Gold: An Insurance against Illiquidity

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The renowned commodities investor Donald Coxe wrote in the Globe and Mail this week on what seems to be an original and profound thesis for gold. Where many have witnessed for years gold’s role as hedge or safe haven during times of economic turmoil and financial instability, it may play a positive role in good economic times as well. From the data alone, academic research can illustrate gold’s role as a safe haven since the price floated in 1971. It is an asset that exhibits close to zero correlation with US equity markets, which means there is no relation in price movements. And Don Coxe does not refute that in gold’s price history. Instead, in what seems to be a welcomed idea for gold investors, it’s that instead of waiting for fear to grip financial markets once again, imagine a world in which gold can rally in a positive economic environment.

Ideas like this are novel and welcomed. I think it is unfortunate that the idea of believing in gold is associated with fear mongering and awaiting an eventual economic collapse, especially during a period of repeated new highs in equity markets. And as some analysts seem to be forecasting, this bull market in equities very much remains intact, and with that comes a recovering strength to the global economy. If Europe is able to move past their triple dip recession, they potentially have the most to gain. Being a group of economies that have stalled out for so long, and are in the process of applying needed structural changes, could pave the way for opportunity in productivity and manufacturing gains. The other key driver for Europe, which relates to a story without the United States, is that they are on aggregate the biggest importer of goods and services from China. This provides the elements for a rebounding global economy with resurging growth from emerging markets as well.

In the US we are witnessing a renewed growth in the oil and gas sector. With that, States linked to extraction and refining stand to benefit. This sector has acted as the catalyst for economic growth in the United States; furthermore, it’s truly surprising that the Obama administration is taking this long to make a decision Keystone XL pipeline. Wavering around the issue of coal production when it’s a far greater polluter than the tar sands crude, illustrates how political this issue has become, and exemplifies that this is a decision without thought to sound economic policy. Without moving too far from the point though, what is evident from what we see in the US right now is that they may lead the globe out of the financial crises that roiled the world markets 5 years ago, but their position as the world economic leader will not be sustained.

Resurging economic growth, however, will lead to the inevitable rise in interest rates. The US Fed will be first, but other central banks will quickly follow. This is central to Coxe’s thesis. Central banks will be forced to act to contain short term inflationary threats and increasing rates of nominal economic growth. In doing so liquidity, the very fuel to the fire that helped stock markets soar out of the 2008 downturn, will begin to dry up. Rising interest rates make the cost of borrowing more expensive and see tighter credit conditions for borrowers. As we see less liquidity in the capital markets, funds will have to go elsewhere. And perhaps, gold becomes that attractive opportunity for an inflow of capital, but perhaps it is also that insurance against decreasing liquidity.

The Imminent Taper

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The markets reacted swiftly to the news of the Federal Reserve’s FOMC’s decision to not taper their asset purchases at their September meeting. The press conference following the policy announcement expanded on this to give the impression that the US Fed lacks confidence in the economic recovery to be able to pare back their extraordinary stimulus. While some question the Fed’s credibility at this point and see Bernanke as a repeat offender for shocking financial markets, there could be other shifts going on at the Fed that have caused them to make this decision.

Earlier this year, it created a huge turn in financial markets when the Fed announced that they begin the withdrawal of their asset purchases later in the year. Immediately there was a huge selloff in all markets spanning from equities to bonds to commodities. The only asset for some stability was the US dollar. That helps explain the reaction Wednesday, when the markets took the complete opposite reaction to the Fed’s decision to delay the much anticipated taper. And if Chairman Bernanke tried his best to make clear one single point, it was that the Fed’s decision to taper was and always has been dependent on the economic data. Despite analysts and financial media over-interrupting his press conferences and meeting minutes, data indicating an improvement in the underlying US economy will allow the Fed to taper. Wednesday signalled that day is not yet here.

