When It Comes to Gold, Stick to the Facts
By Frank Holmes
CEO and Chief Investment Officer
U.S. Global Investors
Gold dipped below $1,600 this week, falling to a six-month low, much to the chagrin of gold investors. I find the timing of the correction peculiar, given the G20 Finance Ministers Meeting taking place this weekend. There’s been a growing debate over Japan’s move to devalue its currency to stimulate growth, with reaction from the G-7 leaders stating that “domestic economic policies must not be used to target currencies,” reports Reuters.
While the G-7 tried to legitimize the currency debasement with this statement, in reality, investors seem to be able to see through to the real motivations.
The main reason the mainstream media gave for the correction in the yellow metal is hedge funds’ selling of gold late last year. According to quarterly filings, Hedge Fund Manager George Soros sold half of his holdings in the SPDR Gold Trust ETF (GLD) in the fourth quarter of 2012. Bloomberg attributed the sell as a move that may “bolster speculation that gold’s 12-year bull-run is coming to the end.” However, Soros may have liquidated his gold holdings because he identified a significant short-term opportunity in the currency markets.
I have said many times that government policies are precursors to change, and late last year, Japan’s new leader, Prime Minister Shinzō Abe, openly indicated his intention to drive down the currency to make the economy more competitive and increase inflation. As a result of Japan’s policy changes, the yen weakened, driving up the price of gold in Japan’s local currency.
In other words, a gold investor in Japan was likely ecstatic with his gold trade over the past few months.
Take a look at the comparison of gold’s return in different currencies. The chart below compares the percentage change of gold in the Japanese yen to the metal’s percentage change in U.S. dollar terms over the last six months. From the middle of August 2012 until about November, gold prices in both currencies closely followed each other.
However, as a result of changes in government policies, over the six-month period, gold rose nearly 19 percent in yen, while only increasing less than one percent in U.S. dollar terms.
George Soros seemed to anticipate the effect that Japan’s government policies would likely have on the velocity of money. This turned out to be a brilliant move, as “wagering against the yen has emerged as the hottest trade on Wall Street over the past three months,” says the Wall Street Journal. The newspaper reported that Soros gained “almost $1 billion on the trade since November,” during a time the yen declined nearly 20 percent in four months.
I admire Soros for his ability to identify significant effects that government policies have on markets as easily as recognizing when ice turns to water. More importantly, he quickly acts on these emerging events.
This isn’t his first big win in foreign markets. In 1992, based on British government policy changes, Soros shorted British pounds and bought German marks, earning $1.8 billion for his fund.
Just like recognizing how new equilibriums can alter the dynamics of an environment, government policies can significantly change the velocity of money. Global investors watch for these trends to know where to invest in commodities and markets, find new opportunities and adjust for risk.
I discussed the potential motivation behind Soros’ trade with Simon Hobbs this morning on CNBC. I explained how gold’s correction was reaching an extreme, indicating a potential buying opportunity. You can see on our oscillator model how gold has dropped nearly 2 standard deviations on a year-over-year basis. An event like this has happened only about 2 percent of the time over the last 10 years. Following these extreme lows, gold has historically increased as much as 15 percent over the next year.
Back in June 2012, I told CNBC the same thing: Gold had reached an extreme low, and only a few months later, the metal climbed nearly 10 percent.
During short-term gold corrections, it’s much more important to focus on the facts, including the fact that gold is increasingly viewed as a currency. Rather than buying real estate, lumber or diamonds, central banks around the world are buying gold. According to the World Gold Council (WGC), over 2012, central bank demand totaled 534 tons, a level we have not seen in nearly 50 years.
Emerging market central banks have been adding gold to their reserves, including Mexico, Brazil, the Philippines, South Korea and Russia. Over the past decade, Russia has accumulated a total of 958 tons of gold, making its gold reserves the eighth largest of all central banks, says the WGC.
Another fact about gold is the persistence of the Love Trade. As you can see below, jewelry demand declined slightly, about 3 percent in 2012, and more than half of this demand came from India and China, the countries with a cultural affinity toward gold. India’s gold purchases declined 12 percent due to an import tax and a weak rupee. However, even though the gold price experienced a significant increase in local currency, India’s demand is “all the more remarkable and serves to emphasise the importance of gold to Indian consumers,” says the WGC.
Notably, India had a better-than-expected fourth quarter, and retained its rank as the largest gold market in the world.
In China, there was a slowdown in GDP in the first half of the year, which weighed on gold purchases. For the year, the WGC indicated that there was only a slight increase in demand over the previous year.
