The austerity affair is over and gold knows it

Don’t tell Boaz Shoshan, my colleague over at Capital & Conflict. I’m about to commit what he calls a “chart crime”. It’s when you fiddle with or cherry-pick the dates you use on your charts to help support your conclusion.

In this case, I’ll lie both ways, like a pair of lawyers.

We’re looking into the performance of gold relative to gold stocks. In the US market, to strip out exchange rate effects.

The Aberdeen Standard Gold ETF Trust (SGOL.NYSE) is our proxy for the gold price. It’s an exchange-traded fund that tries to mimic the price of gold, less the cost of running the fund. Our gold stocks proxy is the GDX ETF, a broad collection of gold stocks.

If you pick your dates based on the 2016 bottom in gold stocks, the comparison looks like this…

Gold (blue) and gold stocks (red)

Source: Yahoo Finance

Gold stocks have outperformed gold nicely. But pick a different date – 2017 – and you get a different story…

Gold (blue) and gold stocks (red)

Source: Yahoo Finance

The two look closely correlated. And that’s the typical result you get if you play around with the timing. Gold stocks are just a more volatile version of gold.

But if you bring the chart out a few months earlier, it looks like the gold bullion price has outperformed gold stocks. Or if you go back to 2010, gold stocks have been very poor relative to gold. The GDX was down 80% at one point…

But I’m sure you get the point. Your returns are determined by when you invest in them, not which one.

This is a strong argument for gradual accumulation of investment assets. Put some money in each paycheque and the arbitrary nature of the day you bought sort of gets diversified away.

But that’s not the message I have for you today. It’s all about whether you should be buying gold or gold stocks. Because it should be possible to determine which of the two is set to outperform. In its simplest version, this argument goes as follows: when gold stocks underperform gold, they’re a buy.

Is that how things look now? The answer may well be hidden in the first chart. While gold is at seven-year highs, gold stocks haven’t even recovered to 2016 levels…

This is a surprising divergence. Back in 2011, Wealth Daily wrote “Gold mining companies have always outperformed the physical bullion in the market. By some estimates, gold stock investors beat spot prices by a 3-to-1 ratio”. That’s been wrong ever since…

But why is hard to figure out.

The equation for gold stocks includes the cost of financing. And that’s at incredibly low levels thanks to central bank interest rates. In a world of cheap debt and high gold prices, you’d expect gold stocks to boom. It’s the ideal combination. Other input costs for gold stocks include wages, which haven’t soared either.

One theory for gold stocks’ period of malaise says that people were so badly burned in the bear market to 2016 that they don’t want to participate in the current bull market. Gold is a very political topic and its price is set in the futures market, where only a little physical gold is actually traded. Currently, central banks are the major buyers. But that can change if the gold price surges.

All this makes gold a volatile asset influenced by a huge variety of forces. Gold traders, who set the price, are skittish.

Most scenarios where gold surges are not very good for the stockmarket generally. Gold stocks got crushed in 2008 like everything else. So buying gold stocks means adding risk on to risk.

But recently, both gold and gold stocks have performed well. A few days ago, our gold stock expert Eoin Treacy made a video about gold’s prospects and why it had shot up so dramatically. The short-term answer may have been Donald Trump’s drone strike. But the long-term answer is one that Eoin and I are increasingly focused on.

We’ve had quantitative easing (QE) come and go and come back again in the last decade. This was supposed to cause inflation. But it didn’t. It didn’t even make gold go up much. Why? Because the other half of the equation was missing.

Historically, money printing and government spending were inseparable. But a decade ago, they got divorced. Austerity and QE had an affair – opposites attract and all that. But now she’s promising that’s over. With Trump and Boris Johnson in power, and the EU set to review the Growth and Stability Pact – the legal basis for austerity in the eurozone – this month, deficit spending is back in the picture.

And we both know what happens when fiscal deficits and QE get together. They have children called inflation.

This is what’s behind gold’s move – why it has held up in the face of a half-baked retaliatory strike out of Iran. Because inflation is coming, in the form of QE and deficit spending.

This would be a stunning shock, completely out of the blue. Inflation is not exactly priced into European bond markets with their 0% rates. And yet, the portion of bonds with negative rates has fallen in recent months. So perhaps the bond market is worried too.

If inflation returns in an era of deficits and monetisation, gold will become the asset of choice. If it isn’t already.

But what’ll this do to gold stocks? Find out here.

Until next time,

Nick Hubble
Editor, Southbank Investment Research

Category: Commodities

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