing (a trend which I have tracked since 2007), shale fracking and horizontal drilling in the energy industry, and nanomedicine and nanotechnology in general–leading to advances in targeted cancer treatments, more efficient conductors, and stronger/lighter-weight materials.

As we have covered in our newsletters and commentaries, we are confident that the U.S. is on the cusp of a new technological revolution. It takes strong leadership, a functional financial industry, the right markets, and a bit of luck to commercialize the many, revolutionary technologies that we have written about. The U.S. is already undergoing an energy revolution–the rise in domestic crude oil production over the next several years will surpass the last domestic oil boom in the 1950s and 1960s. The 1950s/1960s domestic oil boom drove U.S. manufacturing and industry to unprecedented heights–and led to the creation of the U.S. middle class. The rise of 3-D printing, along with advances in 3-D scanning technology, means we could create our own tailored t-shirts in our own homes. I envision a timeline of just five years. Eventually, we will be able to “print” more complex objects with more differentiated parts. Together with cheap natural gas prices, the U.S. is already experiencing a renaissance in “in-shoring” and “in-sourcing,” beginning with low-labor content goods.

Slowly but surely, the U.S. giant is awakening. The economic recovery since 2009 is merely a precursor–a big, giant yawn. Our expertise and networks in healthcare, technology, and energy has placed CB Capital right in the center of the next technological boom, driven by American ingenuity, focus, and honest hard work. We are looking forward to the ride.

Behind the Panic Selling in Gold

In our January newsletter (please contact us for a copy), we argued that gold was in a major correction phase, and that over the next 12 to 18 months, gold will correct to the $1,100 to $1,300 range. Over the last five days, June gold has hit an air-pocket–declining by over $200 an ounce to trade at just over $1,350 an ounce.

Speculators in gold tend to overuse the term “money printing,” and why “money printing” will inevitably lead to higher gold prices. This is a patently false and misleading idea. First of all, global central banks (through the high-powered monetary base), commercial banks (through the traditional money multiplier), and investment banks (through balance sheet expansion and esoteric product creation) have essentially been “printing money” since the United States left the (quasi) Gold Standard for the final time in 1971.  The price of gold made a major peak at $850 an ounce in January 1980. For the next 20 years, the price of gold fluctuated between $250 and $500 an ounce–despite an increase in the nominal global GDP from $18.8 trillion in 1980 to $41.0 trillion in 2000. In fact, if one was to draw a regression line from 1981 (excluding the 1980 peak) to 2000, the long-term trend in the price of gold would have been depicted as a downward sloping line! Clearly, the price of gold suggested no correlation to the amount of “money printing”–and was certainly no inflation hedge.

Second of all, our turning bullish on gold in late 2000 rested on a couple of simple ideas: 1) The last seller had left the gold market. Gold bugs were capitulating. Central banks were selling en masse, while gold producers further reinforced the downtrend by hedging (i.e. shorting) a substantial portion of their future production. Everyone I spoke to in late 2000 thought I was crazy for buying gold coins and precious metals mining stocks. Treating it as the perfect contrarian indicator, I bought more; 2) The Greenspan-led Fed would ease monetary policy in an unprecedented way. More important, we believed the excess liquidity would directly fuel commodity price inflation as the United States has dis-invested in natural resource production (including energy production) since the early 1980s oil bust. It is not a coincidence that the price of Henry Hub natural gas rose above double-digits for the first time in late 2000.

That is, we bought gold because it was: 1) the most unloved asset class, and 2) we believed the excess liquidity created by the Greenspan-led Fed would flow to this asset class. We also made a bet that investors’ perception would shift from hating gold to beginning to treat the precious metal as an alternative currency. Gold has been treated as money in most societies for the last 5,000 years, but other commodities had once been in the same coveted category, including tobacco, sea shells, tulip bulbs, copper, large stones, alcohol, and cannabis. As we argued in our January newsletter, there are few iron-clad rules, if any, when it comes to economics or the financial markets. Yes, gold had been the predominant medium of exchange for centuries. But Classical (Newtonian) Physics was in the same category, and that eventually gave way to General Relativity and Quantum Mechanics in the early 1900s. In a capitalist society, the trick is to gradually and consistently inflate, and to broadcast one’s intention/plan to inflate to economic agents well in advance. For the last several years, investors have piled onto the long side of gold because of its increasing perception as an alternative currency. Over the last five days, this perception has shifted. This shift in perception caught a substantial amount of long investors on the wrong side and by surprise. That is all.

