Gold’s 2019 Resolution: Challenge the Resistance

Gold rides positive trend in December, supported by pause in trade conflict and rate hike

After spending several months consolidating around the US$1,200 per ounce level, we believe gold has embarked on a new positive trend supported by strong inflows to bullion exchange-traded products. Early in December the gold price gained with other commodities after China ans the US called a temporary truce in their trade conflict. Gold then rose to a six-month high following the Federal Reserve’s decision to raise rates on December 19. The stock market, crude oil, bonds, and US President Donald Trump all signalled that Fed Chairman Jerome Powell had made a grave mistake by indicating more rate increases to come in 2019. We also believe that the Fed made a serious mistake, but we think the blame should be placed on Mr. Powell’s predecessors, who waited too long to normalise monetary policy. Now the Fed is tasked with normalising rates late in the cycle, and it is rapidly running out of time.

Since the stock market peaked on September 21, gold has outperformed West Texas Intermediate (WTI) crude oil by 42% and the NYSE Arca Gold Miners Index has outperformed the S&P 500^® Index  by 27%. Markets are beginning to price in an end to the post-crises expansion in 2019, while gold, the US dollar, and US Treasuries are all signaling a rise in global financial risks. For the month of December, gold gained US$59.95 (4.9%) to US$1,282.45 per ounce. Gold stocks trended higher with gold, as the NYSE Arca Gold Miners Index advanced 10.8% and the MVIS Global Junior Gold Miners Index gained 13.1%.

US dollar strength was main headwind for gold’s lacklustre performance in 2018

Excluding December, it was a difficult year for gold and gold stocks. The U.S. dollar was stronger than expected in 2018, which created a major headwind for gold. The U.S. economy received a boost from the Trump tax cuts and deficit spending, resulting in strong growth, low unemployment, and an annual gain of 4% for the US Dollar Index (DXY). Investors showed little interest in gold investments amid the booming economy and stock market rally. Rising rates coupled with the strong US dollar created problems for emerging markets debt, which culminated in a currency crisis in Turkey. The US dollar saw additional gains against many emerging markets currencies that are not included in the DXY. Weak fundamentals caused the gold price to fall through technical support to its yearly low of US$1,160 in August. However, gold cut its losses late in the year, as market sentiment seemed to change to favor gold. Gold ended 2018 with an annual loss of just US$20 (-1.6%).

Gold stocks suffered despite strong financials and attractive valuations

The lack of interest in gold for most of the year was magnified for gold stocks. The NYSE Arca Gold Miners Index fell 8.5% in 2018, while the MVIS Global Junior Gold Miners Index declined 11.3%. It was a particularly difficult year for junior companies, which we define as developers and those companies producing less than 300,000 ounces per year. Most juniors failed to outperform their large peers. Tax loss selling and liquidation of a large gold fund weighed on juniors in the fourth quarter. However, the weak stock performance belied the fact that gold companies are doing well both operationally and financially. This has resulted in valuations that are well below the long-term average. Strong company fundamentals suggest that this value gap could close once investors take a more positive outlook for the gold price.

Contrary to last year, 2019 is beginning with global contraction theme

What a difference a year makes. While 2018 began with synchronised global growth 2019 looks like it is beginning with a synchronised global contraction theme. Manufacturing results in China, as measured by the Purchasing Managers’ Index (PMI) from both the official Chinese National Bureau of Statistics and Caixin/Markit, a private survey, contracted in December. Japan and Germany logged negative GDP growth in the third quarter. According to a Duke University survey, as reported by Canadian wealth management firm Gluskin Sheff, 49% of US chief financial officers believe the economy will begin a recession in 2019 and 82% are expecting a recession in the next two years. Parts of the US Treasury yield curve have slightly inverted, which has not happened since 2008.

During the post-crisis bull market, the S&P 500 has endured four corrections of 15% to 20%, with the first three occurring in 2010, 2011, and 2015/16. The current correction is the fourth in this cycle and appears to be the most ominous forecast for the economy because it coincides with steep sell-offs in crude oil and other commodities, along with a rally in US Treasuries and widening corporate spreads. After a tax cut-induced surge, corporate profits are set to decline, which may foreshadow a fall in the largest single source of demand for US stocks. Goldman Sachs reported in October that US corporations were on track to repurchase over US$770 billion of their own stock in 2018.

Upcoming Fed action could go two ways and both appear favourable for gold

It is widely believed that there is a 12-month lag for central bank policies to take effect. That means that the economy will feel the full impact of the Fed’s 2018 rate hikes and US$30 billion of monthly quantitative tightening (QT) in 2019. In addition, the Fed is set to raise rates further and has increased QT to US$50 billion per month.

We expect to see one of two scenarios in 2019:

1. The Fed stays on course, possibly driving the economy into recession. This may bring increased financial risks from highly-indebted governments and corporates.
2. The Fed pauses or reverses its tightening cycle. This would likely lead to US dollar weakness.

Both scenarios would be favourable for gold. Gold and gold stocks enter the New Year with positive trends that were lacking for most of 2018. In our opinion, it looks increasingly likely that gold may again test the US$1,365 level of resistance that has been in place now for five years. If the markets are seeing enough systemic risks to move gold through this level, we believe it should be a very good year for investors in gold and gold stocks.

Bear market not crash more likely and gold investments could be less volatile

Finally, if we are correct in calling for a recession to start in 2019, would markets crash as they did in 2000 and 2008, or would it be a more orderly bear market? Barring a black swan event and aside from cryptocurrencies, there are not any obvious manias in this cycle. However, there has been asset price inflation in stocks, bonds, real estate, and other asset classes.On the whole, this has possibly created the largest asset bubble in history, but without mania psychology, a crash is less likely in our view. An added risk in this cycle is an explosion of sovereign debt. This could lead to central bank policy responses that distort and drive markets, but we believe it is unlikely to precipitate a crash, especially with a more stable post-crisis banking system. Gold investments may see less volatility in a gradual downturn.