Our analysis of global markets often comes from a contrarian point of view. Since the 1970s, we have been well-known among investors in precious metals for this reason. We are agnostic about precious metals, viewing them a potentially important tool in an investor’s kit for surviving and prospering under a variety of market conditions. On the other hand, we don’t believe that a significant gold position is wise under all such conditions. However, we understand when gold can be indispensable. Unlike some investment advisors, we would never scoff at the yellow metal; for some investors, an “insurance policy” in gold is wise.
We believe that as the year unfolds, gold will be seen to be in a slow-motion bull market. Gold has been in a broad uptrend since the beginning of 2017, though in 2018 so far it has been moving sideways in a range between about $1300 and about $1370.
Source: Bloomberg
We’ve said often that gold is a “vote of no confidence” in the stability of governments and financial systems. That of course is one of its functions: since time immemorial it has been a haven in the storm during periods of war and crisis of all kinds. Outside of such extreme circumstances, however, the U.S. dollar price of gold depends on three basic interrelated factors: U.S. inflation, U.S. budget deficits, and the strength of the U.S. dollar.
Inflation
Rising inflation is becoming evident. One barometer is the price of oil, which has been rising since mid-2017.
Source: Bloomberg
The price of oil is of course a complex variable in its own right, and often confounding to investors — moving according to technological developments, military and political tensions in oil-producing countries and regions, attempts at manipulation by cartels and governments, global growth trends, etc.
In the present environment, the trend of oil’s rising price likely reflects the same trend that has been visible in the global economy since the beginning of 2016: a reacceleration and shift away from the slow-growth, anemic post-recession recovery.
Directly and indirectly, oil is essential for virtually all manufacturing and transportation. Therefore rising oil prices, with a lag, pass through into the rest of the economy and contribute to inflation.
During the current season of earnings reports, we have heard the managements of many companies comment on their rising costs and the effect those rising costs will have on their margins. (This is one reason why the enthusiasm of market participants has been dampened even though earnings have been very strong.) We view this as another sign that after an long, abnormally low period, inflation is showing signs of life.
Modest and rising inflation supports the price of commodities in U.S. dollar terms. If the trend continues — and we believe the signs still suggest that the U.S. and global economies are in good health — we believe it will support gold.
Budget Deficits
Another key to the gold price is the U.S. budget deficit. (Hat tip to Tom McClellan for this insight.)
Source: Bloomberg
The correlation is general, not close, but the trend is clear: rising budget deficits support a rising gold price. The character of the current U.S. administration is pretty clear: deficit hawks are not warmly welcomed fellow travelers. For now, at least, growth takes center stage; worries about the long-term effects of growing debt are being sidelined. Neither party is now a party of fiscal restraint.
Some analysts suggest that the Republican Party, historically an uneasy amalgam of libertarians, social conservatives, and populists, is undergoing a realignment of the same magnitude as the one catalyzed by Barry Goldwater in the 1960s and Ronald Reagan in the 1980s. The party that emerges from the crucible of Trumpism may marginalize the deficit hawks for some time to come.
If all of this is true, we are at the beginning of a period of higher deficits. Historical precedent suggests that this means higher gold prices.
The U.S. Dollar
So far, then, two of the three long-term factors are supportive of our thesis of a slow-motion bull market for gold. The third, the trend of the U.S. dollar, is not as clear. It has moved up strongly since rising interest-rate fears began to grip the markets in March, but may still be in a longer-term downtrend. Dollar movements are the result of the interplay of complex global financial and economic influences. The chart below shows the value of the U.S. dollar against a weighted basket of other major global currencies, including the euro and the yen.
Source: Bloomberg
The movement of the dollar will have a psychological impact on dollar-denominated commodities such as gold and oil. As we write, the dollar is trying to break above its highs of early January. If it succeeds and continues its present rally, that will act as a damper on gold’s appreciation. On the other hand, should the dollar break down and resume its decline from the January, 2017 high, that will strengthen gold.
Gold Miners and Gold Bullion
One signal that a slow-motion bull market in gold may be getting underway is the relative performance of gold miners and gold bullion. We note that since early to mid-April, gold miners and gold bullion have (at last) diverged, with the miners outperforming. Why has this happened? One big reason is that gold miners are now better-managed than they have been over the last 10 years, with a focus squarely on profits and not on grandiose and expensive new projects. Managements are more sensitive to financial benefits and costs, and less interested in new greenfield projects. We recommend that investors focus on gold miners which are financially sound and well-managed for the majority of their investments. Speculators may be interested in smaller companies with big growth prospects.
Source: Bloomberg
Investment implications: Stock market jitters notwithstanding, interest rates and inflation seem at last to be rising from the prolonged lows of the post-recession recovery, supported by slowly normalizing central bank policy and by stronger economic growth in the U.S. and most of the world. The environment is right for a slow-motion bull market in gold for the remainder of 2018 and into 2019. If gold approaches technical support at $1294, this may be time to add to gold share and gold bullion positions. Should it break that technical support, however, that may indicate that other more powerful forces are countering the positive environment; investors should watch the U.S. dollar carefully to see whether it continues its recent appreciation or resumes its longer-term downtrend.