We will leave you with one final comment: So little is understood of the implications of the BOJ easing. It is no surprise that BOJ easing has done little for gold. The purpose of the BOJ easing was to meet its 2% inflation goal through importing inflation from the rest of the world. This has been partly achieved through a devaluation of the Yen. By definition, Japan is thus exporting deflation, especially to countries such as the United States, Germany, China, and South Korea (i.e. countries that either compete directly with Japanese exports or consume Japanese goods). Deflationary pressures in the United States, Germany, China, and South Korea would only put further downward pressure on the price of gold, to the extent these countries (especially China) purchase gold as an investment or inflation hedge. Such deflationary pressures would only be offset if Japanese investors–spooked by higher inflation expectations–decide to purchase gold as a hedge. Unfortunately for gold bulls, neither Japanese investors nor consumers are significant purchasers of gold. In fact, the Japanese only made a net purchase of $394 million of gold in 2012, equivalent to just 0.9% of Chinese net purchases and 0.8% of Indian net purchases (see below table). Preliminary data also suggests that Japanese investors are more interested in purchasing the Nikkei, U.S. Treasuries and Ginnie Mae securities, German bunds, and Japanese and U.S. real estate in light of BOJ easing. I anticipate a bounce in gold prices as soon as tomorrow, but long-term gold bulls would need to wait a little while longer.


CB Capital’s 2013 Price and Risk Outlook for Major Asset Classes

Happy New Year. Following is our 2013 price and risk outlook for selected major asset classes. We are publishing our annual price and risk outlook for the first time, so a little explanation is required. Our rating score summarizes our view on where we believe prices will head over the next 12 months. A rating of “5” is considered neutral–close to the asset class’ historical median return. Our risk score summarizes the probability for significant deviation from our price outlook. For example, gold’s risk score of 8 suggests the significant possibility that the asset class could remain elevated near $1,700 an ounce (as opposed to our downward forecast), as the price/demand of gold depends on many differentiated factors, such as jewelry demand in China and India; as well as a reemergence of systemic risk in peripheral Europe. The outlook on global monetary, fiscal, and global bank regulatory/lending policy is anything but certain in 2013.

More details will be provided in our CB Capital’s inaugural monthly newsletter. It will be published in the next 7 to 10 days, and will be provided to selected clients. All the best for 2013.

2013 outlook

The Superclass: A Rational (Investor’s) Perspective

It’s that time of the election cycle again. Many frequent musings I overhear include:

“This is one of the most important Presidential elections.”

“The market is going to sink by 30% and the U.S. is entering a recession.”

“The Fed shouldn’t be doing this or that, and the Fed should be abolished.”

This is all random noise, and ultimately a waste of time. It doesn’t matter what you or I think. It only matters what Fed Chairman Bernanke, the ECB, IMF, Angela Merkel, and the new Chinese government think. Unless you are Bill Gross or Larry Fink and have a direct line to Treasury, I won’t care about what you have to say unless you are better at getting inside their heads–as well as the heads of large institutional investors–than I am. If you failed to time the last two major peaks of the global stock market (i.e. early 2000 and late 2007), then you have failed your clients–and should get and stay out of the investment industry.

To quote French dramatist, Jean Anouilh:

“God is on everyone’s side … and in the last analysis, he is on the side with plenty of money and large armies.”

To gauge the sentiment of global policy makers and large financial institutions, you need to at least read Bernanke’s two major publications (“Inflation Targeting” and “Essays on the Great Depression”) and to get inside his head regarding what the Fed will do today. If you had read both books before the late 2007 to early 2009 crisis (which we did), you’d have had a much better idea on Bernanke’s next steps on a real-time basis during and after the financial crisis. It is unacceptable to be learning and reading about things after the fact.

It is also unacceptable to write a long commentary when one could be brief. So here goes.

Today, we know that:

1) US Treasury rates remain at historic lows; therefore, the US government will not cut Federal spending
2) Using the same logic, neither would they increase US taxes
3) And yes, the Fed will inflate–the Fed is already doing this through QE3 with $40 billion of MBS purchases on a monthly basis

A currency regime is only sustainable if the underlying currency is allowed to be debased on a small and consistent basis. It is laughable to hear young Americans advocating for the return of the Gold Standard, when these same Americans (especially the so-called Jeffersonian “yeomen farmers”) were advocating for a bimetallic standard and rallying behind William Jennings Bryan’s “Cross of Gold” speech in 1896. It also did not occur to these same individuals that a true gold standard never existed in the United States. Chaos reigned after President Andrew Jackson killed the Second Bank of the United States. Banks issued their own bank notes and inflated the economy through the normal credit cycle, in spite of the so-called gold standard. The “gold standard” subsequently became a strait jacket on credit creation once the down cycle hits–thus accentuating the busts. For example, at the peak of the Panic of 1873, the NYSE closed for 10 days, and 36% of all corporate bonds defaulted from 1873 to 1876. The latest financial crisis pales in comparison.