The job market had provided the best indication for market analysts for the direction of Fed policy. That is why, in an economic recovery, when those numbers are released each month so much weight goes to what they reveal. In this newsletter a few weeks back, discussing August’s weak payroll report, I suggested this could give voting members uncertainty about the upcoming decision to taper, and create the potential for a few months delay, and that is exactly what we saw. Where the Fed used the unemployment rate as yardstick for the quantity of asset purchases to be made on a monthly basis, they realized that their yard stick was no longer the right measuring tool for the State’s economic performance.

Bernanke cited problems with US job creation. Particularly as we enter a period of decreasing labour force participation, and a retiring boomer population that is not being replaced by a workforce with the same skill set. Thus an unemployment rate of 7 percent to allow for tapering asset purchases looks more like some arbitrary goal than one of actual substance. Better signs for the US employment front can be found in the 4 week moving average of weekly jobless claims as that number indicates almost 40 thousand fewer Americans file for unemployment benefits on a weekly basis as did 4 months ago; however, job creation is the foremost issue, and there are still 7 million Americans either under or unemployed since the peak before this crisis began.

Going forward, it’s truly important that investors make themselves cognisant of two issues. These encompass the realm of possibilities in decisions that could come from the US Fed. Tapering can occur at any instance between now and the Fed’s next meeting. It may not, but eventually the taper is inevitable. This could throw a bit of a curveball at the markets. Despite the Fed’s asset purchases as of late being more impactful on sentiment, any announcement regarding change (or lack thereof) can act as a shock to the financial system.

The second is that investors may want to position themselves for an even more dovish Federal Reserve. While some argue Bernanke went back on his word or misled investors, I would suggest (with full credit to Pimco’s Bill Gross) that the shift is beginning to see Fed Vice-Chair Janet Yellen’s influence increase even more. Thus, this is why the market priced in her leadership overseeing the Fed Funds rate unchanged for a longer time horizon.

Although there are many uncertainties, one thing is clear; despite the Fed’s increased transparency and despite their efforts to provide forward guidance—against all efforts to the contrary they still have the ability to send financial markets for a tailspin.

Gold and Geopolitics

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These last few weeks have acted as a nice reminder that the fundamentals of the gold trade can span beyond the idea of Quantitative Easing and the US Federal Reserve. Ultimately, it was a fear trade that brought an influx of fresh buyers to the gold market since its most recent bottom in June of this year, and thus propelled gold higher surrounding 1,400 US per ounce. Of course investors saw those gains quickly pared back as political gaffes from a defeated US administration allowed investors to see that the dissipating threat of military action on Syria would not jeopardize positions in riskier assets like equities. But without taking a myopic or short term view of the metal, the action in gold reminded us of the role gold plays as a hedge or safe harbour from geopolitical instability.

It purely was the lack of direction and organization of the United States Executive Branch that created a shift in the markets this past week. The inability of the representative of the President of the United States on foreign soil, Secretary of State John Kerry, to deliver a satisfactory press conference by conveying his President’s agenda shifted the US to the passenger seat in terms of negotiations with the Russian’s. It also illustrated to investors that this would become a mundane process with little influence on financial markets as the United States diplomatic ability not only lacks conviction, yet also follow through.

Now the bigger question for gold investors and also potential gold investors is: when is there going to be an appropriate entry point for this market?

It seems this market has quickly shifted past this idea of a “war premium” or increased demand stemmed from geopolitical uncertainty. Moreover, if gold’s role is to act as that hedge when investors lose faith in risk assets and look for a safe harbour, the goal would be to already holding a fraction of your portfolio in physical metal. Investors may position themselves in the metal, but ultimately those holdings would be for a long term hedge in lieu seeking a profitable short term trade. Thus, the focus of gold from short to medium term horizon (12 to 18 months) shifts back to the taper debate at the US Federal Reserve.