In 2013, the WGC expects both markets to remain strong, forecasting growth rates of about 10 to 15 percent. I believe as GDPs in Chindia rise, so will their gold demand. And as long as the precious metal is attractive to both the fear trade and the love trade, hold tight to gold, with a 5 to 10 percent weighting in gold and gold stocks, and rebalancing annually.
- The major market indices generally finished mixed this week. The Dow Jones Industrial Average fell 0.08 percent. The S&P 500 Stock Index increased 0.12 percent, while the Nasdaq Composite lost 0.06 percent. The Russell 2000 small capitalization index closed the week with a 1.04 percent gain.
- The Hang Seng Composite rose 0.99 percent; Taiwan was closed this week, while the KOSPI gained 1.55 percent.
- The 10-year Treasury bond yield rose 5 basis points this week, to 2.00 percent.
Domestic Equity Market
The market was essentially flat for the week, digesting recent earnings reports while economic data was generally as expected. There has been some increased volatility under the surface with certain companies exhibiting large moves in either direction, which is a trend that should be closely monitored.
- The industrials sector led the way this week with broad-based strength. Leaders included rails names such as CSX and Norfolk Southern as well as the industrial supply companies Fastenal and WW Grainger. Masco rose by more than 12 percent and was the best performer in industrials as the company reported a solid quarter and expected a strong home construction market in 2013.
- Financials were also strong this week as Moody’s and McGraw-Hill bounced back after big losses the week before.
- Constellation Brands was the best performer in the S&P 500 this week, rising 36.2 percent. The company will gain full control over the Corona beer and Modelo brands in the U.S. and will also acquire a brewery in Mexico as part of the AB InBev acquisition of Modelo. This deal was reached in an effort to gain anti-trust approval and was very favorable to Constellation Brands.
- The telecom services sector was the worst performer as CenturyLink fell by more than 20 percent after the company cut its dividend, which surprised investors.
- The energy sector also underperformed as exploration and production companies led the way down. Energy has been a strong performer this year, and this may be simple profit taking.
- Cliffs Natural Resources was the worst performer in the S&P 500 this week, losing 20.9 percent. In a surprise move, the company cut its dividend and announced a dilutive equity issuance to shore up the company’s balance sheet.
- Housing and inflation data will be reported next week, and if recent trends continue to hold, then those events could be a positive catalyst for the market.
- After the best January in more than 20 years, a pullback would almost be expected.
The Economy and Bond Market
Treasury bond yields rose modestly this week as economic news was more or less in line with expectations. Positive sentiment regarding the direction of the economy continued. Eurozone GDP slumped 0.6 percent in the fourth quarter which was below expectations and potentially puts pressure on the European Central Bank (ECB) to act. Over the past week or so, there has been a lot of chatter surrounding the strength of the euro and if the ECB were to act to shore up the domestic economy, a side benefit may be a weaker and more competitive global currency.
- The National Association of Realtors reported that home prices rose 10 percent in 2012. That was the biggest increase in seven years and indicates a recovering economy.
- January retail sales rose 0.1 percent, which matched expectations but was viewed positively in light of the payroll tax increase that took effect at the beginning of the year.
- The University of Michigan Confidence Index rose more than expected in the preliminary February release.
- As mentioned above, eurozone GDP contracted during the fourth quarter, extending its recession.
- Industrial production fell 0.1 percent in January in a surprisingly weak start to the year.
- Inflation data in the United Kingdom, India and Brazil are showing signs of acceleration or maintaining relatively elevated levels.
- While some Fed members expressed concerns over continued quantitative easing, the Fed still remains committed to an extremely accommodative policy until the economy improves.
- Globally, central banks are increasing their stimulative policies, with Japan’s recently elected prime minister vowing to take on deflation and deflating the yen.
- The economy appears to be gaining momentum and bonds have sold off. The risk for bondholders is that this trend continues.
- Inflation in some corners of the globe is getting the attention of policy makers and may be an early indicator for the rest of the world.
For the week, spot gold closed at $1,610.10, down $57.10 per ounce, or 3.42 percent. Gold stocks, as measured by the NYSE Arca Gold Miners Index, lost 5.73 percent. The U.S. Trade-Weighted Dollar Index gained 0.28 percent for the week.
