Tax Reform Adds Fuel to Gold’s Engine

Tax Reform Adds Fuel to Gold’s Engine VanEck ETFTax Reform Adds Fuel to Gold’s Engine

Tax Reform Adds Fuel to Gold’s Engine a Gold Commentary July by Joe Foster, Portfolio Manager/Strategist

Gold’s Yearend Pattern Repeated: Oversold Ahead of Rate Increase Then Rebound

The Federal Reserve (the ”Fed”) raised rates for the third time in 2017 following the Federal Open Market Committee (FOMC) meeting on December 12. Since 2015, gold has established a yearend pattern where it becomes oversold ahead of the December Fed rate decision. This pattern repeated again this year as the gold price trended to a five-month low of $1,236 per ounce on the day of the Fed meeting and then promptly rebounded from the Fed-induced low to end December with a $28.11 gain (2.2%) at $1,303.05 per ounce. Commodity price strength also aided gold as copper and crude oil both made multi-year highs in the last week of the year.

Gold stocks also tested their second half lows on December 12 and, like gold bullion, staged a comeback to end December with the NYSE Arca Gold Miners Index 1 (GDMNTR) rising 4.6% and the MVIS Global Junior Gold Miners Index2 (MVGDXJTR) gaining 8.1% for the month.

Strong 2017 Performance on Geopolitical Risk, U.S. Dollar Weakness, and Commodities Strength

Gold and gold stocks performed well in 2017. The gold price advanced $150.78 per ounce (13.1%), the GDMNTR was up 12.2%, and the MVGDXJTR gained 6.2%. These gains were impressive for a market in which investors generally showed little interest in gold while being preoccupied with new records in the stock market, bitcoin, and ancient art. Gold also did not receive much help from the physical markets, as Indian demand remained near the lows of 2016 and China’s central bank refrained from purchasing gold. The resilience in the price of gold came from a global sense of geopolitical risk and uncertainty, overall strength in commodities, and unexpected weakness in the U.S. dollar. Gold stocks typically outperform gold bullion in a positive gold market. However, this year was one of mean reversion after a strong 2016 (GDMNTR up 55%), along with a lack of sizzle that investors are seeing elsewhere. Healthy earnings and increased guidance among gold companies were not enough to capture much investor interest in 2017.

Tax Reform Adds to Deficit, Increases Systemic Risk

Anyone hoping that Washington D.C. would become fiscally responsible under Republican Party rule has seen their hopes go up in flames, as new tax rules appear likely to drive the U.S. deeper into debt. Some say economic growth created by tax cuts will likely generate more government revenue. In a recent Wall Street Journal article, ex-Congressional Budget Office (CBO) director Douglas Holtz-Eakin stated that he believes tax policy can partially offset costs if it is well designed. We believe the new tax code is not well designed, as it is nearly as complicated as the old one, widely unpopular, and contains many provisions set to expire in 2025. The tax windfall corporations will receive comes at a time when profits are high and cheap credit is plentiful. If companies were inclined to spend more on capital expansions, they would have done so already, but instead many companies have used cash to buy back stock and pay dividends. We believe it is too late in the cycle for tax stimulus to have a lasting effect. In addition, fiscal stimulus has limited effects when debt levels are high, as they are today. None of the federal income tax cuts since 1980 have succeeded in shrinking the deficit through growth. The Reagan tax cuts of 1981 could not forestall a recession that started in July of that year, caused by tighter Fed policy. Similarly, any growth resulting from Trump’s tax cuts could give the Fed more latitude to raise rates.

Tax reform will add an estimated $1.5 trillion to the deficit over ten years, according to the Joint Committee on Taxation (JCT). In October, the U.S. Treasury Department reported the budget shortfall increased 14% in 2017 to $666 billion, which is equal to 3.3% of GDP. At $16 trillion, public federal debt is 85% of GDP and Harvard University economist Jason Furman estimates debt escalating to 98% of GDP by 2028. The CBO figures interest charges will consume 15% of federal revenues in 2027, up from 8% currently. The annual report from the trustees of the nation’s largest entitlement programs show the trust funds running out for Medicare in 2029 and for Social Security in 2034. The new tax law only piles more onto this growing mountain of debt.

