David Fuller and Eoin Treacy's Comment of the Day
Category - General

    In gold we trust

    Thanks to a subscriber for the 11th annual edition of Ronald-Peter Stöferle and Mark J. Valek’s trademark report on the gold market for Incrementum. Here is a section:

    Moreover, the ratio of real assets to financial assets is currently the lowest since 1925.5 In a study worth reading, Michael Hartnett, chief strategist at Bank of America Merrill Lynch, recommends to “get real”, i.e. to reallocate investments from financial assets into real assets.

    "Today the humiliation is very clearly commodities, while the hubris resides in fixed-income markets" as Hartnett explains. Gold, diamonds, and farmland show the highest positive correlation with rising inflation, whereas equities and bonds are negatively correlated with increasing prices, a finding that we have pointed out repeatedly. The political trend towards more protectionism and stepped-up fiscal stimuli will also structurally drive price inflation.6

    In the past years, rate cuts and other monetary stimuli have affected mainly asset price inflation. Last year, we wrote: “Sooner or later, the reflation measures will take hold, and asset price inflation will spill over into consumer prices. Given that consumer price inflation cannot be fine-tuned by the central banks at their discretion, a prolonged cycle of price inflation may now be looming ahead.” 2016 might have been the year when price inflation turned the corner. However, the hopes of an economic upswing due to Trumponomics and the strong US dollar have caused inflation pressure to decrease for the time being. Upcoming recession fears resulting in a U-turn by the Fed, and the consequential depreciation of the US dollar would probably finalise the entry into a new age of inflation. This will be the moment in which gold will begin to shine again.

    Low interest rates combined with the pressure to invest and FOMO, have nurtured a treacherous sense of carelessness within many market participants. Scenarios such as significantly higher inflation or a recession are currently treated like black swans, although history shows that these events do occur at regular intervals.

    Many signals suggest that we are about to face a big shift within the financial and monetary system. Nobody can foresee what it will look like. But an early look at such scenarios creates a good opportunity to come out stronger at the other side of this transition. As Roland Baader brilliantly summed it up: “In the middle of the boisterous summer party, the sensitive ones start feeling the chills.”7 To some degree, we find ourselves in this quote.

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    Why Diplomacy Is Unlikely to Solve the Korean Crisis

    Thanks to a subscriber for this article by George Friedman at his new venue Geopolitical Futures. Here is a section:

    All of this raises the question of whether China is acting in good faith. By cooperating, China might gain economic concessions from the United States, but it’s unclear how long they would last. And China might actually welcome a United States obsessed with a North Korean ICBM aimed at the U.S., since this might divert U.S. focus in East Asia from China to North Korea permanently. Finally, while common sense would suggest that China has significant leverage with North Korea, that should not be overstated.

    Economically, North Korea is relatively self-sufficient. It has chosen poverty over dependence. The economic sanctions China can impose, such as blocking North Korean coal exports, have already been used in previous crises. The North Koreans, moreover, haven’t trusted China since the Korean War, when China made no attempt to intervene until the U.S. threatened to cross the Yalu River into China. Absent that, the Chinese, having encouraged North Korea to invade the South, were willing to see North Korea fall. Using China as a negotiator might seem logical, but China has few chips to play and a history of betrayal.

    Mattis presented this issue in an interesting way in Singapore. On the one hand, he expressed confidence in China on North Korea. On the other hand, he ripped into Chinese policies in the South China Sea as violating international law. The message was that nothing China does in North Korea will make the U.S. concede the South China Sea, which was a relief to the audience in Singapore. But Mattis also conveyed the message to China and others that the U.S. is not confident in finding a diplomatic solution to this crisis.


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    Gold remains expensive insurance

    Thanks to a subscriber for this report from the Deutsche Bank which may be of interest. Here is a section: 

    Expensive by any number of measures…
    At the current spot price of USD1,260 – 1,265/oz, gold screens as expensive against almost all other metrics. The average of nine metrics suggests that the fair value for gold is USD1,015/oz. At the bottom end of the range G7 per capita income (gold’s affordability) would suggest a fair value of USD735 – 740/oz. At the upper end of the range and the only measure whereby gold looks cheap is treating gold as a reserve currency. Here the size of the big four central bank balance sheets (ECB, BoJ, PBoC and Fed) would suggest a fair value of USD1,650/oz. As a blunt gauge of relative value, this approach is okay, but the spread is too wide to be of any real use as a serious forecasting tool. Instead, we prefer to synthesize the main price drivers into a four factor regression model.

    The current gold price suggests that heightened risk perceptions persist
    Although the correlation coefficient on our model is 87%, there are very discrete periods when gold trades above the model forecast as well as below. Our interpretation is that when gold trades above, the market is going through a period of heightened risk perceptions, be it the expectation of a collapse in the global financial system or rampant inflation. Over the past 10 years, we have had an extended “bull market” period lasting 3 and half years and an equivalent “bear market” of 3 and a half years. Our model suggests that gold should be trading at USD1,185/oz, 6% below the current spot price. The current “premium” period for gold started in February 2016. We expect this environment to continue into 2018. Nevertheless, we retain our cautious to neutral view on gold with the Deutsche Bank house view on the model inputs pointing to a year end price of USD1,150/oz even when factoring in further political and financial uncertainty. Our Q4 price forecast is USD1,230/oz, which already incorporates a risk premium.