- The Kusasalethu gold mine in South Africa will re-open following a sustained period of labor unrest. Harmony Gold, the owner of Kusasalethu, set a strong precedent when deciding to shut down the operation rather than agreeing to labor demands. It is the first time a company has taken a stand and closed a profitable operation in South Africa, as well as the first time in five years that a mining company has dictated the return-to-work conditions as opposed to employees and unions.
- DRDGOLD declared an interim dividend this week following a period of lower operating costs and higher Rand gold prices. Furthermore, the company announced it is targeting a 4 percent dividend yield, together with a 30 percent payout ratio.
- Coeur d’Alene Mines, the Idaho-based silver and gold producer, has made a tender offer for Orko Silver valued at $379 million. The offer comes on the back of a First Majestic Silver bid for Orko Silver. We believe it is significant that we are now seeing counterbids coming into play to acquire cheap assets.
- With Chinese markets closed for the week for New Year celebrations, gold prices were on a slippery footing for the most part. This weakness was further exacerbated on Friday when filings for Soros Fund Management and Moore Capital showed that both players had sold a significant amount of their U.S.-held ETF gold investments in the fourth quarter. However, with Soros being an astute investor in the currency markets, it is not inconceivable that he swapped his U.S. dollar-based gold holding into gold denominated in yen. Over the last six months, gold is flat in dollar terms but in yen terms is up almost 19 percent, with the price breakaway starting in the fourth quarter.
- San Gold is set to raise 50 million Canadian dollars through the sale of convertible unsecured subordinated debentures on a bought-deal basis early next month. The news comes after the company lost 53 percent of its market cap year to date, and on the back of its February 8 announcement of failing to meet gold operation guidance.
- Avocet Mining provided a resource update outlining the new test work done at its Inata mine in Burkina Faso. The study indicated the resource is more complex than previously estimated, leading to a new reserve estimation of roughly half of the previous guidance. As a result of the current cash restrictions and financial standing of the company, Avocet has announced it needs to restructure its arrangements to remain viable. The share price fell more than 50 percent on the news.
- David Zervos of Jefferies noted that the quick and steady rise of the euro in terms of yen that we have seen in the last few weeks led the ECB to fire its first shot in this year’s increasingly violent currency war. The key takeaway from this move is to remember that all of the largest central banks in the world are now in monetary easing mode (read: printing money) to sustain the economic recovery. In these turbulent circumstances, investors must seek ways to isolate themselves from currency devaluation. Commodities in general, and gold specifically, are the direct ways to hide from this war.
- Russian president Vladimir Putin continues to turn his black gold into bullion. After turning Russia into the world’s largest oil producer, Mr. Putin has turned the country into the biggest gold buyer. His claims of the U.S. endangering the world economy by abusing its dollar monopoly have led Russia to seek safety in gold. The country added 570 metric tons of gold in the last decade, beating runner-up China by almost 150 metric tons. Gold has risen almost 400 percent since Putin’s purchases.
- Building into sovereign purchases of bullion, Christopher Wood of CLSA noted in his latest article that central banks bought a net 145 tons of gold in Q4 2012. Furthermore, central banks across the world purchased a whopping 535 tons of gold in 2012, making it the year with the biggest official demand for the metal since 1964.
- Gold has also been under threat due to speculation that the Fed will end asset purchases well before the end of 2013. Currently the Fed is buying $85 billion per month and if that pace continues, it would be buying 60 percent of net Treasury issuance this year. Bank of America Merrill Lynch expects the Fed to continue buying well into 2014, as the sequestering of spending could take 0.5 percent off the U.S. GDP in 2013.
- Heavy short-selling of gold in the past few days has revealed the size of current short positions on bullion. According to Standard Bank, total short positions in gold amounted to 168.2 tons at the beginning of the week, flying well above the 100.8 tons averaged over the last five years. Gold continues to be the most oversold sector, and the size of the short positions will pose resistance to a price increase.
- Despite the fiat money printing frenzy and indication of the Fed’s balance sheet now surpassing the $3 trillion threshold, consensus opinion is that inflationary pressures will be contained. As noted in Bank of America Merrill Lynch’s latest Bond Breakers commentary, the 2-, 5-, and 10-year-ahead inflation expectations remain well within historical ranges, potentially deferring investors’ move to hard assets.
Energy and Natural Resources Market
- Global oil price benchmark Brent has climbed 7 percent since the start of the year and, according to Deutsche Bank commodity analysts, it has been propelled by positive economic data that has renewed optimism about global growth and consequently global oil demand, including: January oil data for China confirming a strong start to the year with near-record crude oil imports, driven less by stockpiling and more by demand; indications that Saudi Arabia has cut production to around 9 million barrels per day, more than 1 million barrels per day below peak levels in the prior summer which has tightened global supply; and geopolitical tensions in Middle East/North Africa.