With regards to U.S. interest/Treasury rates, we also know that there exists a shortage of global risk-free assets. According to numerous studies, there will at least be a shortage of $9 trillion worth of risk-free assets in the next five years due to the destruction of risk-free assets during the European sovereign debt crisis; as well as the implementation of Base III requiring higher capital standards of global banks.

That means there will be a rush to purchase more US Treasuries, no matter where US domestic inflation lies. By the way, there is no hard rule that nominal interest rates have to track inflation; nor any hard rule that nominal interest rates have to be positive. In fact, my base case scenario is for the U.S. Treasury Bill rate to decline below 0% sometime in the next several years.

Besides, we also know that inflation is nowhere near as “sticky” as it was in the last inflationary cycle during the late 1970s (culiminating in the peak of the gold price at $850 in January 1980). A comparison to the late 1970s to 1980 is thus erroneous. Inflation was very sticky in the 1970s given the rigidity of wage increases due to the power of unions and the fact that US labor was mostly domestic in nature. Today, unions no longer hold any power; and US labor wages are tied to global wages due to outsourcing.

So in a nutshell, yes, the Fed will continue to ease. And no, the government will not spend less; nor will it increase taxes. And yes, interest rates will remain low until at least the next Presidential election. And yes, what you say does not really concern me, unless you happened to be in a “Top 50 list” of global policymakers or a fund manager with >$100 billion in AUM. And at the end of the day, it doesn’t matter whether you agree or disagree with these global policies. As an investor, my concern is only about making money for my clients. And outside of that, my time could be better spent with family and friends rather than discussing the questionable virtues of a “sound currency” or “sound policy”–whatever that means.

Gold: The Barbaric Relic, or The New Internet Stock?

Gold spiked 2.7% last week as investors anticipated more ECB easing; and finally, QE3 from the Federal Reserve as Friday’s jobs report (+96,000) disappointed. Gold closed $1,737.60 an ounce for the week, up from a recent trough of $1,547.60 an ounce in late June.

In late 2000, I purchased a substantial portion (at least for me) of physical gold and silver, and precious metals mining stocks. Gold traded at just $275 an ounce, with silver at just over $4 an ounce. I saw investor capitulation all around–including the mining companies themselves who were hedging (shorting) as much future production as they could. I distinctly remember hearing about folks selling gold or gold mining stocks that they had held for over a decade. With the Greenspan Fed starting to ease monetary policy, I figured that purchasing gold would be a low-risk option–both as an inflation hedge and for speculative purposes.

Since then, gold has been on a multi-year bull market. There are many reasons–central bank easing, heightened jewelry demand from fast-growing emerging market countries such as China and India (jewelry and investment demand from these two countries make up 45% of world’s demand), the ease of investment with the creation of the gold ETF GLD, and the best of them all: investors tend to buy what went up the year before–momentum is by far the most predictive factor of future prices. Gold is valued and coveted by all cultures. It captures the imagination of royalty to treasure hunters to pirates and commoners. Over 5,000 years of history suggest that nearly all cultures used gold as the primary means of exchange. Paper currencies have failed for the most part.

In light of Friday’s disappointing job numbers and the threat of a “fiscal cliff” later this year, Fed Chairman Bernanke will most likely implement QE3 before the end of this year. Make no mistake: Bernanke is a scholar of the Great Depression–not just locally but of the Great Depression in other Western countries. His main thesis: That countries who devalued or left the Gold Standard ahead of others fared the best. In fact, when Great Britain left the Gold Standard and devalued in September 1931, the country started its recovery, while the U.S. economy worsened. As gold left the U.S. in favor of cheaper currencies (i.e. the Pound Sterling) that month, the Federal Reserve responded by hiking its policy rate by 1%. The Dow Industrials plunged 30% that month, while hundreds of banks failed. September 1931 still qualifies as the worst-ever month for U.S. stocks, even when including data going back to 1815 (source: Ibbotson). Bernanke will no doubt ease–likely by purchasing Agency securities–which should provide a significant tailwind for the U.S. housing market as housing prices have lately been rising (on a side note, we regard the latest talk of the U.S. potentially shifting back to a Gold Standard as impractical, as Keynes shrewdly noted 80 years ago).

The structural bull market in gold is intact. QE3 should provide further support. Recent technicals show that gold is once again trading above its 200-day moving average; with the 50-day moving average quickly rising to meet the 200-day moving average. Gold technicals is thus bullish.

The weakness in gold earlier this year isn’t a surprise–given the economic weakness in both India (which suffered one of its most dramatic currency devaluations) and China (note that Q2 2012 gold jewelry demand declined significantly, as per below table from the World Gold Council) . However, the former is stabilizing; and with Chinese inflation remaining steady at 2%, there is no question that the People’s Bank of China will cut rates again before the year is out. We remain bullish on gold for this year, and in 2013.