    A short term insurance policy for those who want it
    Although gold screens as expensive, there is a short term scenario (3 month) which would justify gold trading higher, in our view. In the near term, our US rates economist Dominic Konstam sees scope for the US 10-year bond yield to fall to 2% (before rising to 2.75% by year-end), as falling excess liquidity points to softer US growth momentum ahead. If we apply a US 10 year bond yield of 2%, a USD 2% weaker from current levels (not our FX strategist view) and the S&P500 down 5% from current levels, our fair value model points to a gold price of USD1,320/oz.


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    Monte Paschi Wins EU Backing on Revamp, Paving Way to Rescue

    This article by Aoife White and Sonia Sirletti for Bloomberg may be of interest to subscribers. Here is a section:

    The EU will now work with Italy on details of Monte Paschi’s final restructuring plan. Italy will need to formally notify the EU of the plan, including commitments on the restructuring. The EU will then move to adopt final approval for the recapitalization.

    Monte Paschi’s senior management will have their salary capped at 10 times the average salary of bank workers as part of measures “to substantially increase its efficiency."

    While subordinated bondholders will have to contribute to the costs of the restructuring, Monte Paschi will compensate retail junior bondholders who weren’t properly informed of the risk they were taking on that bonds might be converted to equity, according to the statement. The bank will buy the converted equity from those investors and pay them in “more secure senior instruments."

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    U.S. Won't Change Efforts to Cut Emissions Post-Paris: Tillerson

    This note by Katia Dmitrieva for Bloomberg may be of interest to subscribers. Here it is in full:

    Secretary of State Rex Tillerson says the U.S. won’t change “ongoing efforts" to reduce greenhouse gas emissions in the future, despite pulling out of the Paris climate accord.

    U.S. “has a terrific record on reducing our own greenhouse gas emissions It’s something I think we can be proud of and that was done in the absence of a Paris agreement," he tells reporters before meeting at State Dept with Brazilian Foreign Minister Aloysio Nunes Ferreira


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    U.K. Pollsters See May Upping Majority Even as Lead Shrinks

    This article by Tim Ross for Bloomberg may be of interest to subscribers. Here is a section:

    May is set for a healthy majority of at least 50 seats which could become a landslide of as many as 200. “In this type of election, which has switched back to two-party politics, once you start polling in the 40s you can win big.” Tony Blair won his landslide in 1997 with 43 percent of the vote. The "numbers behind the polls” -- such as the relative ratings of the leaders and who’s best to manage the economy -- all still favor May.

    Joe Twyman, head of political polling at YouGov
    May should get a majority of 40 to 60 seats. “A lot could still happen. The Tories have not had a good campaign. Labour have had a better one, but started from a low base. Turnout will be crucial given how age is now such an important social cleavage in Britain.”

    Adam Drummond, senior research manager at Opinium
    May is on course to win a majority of 72, based on the latest data. Even if the Tory lead narrows further, she should still have a majority of 50 to 70, partly because the party’s so far ahead of Labour among older voters "who always go out to vote."

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    How Long Can the Fed Keep the Boom Going?

    Thanks to a subscriber for this article by Thorsten Polleit for the Mises Institute. Here is a section:

    To keep the boom going, the central bank must keep interest rates below their natural levels. It cannot raise them back to “normal.” First and foremost, higher interest rates would make the boom collapse. The credit market would collapse, stock and housing prices would tumble, and the financial system and the economy as a whole would go into a tailspin.

    One may ask: Why is the Fed then raising rates then? Perhaps the Fed’s decision-makers think that the US economy has overcome the latest crisis and higher interest rates are economically justified. Others might wish to tighten policy for getting the short-term inflation adjusted interest rate out of negative territory.

    Be it as it may, the disconcerting truth is this: Fed rate hikes will close the gap between the natural interest rate and the actual interest rate level. This, in turn, amounts to putting a brake on the boom, bringing it closer to bust. It is impossible to know with exactitude at what interest rate level the US economy would fall over the cliff.

    One thing is fairly certain, though: The US economy, and with it the world economy, is caught between a rock and a hard place. Maybe the Fed’s current rate hiking spree will bring about the bust. Or the Fed refrains from raising rates further and keeps the boom going a little bit longer.

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    Japan Business Investment Rebounds as Corporate Profits Jump

    This note by Connor Cislo and Maiko Takahashi for Bloomberg may be of interest to subscribers. Here it is in full:

    Capital spending in Japan topped estimates during the first quarter of the year as the tightest job market in more than two decades drove investment in labor-saving technologies.


    Capital expenditure rose 4.5 percent in the first quarter of 2017 from a year earlier (estimate +4 percent).Corporate profits climbed 26.6 percent. Company sales rose 5.6 percent.

    Key Takeaways

    A moderate economic recovery and a labor shortage have created a favorable environment for business spending, prompting companies to invest in technology. Today’s figures will be used to revise first-quarter growth, with the result due to be released next week. The preliminary reading showed an annualized expansion of 2.2 percent.

    Economist Views

    * “Non-manufacturers are taking the lead” as they try to save manpower to deal with the labor shortage, said Takeshi Minami, chief economist at Norinchukin Research Institute. “That’s a good trend. It’s long been said that old production systems are weighing on productivity.”

    * “The business-spending figure in the GDP report may be revised up slightly” after the data, said Hiroaki Muto, chief economist at Tokai Tokyo Research Center in Tokyo. “With corporate profits rebounding a lot, companies are probably making investments to renew their old facilities and equipment or to boost productivity.”

    Other Details

    * Spending minus software rose 5.2 percent from a year earlier (estimate +4.1 percent).

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