- According to Macquarie research, Indian thermal coal imports reached a record high of 140 million tons on an annualized basis in December 2012, overtaking Japan to make the country the second-largest consumer of seaborne coal in gross weight terms (behind China).
- Also in coal, the U.S. exported 10 million tons in December, the highest since September, which brought full-year coal exports to a record 124.4 million tons, an 18 percent year-over-year increase.
- The spot gold price fell to a six-month low this week, dragging gold mining equities down to nine-month lows as well.
- Natural gas fell 4 percent this week to a one-month low price on weaker demand, per weekly Energy Information Administration inventory data.
- Colombia, the world's fourth-largest coal exporter, produced 89.2 million tons of coal last year, missing its full-year target after problems with strikes and environmental permits bit into output, the government said on Thursday. Colombia's mining sector has been hit over the last year by a spate of labor disputes, including a strike at the main coal railway and a walkout at a Glencore-owned mine, as well as delays in environmental permits and a rise in guerrilla attacks. Coal production last year missed the 2012 target by nearly 9 million tons, according to the National Mining Agency, a new government body created to handle increasing demands on public institutions from a boom in the mining sector.
- China’s demand for commodities will grow “strongly” for some time, albeit at a slower pace, Reserve Bank of Australia Assistant Governor Christopher Kent said, “Because the Chinese economy is so much larger now, even a somewhat slower rate of growth represents a large quantity of new demand for raw materials.” Kent told the Committee for Economic Development of Australia forum, “For much of the past year we have been looking for signs that China’s growth might stabilize…. A broad range of indicators suggests that this has now occurred, with economic conditions improving through the second half of 2012.”
- PwC has issued a report that claims that “The global impact of shale oil could revolutionise the world’s energy markets over the next couple of decades, resulting in significantly lower oil prices, higher global GDP, changing geopolitics and shifting business models for oil and gas companies.”
- Australia's long boom in mining investment is likely to peak sometime this year, creating much uncertainty about whether the rest of the economy can take up the slack, a top central banker said on Friday. Reserve Bank of Australia (RBA) Assistant Governor Christopher Kent said the long-term outlook for the country's resources sector remained strong thanks to demand from an urbanizing China. But there were risks near-term. "Our expectation is that growth of economic activity will be a little below trend over 2013 before picking up a little in 2014," said Kent, who heads the central bank's economics unit.
- U.S. copper makers Southwire and Encore Wire are launching a legal challenge against the U.S. Securities and Exchange Commission (SEC) approval of JPMorgan Chase's physically-backed copper exchange traded fund (ETF). The companies, which say the copper ETF will inflate prices for the metal and distort supplies, filed a notice of appeal on Tuesday asking the U.S. Court of Appeals in Washington, D.C. to review the SEC's December 14 ruling that gave the green light for the copper ETF.
- Moody’s Investor Service warned that environmental factors, such as water scarcity, could adversely impact the ratings of global mining companies if they failed to proactively manage the accompanying operational and political risks to their businesses. In its “Global Mining Industry: Water Scarcity to Raise Capex and Operating Costs, Heighten Operational Risks,” Moody’s highlighted that mining projects were already competing with local communities for limited water resources, while having to comply with stringent environmental rules that could add to the capital expenditure (capex) budgets for new mines.
- China’s central bank, People’s Bank of China (PBOC), injected $72 billion on February 12 into the system to maintain holiday liquidity through a 14-day reverse repo operation.
- China became the largest trading partner in 2012 after achieving 3 percent more trades than the U.S., the second-largest trading country.
- Lunar New Year data showed visitation to Macau grew 20.8 percent from February 10 to February 13 on a year-over-year basis. The highest growth of Chinese visitors was recorded at 36.5 and 35.8 percent on February 10 (the Lunar New Year) and February 12, respectively. The border checkpoints on the China side were overloaded and it took an hour-and-a-half to pass through during the holiday. The mayor of Zhuhai says that checkpoint expansion will be ready in a few months. Macau is now in a structural growth stage after the Hong Kong and Macau Bridge over the ocean is completed which will shorten the time of travel to about 30 minutes from the Hong Kong airport.
