Below is the View On Gold by Mr. Chirag Mehta, Sr. Fund Manager-Alternative Investments
Gold has been under major pressure and losing value since April when it traded to the highest value this year and began to sell off. Even this month gold posted a decline of -2.3% for the month taking the year to date losses to -6.1%. The latest round of weakness in gold price was motivated by the hawkish rhetoric from the Fed Chair Jay Powell. He argued that the US economy remains strong enough to support further gradual increases in interest rates. Implication of this monetary stance and a relatively better economy has led to a stronger dollar which has masked any benefit to gold on account of the ongoing trade tensions. The strong risk on sentiment as evidenced in U.S. stock indices near record highs is ensuring Investors flight from gold to equities.
Most recently, statements made by Fed Chairman Jerome Powell indicated a more hawkish stance as the Central Bank continues its monetary policy of quantitative normalization. His most recent testimony suggested that they would implement a total of four rate hikes this year and continue to raise interest rates next year as well. At the same time, the Federal Reserve has been shrinking its balance sheet since October of last year and has already shrunk it by about $179 billion, with an expectation of eventually shrinking by $1.9 trillion. This puts Feds monetary policy in stark aggression to its counterparts, leading to a renewed strength in the dollar.
The lack of demand for gold during tensions over international trade has been telling. The current trade dispute, which has a real possibility of becoming a trade war, has not moved the needle in terms of gold pricing. Traders continue to focus upon rising U.S. equities and the risk-on market sentiment that has been so prevalent over the last couple of years. The trade war issues have not been fully priced into the financial markets, as most analysts continue to believe that the U.S. position is more one of posturing than execution. However, the threat from further aggravation of trade war is real. Powell’s testimony also highlighted the uncertainty facing the Fed as it gauges how high to raise rates as fiscal stimulus boosts growth, while prospects of a trade war increase headwinds.
U.S. GDP grew at the fastest pace since 2014, a testament of Powell’s optimistic assessment of the U.S economy. However, the details about the housing market raised some red flags on some glaring signs of unrest. Existing-home sales, which make up about 90% of the market, fell for a third straight month in June, indicating a shortage of affordable listings while rising prices continue to limit demand. And new residential construction, or housing starts, softened in June to an annual rate of 1.17 million units, compared to an annual rate of 1.33 million in March. Residential investment, which includes construction and brokers' fees, shrank last quarter for a third quarter out of four. It's very hard to escape the slump, given the rise in mortgage rates since last fall and the gradual tightening of lending standards.
It’s also puzzling given the tightness of the labour market as showcased by the robust unemployment numbers, wage growth has had little participation. The average hourly earnings rose by 5 cents to $26.98, which implies that they have increased 2.7 percent over the year. Although it’s the same percent change as in May and it missed the expectations of economists, wages are rising gradually.
The balance sheet shrinking is contributing to push the effective federal funds rate closer to the top of the range the Fed specifies, which was not supposed to happen so early. Also, the trade wars and central bank tightening are pulling down the spread between the U.S. 2 and 10 year bond yield, which is now just around 30 basis points, down from 265 in 2014. With a couple of more rate hikes, we could be potentially staring at an inverted yield curve. History suggests that a recession generally follows an inversion by 6-24 months. This could compel Fed to pause raising rates. However, given the level of debt and asset price distortions extant today, it will take much more than just a neutral Fed to stop the slowdown. In response, the Fed would naturally resort to the same old unconventional policies and this would certainly boost gold.
Lastly on the U.S - China trade war, China has more bullets in the form of its massive treasury holdings than just putting a tariff on all US exports. And, seemingly China has more to lose on face value, an all-out trade war is an extremely negative sum game for all parties involved. China could also dump $1.2 trillion worth of its US Treasury holdings. The timing for this would hurt the US particularly hard because deficits are already projected to be over $1 trillion in fiscal 2019 that begin in October. When you add to this the Fed’s balance sheet unwinding, you get a condition that could completely overwhelm the private sector’s demand for this debt. Economically speaking, there are signs of reversal due to the impending complete removal of central banks’ bid for inflated asset prices on a net basis, is further exacerbated by the Trade war.
Debt-fueled Tax cuts have greatly boosted earnings growth on a one-time basis. And this has been completely priced in by the Wall Street. However, with the global trade war and as the bond bubble slowly dilapidates, given its effect on record debt and asset prices--should more than offset the benefit from tax cuts in the coming quarters. Feds attempt to get ahead of its QE unwind is providing investors with a buying opportunity in gold before adversely impacting market and economy. Downside seems limited because the negative fundamentals for the market are for the most part already factored into prices.
The world continues to remain in state of great disequilibrium, both with respect to the global economy and geopolitics as well. Given the macroeconomic picture, gold will be a useful portfolio diversification tool and thereby helping you to reduce overall portfolio risk.
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