The weekend was hardly a relaxing one on Wall Street. With an imminent default ahead due to a fallout in negotiations between Greece and its creditors over the weekend, the drama continues; one has to wonder how far the Greek government is willing to take game theory risks. With Greek banks shut on Monday, the game’s almost over – and along with that, a major, major wrench in the European recovery may be falling in place.
Meanwhile, US economic data – as well as much of the rest of the world’s – continues to moderately impress, albeit in a lukewarm, nonchalant way – sort of warm enough to satisfy the hunger, but not really hot enough to be delicious. The US showed a revised Q1 GDP that contracted less than expected, the Personal Consumption Expenditure index (the Fed’s preferred inflation gauge) nudged higher over the past 2 months, and companies continued to hire while operating at record margins. Overseas, we’re seeing signs of inflation in Japan, US rate hike discussions continuing to weigh on emerging markets, and frontier markets including Cambodia, Pakistan, and others getting more attention as the focus shifts away from China’s manufacturing engine towards less expensive economies. Also worth noting is that the disconnect of China’s markets with its economy seems to be slowly disappearing – Shanghai stocks dropped over 8% last week, complementing a major plunge in the previous week as well. Overall, with Greece’s drama reaching the final frontier and US rate hikes pending, investor seem to be resilient as markets really haven’t given up too much in value. We felt that JP Morgan’s chief US economist, David Kelly, summed it up nicely – according to him, none of the four triggers that cause a bear market – those being a recession, a spike in commodity prices, aggressive monetary tightening by central banks or extreme valuations, are in place. So, at a time when turbulence via rate hikes, inflation, and potential panic due to a Greek exit remain on the radar, an interesting debate this week prompted us to elaborate on gold. Here’s what we’re thinking:
Gold: If there’s one symbol the whole world recognizes in unison, it’s this unique metal. Used for centuries as a currency around the world, the commodity lost much of its monetary relevance in the 1970s, when the gold standard was abolished and national currencies started getting priority for trade. Nevertheless, the emotional and addictive connect – with what is essentially a rock – continues to drive investment decisions, impact jobs and economies, and provide instant insurance under the pillow (or bank locker) for millions – if not more – of households across all income levels, demographics, and regions in the world. Turning to the markets, gold peaked around $1900/oz (in COMEX spot prices) in 2011. The commodity had a massive bull run from the early 2000s, when it was around $300/oz, providing a phenomenal return for those that owned it during the span. Since 2011, however, investors have gotten burned, as it finds itself around $1170/oz today (COMEX spot prices) – down 35% since the peak. Traditionally, gold has provide a good return with inflation – something that has been sorely missed during the economic recovery post-2008. So, given that inflation seems to be slowly returning, is now a time to get back in the game? We think not, for numerous reasons:
Gold, like various other commodities, is priced in US dollars. So, as the dollar strengthens – a trend likely to continue given the US’s imminent interest rate hikes – gold becomes theoretically ‘cheaper’ to buy, and therefore, currency trends should provide resistance for a major upward price. At the same time, a Greek default in the coming days could cause panic, aiding fear assets, with gold near the top of the list for investors seeking protection. As investors, we’re therefore looking at stark outcomes that are hard to quantify, and with diametrically opposite pulls – not to mention that gold – by itself – doesn’t provide cash flows or dividends, making the valuation much more complex.
Over to the consumption side: China and India, which together provide over 50% of the world’s gold consumption, have both been looking elsewhere with their money recently – in China’s case, towards the stock markets or real estate, or in India’s case, elsewhere due to government-imposed controls aimed at reducing gold imports (a decision made by RBI governor Raghuram Rajan, considering gold’s massive impact on the Indian current account deficit over the decades). With investment options increasing as markets become freer, we feel that consumption from these regions shouldn’t be a major driver for prices.
From a supply perspective, South African gold mines, meanwhile, remain turbulent due to union rivalries as highlighted by Barron’s this week – another factor which is well beyond investors’ hands. Although supply constraints seem imminent, the GLD ETF or gold spot prices haven’t really moved much, which makes us feel that worldwide sentiment remains neutral towards this asset. Gold is, in our opinion, not like copper, platinum, or silver, which have far higher industrial usage in appliances and manufacturing, and therefore can be valued more appropriately. Will Rhind, the CEO of the World Gold Trust, stated last week that ‘the GLD ETF hit a high of $2 billion in inflows year-to-date, but as of the 24th of June, there have actually been net redemptions over the course of the year’.
Our point? Despite the 35% drop from its peak in 2011, the outlook for inflation and a potential Greece-induced panic, investors don’t seem to be attracted towards gold, considering futures contracts have barely moved in recent weeks. We feel the same way. Essentially, gold is a fear asset – one for which the returns are contingent on the next buyer paying more than the seller originally did. It doesn’t reward holders by paying dividends – and importantly, it doesn’t add value, the way companies do (investing in gold didn’t create an iPhone, a jet engine, or a water purification system, for example). In effect, it benefits the buyers, but not too many others – and the returns are highly dependent on factors well beyond the holder’s control. The current market definitely calls for diversification, but we believe it’s easier to achieve with stocks and ETFs focused on companies and regions that are not commodity-driven – especially in the case of this specific metal.
What it means for you: We recommend staying away from gold, as rather than cash flows, dividends, or value-addition, sentiment gets far more say in deciding the supply and demand pricing for this commodity than what we look for in an investment. On a broader note, watch the news from Greece this week. We’re concerned that the referendum declared by the Greek government leaves the outcome of the situation in the hands of voters that, while well intentioned, may not have the appropriate incentives to make the right call for the long term. If things do go downhill (the way futures are indicating at the moment), one thing’s for sure – significant bargains will show up in the markets. Picking up the precious jewelry – in the form of companies that investors throw out during panic situations – has the potential to look really good in the long term. The key point, in our opinion, is that domestic fundamentals in major regions are looking pretty good. Keep some cash handy as Wall Street looks for direction from Europe this week.
