Head of Commodity Strategy
Summary: Golds failure to rally over the past few weeks, as the Covid19 spread and economic uncertainty rose, has triggered a great deal of uncertainty about what role gold can play. In the short-term the market is being challenged by a continued demand to raise cash and rising real yields as inflation expectations take a tumble. We maintain a positive outlook and draw some parallels what happened during and after the great financial crisis in 2008 and 2009.
Gold’s failure to rally over the past few weeks, as the Covid-19 spread and economic uncertainty rose, has brought back memories of the 2008 Great Financial Crisis. During the early part of the 2008-09 crisis all assets were sold as a result of the need to deleverage in order to realise cash or pay for losses elsewhere. In the early weeks of the crisis gold suffered a 27% sell-off to $725/oz before beginning the ascent which eventually took it to $1920/oz.
The rally started in gold mining stocks before moving to gold and it took another few months before the stock market finally bottomed out. With this in mind we are keeping a close eye on gold mining stocks, through the Vaneck Major Gold Miners ETF (Ticker: GDX:arcx). Yesterday it slumped to a 49% loss from the February peak before recovering to finish the day higher up by 18.5%.
Whether the low is in remains to be seen but the sharp recovery indicated that buyers had been waiting for the opportunity. While gold has fallen we also have to keep in the mind that the cost of fuel, which account for 20% of the mining cost, has collapsed. Gold miners have therefore, at least for now, not suffered the hit that the drop in gold would otherwise imply.
Gold has now been through a 15% top to bottom sell-off before - at least for now - once again finding support at $1450/oz. The correction has obviously once again raised the question of whether gold is worth it’s tag as a safe-haven and diversifier. We believe the long term reasons for holding gold has if anything been strengthened by current developments.
While official interest rates have been slashed, corporate bond yields have been rising. The broken transmission between central bank actions and developments on the ground is likely to trigger a major fiscal and potential inflationary response from governments around the world. US 10-year real yields, another major driver of gold has risen sharply during the past week in response to much lower inflation expectations. We believe these direction is unsustainable and that real yields eventually will move back into a deeper negative territory (see chart below).
The sell-off has also been amplified by the aggressive sell-off in crude oil. The Russian central bank has been a strong buyer of gold in recent years. That buying has now stopped and depending on how long it will take before crude oil recover we could potentially see Russia become a net-seller. This in order to cover the shortfall after the price of oil slumped below their budge breakeven which is somewhere close to $40/b.
However, as mentioned, the main driver behind gold’s recent weakness has been the “dash for cash”. A move that was strengthened by the elevated leveraged positions that had been built up in gold during the past few months. In my latest COT report covering the week to March 10 I highlighted how deleveraging had become the overriding theme with both long and short positions being reduced. The biggest long reductions were seen in crude oil, gold, sugar, cocoa and cotton while short-covering was seen in natural gas, soybeans and corn.
The open interest in COMEX gold futures has dropped to 573,00 lots, the lowest since last July. A sign that positions, both long and short have now seen a significant reduction from the January peak at 800,000 lots.
The difficulty in fully understanding the sudden weakness and temporary loss of safe haven status have raised some concerns that the link between cash and paper is under pressure. While paper gold has seen a significant amount of selling the cash market has reacted to developments across the different regions. Discounts have been offered in Asia and India while dealers in Dubai have noticed a premium in recent days. Overall we conclude that the Covid19 has triggered a significant disruption to supply chains and logistics. Major buyers have temporary close down their borders while others have witnessed a slump in demand. Against these developments the supply chain is also severely stressed with shipments being held back and not reaching their destination, in this case Dubai.
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Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
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