- The policy initiatives of Korea’s new administration will be positive for banks, the property market, construction and steel sectors by focusing on household debt reduction, economic growth, and small and medium enterprise support, according to Morgan Stanley Research Asia/Pacific. Korea may cut policy rates (currently at 2.75 percent) further in the next central bank meeting. The research also believes won appreciation against the Japanese yen is already priced in, and a rebound of the Korean equity market is probably in the cards.
- The Philippines’ December exports grew 16.5 percent, better than the market expectation of 11.5 percent. Non-tech shipments expanded 50.1 percent. Also in the Philippines, the preliminary fiscal deficit of 2.2 percent of GDP for 2012 undershot the government’s fiscal deficit target due to fiscal under-spending in public-private project delays. The same project delays may continue in 2013, which can support the peso and bond spread. On the policy front, the central bank is prescribing tier-one capital of 8.5 percent instead of the planned 10 percent, essentially adopting loosening monetary policy. Bank lending in the Philippines continues to move up as of November last year, up 14 percent year-over-year, while the nonperforming loan ratio continues to soften, hitting at an all-time low of 2 percent.
- Indonesia sustained strong foreign direct investment growth to rise to $4.5 billion, 2.1 percent of GDP, in the fourth quarter, providing funding for the current account deficit.
- Colombia’s second largest Bank, Banco de Bogota, successfully issued $500 million in 10-year bonds at 5.375 percent on Monday. The issue was nine times oversubscribed and rallied to 103.25 on its first day of trading, confirming investors’ appetite for well-managed Latin American debt and equities. The news follows the postponement and scrapping of two planned junk-debt offerings by Brazilian issuers who attributed the decision to weak investor demand.
- Thailand will raise the cooking gas price by 33 percent in April, which will add 0.2 to 0.3 percent on CPI, according to a JP Morgan estimate. With a minimum wage increase of 40 percent last year, demand will be strong, which will add additional pressure on consumer prices. Although these factors won’t change the dynamics of the economy, the Bank of Thailand may not cut rates in the meeting next Wednesday.
- Indonesia’s current account deficit widened to 3.6 percent of GDP in the fourth quarter last year. Increasing domestic consumption and oil imports may continue to keep the current account deficit near 3 percent of GDP. The Bank of Indonesia left the policy rate unchanged at 5.75 percent in the recent meeting.
- Malaysia’s December exports contracted by 2 percent due to lower crude palm oil and weak electronics production.
- Currency revaluation continues to create hazards for Latin American countries. Peru’s fall in exports and softening construction activity slowed its economic growth to a three-year low in December. Similarly, Brazil’s economy grew a meager 0.9 percent during 2012, a far cry from its BRIC peers (Russia, India, and China).
- The chart above shows that going back 10 years, there’s been a significant increase in Chinese stocks in the month following the week-long Chinese New Year holidays. Based on median returns, the Shanghai Composite Index rises 3.46 percent, while the China H Shares climb 4.32 percent.
- Somewhat unexpectedly, Colombia showed the lowest inflation rate of any Latin American country in January 2013. The news comes after Chile saw a spike in inflation driven by increased copper exports to China. The news grants further room to the Colombian Banco de la Republica to continue its monetary easing program, keep the Colombian peso revaluation in check, and sustain economic growth. A 25 basis point interest rate drop has become highly likely for the Central Bank’s March meeting.
- Global emerging markets’ underperformance relative to the developed markets year to date is largely due to a heavy bias of outperformance of the largest of the developed markets and underperformance in the larger emerging markets. Citi calls for a potential reversal of this theme, buying emerging market laggards and selling developed market outperformers.
- It seems China’s government doesn’t need a robust housing market to support the economy today, fearing speculation and inflation risks. The rhetoric to curb the housing price was seen rising recently after moderating for a while since the end of 2011 when economic growth was hindered by monetary and housing tightening. Indeed, housing sales and prices are all up, though not alarming, and therefore the risk of further housing tightening is high. Even if further tightening policies may not affect sales, the negative sentiment can put pressure on the stock prices of developers.
- Following last week’s announcement by the Venezuelan government to devalue its currency by 31.7 percent, foreign companies operating in the country are facing a capital loss on any capital repatriation. The new rate of 6.3 bolivars per U.S. dollar still overvalues the bolivar by about 12 percent on purchase power parity terms, adding to a 26 percent inflation rate, indicating the possibility of further currency devaluation in the future.
- 2.7 percent GDP contraction in the fourth quarter in Hungary raises the risk that the Orban government will further reach for unorthodox policy levers as it heads into election season, according to a Standard Bank analyst.
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