[We have considered prices of financial assets (primarily stocks and bonds), liquidity in financial markets, savings and debt levels in the personal and corporate sectors and the associated volatilities as inputs while thinking about the possible direction of gold prices over the next 12-18 months.]
The benchmark Dow Jones Industrial is year-to-date up by 15 per cent after ending 6 per cent lower last year. The volatility index of some of the major benchmarks, S&P 500, DJIA and Nasdaq are way lower than their 52-week highs. Stock markets in India, UK, China and Japan are also up by varying degrees. However, so far as the US market is concerned, the cyclically adjusted price to earnings ratio for S&P500 as of December 2018 was around 27 — very close to the average of the past 28 years. The rise in equities since 2009 has been driven by increasing P/E ratios, aided by an increased liquidity from quantitative easing.
So far as liquidity is concerned, consider the ripples caused by a small stone when thrown into a large lake and a small puddle. Liquidity is like water — if it is deep and plentiful, the ripples will be small; but if it is shallow, the ripples will be large. Deutsche Bank has a report that shows that financial conditions in the US have become markedly tighter in recent months.
Liquidity is to the economy what grease is to engines. More liquidity (up to a point) helps the engine run more smoothly, while less liquidity reduces the engine’s efficiency. Like the grease in an engine, the difference between optimum and sub-optimum is often very fine and dependent on many variables. Too much grease will not significantly enhance engine performance, but too little grease can lead to disastrous consequences. Similarly, too much liquidity will not enhance growth, but too little liquidity can cause a significant short-term drag. One needs to look no further than India’s economic growth shortly after demonetisation. While liquidity due to quantitative easing has declined, there is still sufficient left in the tank in global markets, though the exact numbers are disputed.
Currencies of some of the developed and emerging economies are all in the green. The Credit Default Swaps market for both developed and emerging countries show that the level of risk is by and large low, but for some outliers like Greece, Italy and in the East-Asian markets Indonesia, is concerning.
In the United States, personal savings as a percentage of disposable income as of the end of 2018 was 6.8 per cent, according to the Bureau of Economic Analysis, down from its 2012 peak of 10.2 per cent. This is even with personal disposable income growing at an average rate of 5 per cent in the past five years after a 2 per cent decline in 2013 and last decade’s average year-on-year growth of 4 per cent. In absolute value terms, savings as a percentage of disposable income is the highest since 2012, second-highest on record, and the amount is equivalent to the total disposable personal income in 1973 on a relative basis. The majestic “Under Pressure: The Squeezed Middle Class” by OECD shows that "middle-class households have felt left behind and questioned the benefits of economic globalisation. The costs of some goods and services which are essential for a middle-class lifestyle, such as housing, have risen faster than earnings and overall inflation". In many OECD countries, middle incomes have grown less than the average.
Trying to relate this with the US macroeconomic numbers, it is hard to find a reason that would indicate a slowdown in American consumption; rising tariffs could be one, though, if the (US President) Donald Trump-led trade wars are not called off. Household debt is now at a record high of $13.54 trillion, but as a percentage of gross domestic product (GDP) it is only 68 per cent, compared with about 88 per cent in 2008.
But then, isn’t it the debt that helps the economy run, especially the US and Chinese economies? What should be of concern is the leveraging on this debt and whether the Federal Reserve and treasury department have the ammunition in hand to shoot down systemic risks in the market. The US debt to GDP is at 107 per cent; the Chinese debt to GDP is estimated at more than 300 per cent — though one is unsure of the latter number. That makes us refer to the International Monetary Fund’s (IMF’s) Global Financial Stability Report, the highlight of which is the rise of non-banking financial institutions and the fact that they hold $1.1 trillion of leveraged loans in the United States, double the pre-crisis levels. The report was released in October and the market seems to have apparently shrugged it for now. But the temptation to take profit off the table from high-risk assets could become the priority and might see a shift to low-yield assets.
