An interesting article came my way from UBS analyst Julien Garran on the
driver for gold. I do not have a link to share so excerpts will have to do.
Garran's article is one of the better one's I have seen. Unlike others,
Garran does not cite jewelry, mining capacity, central bank purchases or
sales or other similar (and wrong) notions that unfortunately are widespread
among most analysts.
Commodities & Mining
Q&A (by Julien Garran)
Q1. What drives gold?
A1. In the past, we’ve argued that international US$ liquidity is fundamental
to calling first gold and then the industrial miners. In this note, we go a
step deeper, arguing that gold is a call on excess returns in the US economy,
the policy response and finally the impact on that policy on international
US$ liquidity.
Q2. What is gold about to tell us?
A2. The key issues facing gold; excess returns in the US are under pressure
as the strong US$ and falling energy squeezes cashflow. As wages pressures
rise, weak productivity means that cashflows could be squeezed further. Both
undermine credit conditions and threaten the longevity of the cycle. We
believe the prospect of deteriorating liquidity magnifies the threat. That in
turn is limiting the Fed’s ability to tighten policy and may induce it to
ease in the future. We think the Fed has started to recognise that pressure
with its dovish backtracking at the March meeting last week.
A1&2. In commodity strategy, we believe that a forthcoming rally in gold
may warn us that declining returns could ultimately force the Fed into a new
round of international reflation. We think the first step was likely the
Fed’s dovish backtracking at the March meeting.
In the past, we’ve argued that gold behaves as a probability indicator of
whether international US$ liquidity will be improving or deteriorating in six
months’ time. Industrial commodities are a call on whether international US$
liquidity is rising now.
So to call gold, and then the industrial miners, we have analysed the key
drivers of those flows;
- The Fed
- The US current account deficit
- Bank’s asset buying/accumulation
In this note we go a step deeper – arguing that gold is a call on excess
returns in the US economy, the policy response and then finally the impact of
that response on international US$ liquidity. We contend that the state of
economy wide excess returns ultimately determine the longevity of the cycle,
and so it is the progress of excess returns, above the intermediate targets
on inflation & unemployment, that ultimately drive monetary policy.
Right now, excess returns are under pressure from four main areas; The rest
of the world is exporting deflation to the US.
- The combination of rising wage pressure and low
productivity/secular stagnation.
- A potential deterioration in liquidity.
- Deteriorating credit conditions and a rising Wicksell
spread.
- Recent papers by Shin and McAuley hint at the reason.
The impact is visible in the deterioration in cashflow & EPS momentum, as
well as in low trend US growth.
S&P Cashflow Momentum
S&P EPS Momentum
Rest of World exporting deflation to the US
As we’ve highlighted in our last note, international US$ liquidity has
collapsed.
Secular stagnation, weak productivity & wage pressure
The second key threat to US returns comes from low productivity & the
dearth of investment, itself induced by the high level of debt and the
subsequent low rate of growth (See Buttiglioni – Deleveraging, What
deleveraging? 2014).
The UBS house view, consensus and the Fed are all arguing that wages are due
to accelerate. The Fed is watching several signs suggesting that labour markets
are tightening and that wages are on the cusp of picking-up. Unemployment has
fallen, the workweek has risen. Quits, a sign that the jobs market is tight
enough to get people quitting work for better opportunities, are trending up.
And the Fed is watching professional wages trend-up. Its mental model is that
median wages are attached by elastic to professional wages. When professional
wages rise enough, median wages follow. There are clear anecdotal signs this
is happening. Walmart and McDonalds have both announced a buck increase in
basic wages in recent weeks. The impact is that labour costs are rising.
In the 90s rising wages promoted an extended cycle. Wages started
accelerating in 1994. They accelerated from 1995-8. But cashflow held up.
That was because of productivity. Robert Gordon, the godfather of the secular
stagnation debate (see ‘Secular Stagnation, 2014 – available free on the Vox
website), highlights that total factor productivity rose at a 2.5% rate over
the mid-90s. That was partly due to the burgeoning adoption and networking of
PCs. And partly it was their increased use managing just in time inventories
in a globalising, and lower cost, supply chain.
Of course, conditions are very different today. In ‘Disinflation or
deflation?’ January 2015, we argued that deteriorating government
productivity, something not measured in the GDP stats, was bringing down
productivity for the economy as a whole. The combination of negative net
investment and weaker productivity from tech applications means that
corporates will struggle to offset rising wages.
US Productivity
So, in contrast to the extended 90s boom, weak productivity means that, as
labour costs rise, cashflow gets squeezed, and credit fundamentals
deteriorate further.
Liquidity & Credit Conditions
The most important support for US liquidity is corporate debt issuance for
buybacks & M&A. So corporate debt issuance is also a key driver of
EPS momentum. From 2010-14, corporates were able to issue large quantities of
low quality debt.
In part, this was because there was a huge bid from mutual funds. Persistent
Fed, foreign central bank and Investment bank treasury buying over the past
five years induced mutual funds to reach for yield. But now that those
sources of treasury buying have evaporated, mutual funds have much less
incentive to reach for yield – so high yield appetite has deteriorated. Just
as the fundamentals of debt, cashflows, are under pressure from the
deflationary forces highlighted above.
Transmission Mechanism
The Wicksell spread The combination of low growth, weak productivity and
deteriorating credit conditions put the cycle under increasing pressure. The
Wicksell spread is the difference between corporate bond yields and nominal
growth. Knutt Wicksell argued that a negative spread (with corporate yields
below nominal growth) was like a subsidy to investment. A negative spread was
increasingly a tax.
Late Cycle Signals
We have combined both cashflow and separately EPS momentum (giving them a
negative sign so deteriorating momentum triggers a rise in the chart) and
high yield spreads in our two ‘late cycle’ indicators below. The signals have
spiked – suggesting that we are late in the cycle.
On each previous occasion that we have seen a spike of this magnitude in the
indicators, we saw a significant market correction.
Our UBS proprietary Fed action model works on the basis that, over the past
20 years, the Fed has always reflated within two weeks if
- The S&P fell 20% from peak.
- High yield became stressed (HYG at 85 or below).
So, even though the Fed may focus on the intermediate targets of unemployment
and inflation, it is ultimately the underlying sustainability of economy-wide
excess returns that forces its hand.
The prospect of a more dovish Fed would set up the potential for a return of
international US$ flows. A couple of recent academic papers by Shin &
McAuley support the analysis.
