Van Eck Global’s gold specialist Joe Foster comments that the panic that hit global financial markets in August had a good effect on the gold price.
He writes that the unfolding events in China brought weakness and volatility to markets around the world. “Gold started trending higher on August 11 when the Chinese government made adjustments to the way the yuan is currently managed, enabling the currency to experience its largest two-day decline in more than a decade.”
He observes that some analysts saw this as a desperate attempt by China to help stimulate its ailing economy through currency devaluation. “With confidence waning, on August 18, China’s stock markets began a plunge to new lows for the year, with the Shanghai CSI 100 Index declining 24 per cent in six trading days. This reverberated through global markets as commodities, emerging market currencies, and many developed market stock indices declined to new lows. While the gold market encountered considerable volatility, gold bullion outperformed most asset classes in August with a USD38.98 (3.6 per cent) gain, compared to declines of 1.5 per cent for copper, 1.3 per cent for the US Dollar Index (DXY), and 6.0 per cent for the S&P 500 Index.”
Foster writes: “Gold stocks felt the pressure of the general stock market sell-off, however, they were still able to achieve gains for the month, as shown by the 2.06 per cent advance in the NYSE Arca Gold Miners Index and the 4.66 per cent gain in the Market Vectors Junior Gold Miners Index.”
Several indicators suggested tight supplies of physical gold in August, according to Foster. “After experiencing heavy redemptions in July, gold bullion exchange-traded products became buyers, Shanghai Gold Exchange premiums trended higher, and gold forward lease rates turned negative. Offsetting these bullish indicators were reports of hedging by gold producers in Australia. With the Australian dollar gold price up 9.8 per cent this year, some producers are seeing an opportunity to use limited hedging (selling gold forward) to ensure cash flows to high cost operations or to service debt.”
Looking forward, Foster comments that in August, gold performed as a safe haven investment, evidenced by its outperformance against most asset classes in the midst of
widespread panic.
“Investors were afraid that further economic weakness in China might spread to engulf the global economy. Since 2013 gold has experienced several short-covering rallies sparked by geopolitical or financial stress. The last took place in January, when Greek debt problems re-emerged, and the Swiss broke its currency’s peg to the euro.”
Foster believes that these rallies had no legs because, in the firm’s opinion, the risks that drove them posed no real or lasting threat to the global economy, particularly the US economy or financial system. Foster writes: “Now financial risk is again driving gold and we ask, is this another temporary short-covering rally or the beginning of a sustainable trend? Once the short covering has run its course, is there enough investment demand to drive gold?”
The firm believes that international markets are overreacting. “China has been working with the International Monetary Fund (IMF) and others to enable the yuan to achieve international currency reserve status.”
The IMF is expected to make a decision, which may come later in 2016, on whether to include the yuan in its currency basket. “The recent disclosure of China’s gold reserves and moves to eventually enable the yuan to float freely are part of this process. It looks
as though the Chinese government is learning the hard way that changing currency policy in the midst of a stock market rout is not the best timing.”
Foster writes that the meteoric rise of the Chinese stock market this year was driven
mainly by a change in margin rules that enabled retail investors to speculate. “With the market crash, the Chinese government is again learning the hard way what happens when inexperienced investors are given access to loans used to speculate on the market.
While these events are important to China, their fundamental impact on the global economy and financial system dissipates as one moves further from Asia.”
The Asian crisis of 1997–1998 was much worse, Foster points out, eventually triggering a Russian debt default and the implosion of hedge fund management firm, Long Term Capital Management. “Yet the US economy survived unscathed and gold’s
overall trend was down from 1996 to 1999. Similarly, we don’t believe current events in China can serve as the source of longer-term support for gold as a safe-haven investment in the West.”
The firm sees greater risk elsewhere with nervous markets which are not a good backdrop at a time when the Federal Reserve (Fed) is poised to make a historic
rate decision. “With policy rates near zero, the Fed’s primary tool (rate cuts) to kick start the economy is useless, in our view. This probably accounts for much of the nervousness, as investors must decide whether a shock in Asia can generate a market tsunami that reaches US shores with virtually no policy protection.”
He is concerned that the rest of the world will fear that the Fed will “set off a ripple effect with a rate increase that turns into a tsunami on distant shores”.
Looking globally, Foster finds that the U.S. economy is relatively healthy and could probably withstand a series of rate increases. “However, the Japanese economy contracted by 1.6 per cent in the second quarter. China’s struggles are widely known. Brazil is in recession. European growth is slow and consumer prices advanced just 0.2 per cent (annualised) in August.”
The price of WTI crude oil fell below USD40 per barrel in August and copper is nearing USD2.00 per pound, Foster notes. “The flow of easy money brought on by quantitative easing and the carry trade into emerging markets reversed course when the Fed began to taper a couple of years ago. The world outside of the US is now on the verge of deflation. Will rising rates, a strong US dollar, and economic opportunities in the US suck the remaining economic life (growth capital) out of the global economy? Can the US remain an island of prosperity?”
In conclusion, Foster says that an important difference between now and the period of the 1997 Asian crisis are the imbalances in the global financial system caused by radical monetary and fiscal policies. “Imbalances in interest rates, sovereign debt, asset prices, and central bank holdings are currently at unprecedented levels. Raising rates in a weak global economy with macro imbalances has risks. Postponing or eventually reversing course would damage the Fed’s credibility and would risk a loss of confidence. As we move towards 2016, these are some of the issues that could be supportive of the gold market. The more probable source of systemic risk lies in Washington, DC, not Beijing.”