This increased saving and the risk of leveraged loans is reflected in the increase in demand for 5-year US treasury over the 2-year one, leading to an inverted yield curve. We compared the prices of treasury yield and DJIA on a weekly close. Our observation is that it has been consistently holding since the first week of December 2018; that is a reason for worry. Last time, the yields were inverted for 77 weeks (second week of 2005 to first week of June 2007) and DJIA hit a peak in December 2007 before turning sharply lower. And before that, from March 2000 to December 2000 yields were inverted, but DJIA was range-bound all through after hitting a peak in Jan 2000 and falling subsequently in the following year. Further rewinding, from July 1978 to April 1980 yields were inverted, DJIA reversed from 1020 in April 1982, falling by more than 20 per cent over the next 18 months. So as you see here, 2008 was sub-prime, 2001 was Y2K and 9/11, and 1982 was contractionary monetary policy. We are confident of not a repeat of severity as seen in 2008, but yes the geopolitical risks and the US Federal Reserve’s monetary policy are where we have our bets placed.
All the recent economic evidence is pointing to a slowdown. So there is little reason to expect a rate hike from a data-driven Fed. The "dot plot" that makes up members' projections showed 2019 year-end expectations for the fed funds rate at 2.375 per cent, lower than a previous expectation for 2.875 per cent. In the main, it feels like central banks are done with this tightening cycle. They have a weaker arsenal at their disposal to deal with a recession (and one is coming!).
Was the Fed trying to stave off an impending recession? As investors analysed the information, two weeks ahead of the last rate-cut announcement in December 2018, the 2- to 5-year spread started showing signs of a possible move into inverted-term structure, followed by a dovish statement in the March 2019 FOMC meeting. Two points to note: First, any recession does not immediately follow an inverted term structure. Historically, a recession takes between 12 and 24 months after the spread gets inverted. Second, the 2-5 and 3-10-year spreads are pretty reliable indicators that a recession will happen — but say nothing about precisely when!
Our conviction also stems from the volatility of gold, both in dollar and non-dollar currencies, which for many countries incidentally are the lowest since 1995-96 and for some of them the lowest from the period we calculated (that is 1980). Volatility dropping to more than two-decade low levels, that too when gold in dollar is languishing at a lower range, could be an indicator of a sharp move waiting to happen. We also looked at the LBMA price forecast for last 10 years to judge sentiment of some well-regarded 30 analysts who regularly provide their annual forecast at the beginning of each year to LBMA. An interesting observation was narrowing down of the forecast range between high and low in last five years from $1,300 to $325, while the lows have reduced over the years, the higher range has remained consistent.
Factors that concern dollar for the next two years is President Trump’s trade policies and the impact of the Mueller report on Trump’s regime. Fed’s recent outlook on interest rates shows its dovish stand, a sharp shift from last year’s four consecutive interest rate hikes. The volatility in some major currencies is near multi-year lows. This coincides with Citi Macro Risk Index, which is near a point of U-turn. The volatility in benchmark equity indices is also only a few points above the 52-week lows, and so is the volatility in gold prices in various currencies.
The demand for gold also remains robust. An important bullion bank supplier of gold in Asia says that as on March 31, 2019, the central bank uptake of gold remained at a run rate that could match the annual central bank purchase of gold in 2018.
All of these would suggest that gold prices are likely to rise. By how much and when? Over the period of 12-18 months, a 10 per cent increase is not unlikely. If the recession portended by the inverted yield curve becomes more likely or is seen to be closer, the rise could happen more quickly, and be higher.
Term structure of US treasuries: Trying to protect from short-term headwinds
Arvind Sahay is Professor of Marketing and Inernational Business at IIM-Ahmedabad and Chairperson of India Gold Policy Centre (IGPC), and Sudheesh Nambiath is head of IGPC at IIM A.
The views presented here are of the authors and do not necessarily reflect the opinion of the institution they are affiliated to.