As the Fed begins their two day policy meeting in Washington next Tuesday, it has long been the anticipation of investors that the Fed will commence tapering asset purchases. Personally, I would like to think that this effect was priced into the market when it collapsed back in the second quarter of this year, but more bearish forecasts arise as Goldman Sachs commodity’s research chief said Friday he could see the metal dipping below 1,000 US per ounce as the Fed reveals there tapering schedule. UBS AG’s Wealth Management commodities research head echoed that message as an advanced taper could ultimately provide a shock to the market. But the message from the investment banks is a signal that the mainstream perspective for gold’s outlook is sideways to negative. Nonetheless, this relates back to gold’s ultimate role as a hedge.

A hedge is an asset that is negatively correlated or uncorrelated with another asset. An example of this is gold and the US dollar; US dollar strength is often associated with weakness in the gold market and vice versa. Stanley Druckenmiller, George Soros’s point man for his infamous Quantum Fund, which brought down the British pound, appeared on Bloomberg recently. According to Druckenmiller, “QE has subsidized all asset prices, and when you end that, all prices will go down.”

Gold will act as that hedge, even if it does not go up in value, it will hold its value amidst market turmoil elsewhere. It has throughout history, and it will continue to.

Jobs and Syria

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The market quietly awaited the August jobs report Friday with premarket trading and futures markets remaining little unchanged ahead of the reading. For the last while, this has been the foremost important monthly event that provides investors with some sort of indication into the direction of US Federal Reserve policy, and thus anticipation for the future course of financial markets. As the Wall Street Journal put it quite succinctly, it’s “the ever-so-brief moment the interests of Wall Street, Washington, and Main Street are all aligned on one thing: Jobs.” Of course as events unfold in Syria and the thought of a US led intervention has investors holding off on returning to the stock markets following a directionless summer, but without a catastrophic blow up in the Middle East, Fed policy will continue to guide markets.

To be upfront and clear, expectations for a September taper are now diminishing, and for the Fed to delay by one month would not be unlikely. Prolonged easing would be a friend of the equity markets as the gains since 2009 have been somewhat exponential thanks to the US Fed’s assistance. But it is the fact that the ever so moderate gains in US job creation are pointing towards sustained, albeit, minute improvement for their labour market. In reality, their labour market still leaves much to be desired. To look into the sectors where job gains are posted, they belong to the retail, service, and hospitality industries. Traditionally, these are sectors where growth is not indicative of an expanding economy. It would be optimal to see the employment in construction and manufacturing moving significantly higher.

Labour force participation, which is in my opinion one of the foremost important numbers to follow, is at its lowest level since August of 1978. And what this translates to is that the percentage of Americans that make up their labour force is diminishing. More and more Americans thus require some form of Social Security or assistance from government as fewer working Americans contribute to these government programs. This is one of the many structural problems the US faces, and these are the pertinent budgetary issues that continue to be left unaddressed over the long term.

The other big shift in the labour market has to do with downward revisions made to the estimate of job creation in the months prior. As the US created 169 thousand jobs in August, both June and July were revised down by a total 74 thousand jobs. Instead of averaging 170 thousand jobs created in the last 3 months—that number sits closer to 145 thousand. That’s fairly significant considering it was the improving prospects of the US labour market that was influencing the US Fed to taper asset purchases come September.

The idea of a September taper is now getting increasingly difficult to call by the day. And again, this has to do with the two aforementioned factors. The first being the questionable jobs data that comes out on a monthly basis and spans from unimpressive to mediocre. The second is the uncertainty created around a US led intervention in Syria. This really gives no indication what might happen in the days ahead, but on one thing we can be certain is the US in Syria has investors wanting to hold gold; moreover, any delay beyond expectations in terms of tapering asset purchases will drive demand for gold.

An Aside: The debate surrounding who should be the next Chairman of the US Federal Reserve is getting increasingly more ridiculous by the day. The seven appointed governors (including the chairman) of the Fed board all vote in unison and it’s the conditions of the economy that warrant and determine policy over the CV of the candidate. Where someone might have more influence on economic policy would be as the Secretary of the Treasury Department or as the Director of the National Economic Council for President Obama designing a TARP bailout package (posts Larry Summers has held). Thus, it’s a little surprising this debate over the qualities of Larry Summers is just happening now.