Total non-financial debt in the U.S. stands at $47 trillion, equal to 250% of GDP and $14 trillion more than at the peak of the last credit bubble when debt/GDP stood at 225%. Thanks to below market rates engineered by central banks, debt service has not yet become a problem. Low rates have forced investors to take on more risk in order to generate acceptable returns. Another side effect is the proliferation of European ”zombie companies”, meaning their interest cost exceeds earnings and kept on life support by banks fearful of losses if the companies declare bankruptcy. The Bank for International Settlements (BIS) estimates that 10% of publicly traded companies in six major European countries are zombies. As central banks embark on tighter policies, at some point higher rates could create debt service problems. Gluskin Sheff3 reckons every percentage point rise in the level of rates will ultimately drain 2.5% out of nominal GDP growth.

Looming Economic Downturn, Decline in Markets Supports Gold Allocation

It appears the only way to stop sovereign debt from growing is through tax increases or spending cuts. By now it should be clear that these options are politically impossible, which suggests that deficits will continue to grow until they cause a crisis severe enough to motivate change. ”Crypto-mania” and a stock market that goes nowhere but up indicates that a crisis is the last thing on investors’ minds. However, in our opinion, we are at a stage in the cycle when concerns should be high. The expansion is heading into its ninth year. The economy is at full employment and the personal savings rate has declined from 6% in 2015 to 2.9% in November. By now many have bought their first home, a new car, remodeled the kitchen, taken that overseas vacation, or bought a second home. Some are in a position to speculate on their favorite ETF, cryptocurrency, or FAANG stock (Facebook, Apple, Amazon, Netflix, and Google). There comes a point when investors are all-in and something happens that triggers a selloff – a geopolitical event, an economic downturn, or a black swan 4 emerges. Markets decline, but there are few investors with the capacity or desire to buy more, so markets decline more. Momentum kicks in and there’s more selling until sentiment turns for the worse. The selloff becomes a contagion that spreads uncontrollably. It has happened to tech stocks and it’s happened to instruments linked to mortgage securities. It is likely to happen again.

Based on the gold price strength following December rate increases in 2015 and 2016, we expect to see firmness in the gold price in the first quarter. However, headwinds may come for gold if economic growth enables the Fed to tighten more than expected. Also, the U.S. dollar might strengthen if the new tax code causes corporations to repatriate profits stockpiled overseas. We believe any weakness in gold during the first half of 2018 could be transitory. Moving through 2018 and into 2019, we believe the chance of an economic downturn increases, along with the probability of a significant decline in the markets. High levels of debt could cause a downturn to turn into a financial crisis. We now know that quantitative easing5 and below-market rates have failed to generate needed growth or inflation. In the next crisis, look for central banks to resort to even more radical policies, such as directly funding treasuries. It is conceivable that there could be global currency debasement on a scale never seen before. In such a scenario, hard assets, especially gold and gold stocks, could significantly outperform most, if not all, other asset classes in our opinion. There comes a time in every economic cycle when investors should seek portfolio insurance. We believe the time is now.

by Joe Foster, Portfolio Manager and Strategist

With more than 30 years of gold industry experience, Foster began his gold career as a boots on the ground geologist, evaluating mining exploration and development projects. Foster is Portfolio Manager and Strategist for the Gold and Precious Metals strategy.

Please note that the information herein represents the opinion of the author and these opinions may change at any time and from time to time.


1 NYSE Arca Gold Miners Index (GDMNTR) is a modified market capitalization-weighted index comprised of publicly traded companies involved primarily in the mining for gold.

2 MVIS Global Junior Gold Miners Index (MVGDXJTR) is a rules-based, modified market capitalization-weighted, float-adjusted index comprised of a global universe of publicly traded small- and medium-capitalization companies that generate at least 50% of their revenues from gold and/or silver mining, hold real property that has the potential to produce at least 50% of the company’s revenue from gold or silver mining when developed, or primarily invest in gold or silver.

3 Gluskin Sheff + Associates Inc., a Canadian independent wealth management firm, manages investment portfolios for high net worth investors, including entrepreneurs, professionals, family trusts, private charitable foundations, and estates.

4 A black swan is an event or occurrence that deviates beyond what is normally expected of a situation and is extremely difficult to predict; these events are typically random and are unexpected.

5 Quantitative Easing by a central bank increases the money supply engaging in open market operations in an effort to promote increased lending and liquidity.

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What is behind the rise of global bond yields?

What is behind the rise of global bond yields?

Fixed Income Research  – What is behind the rise of global bond yields?


  • The rise of US yields is driving up yields around the world.
  • We expect higher volatility in global rates, amplified by geopolitical risks and commodity price movements.
  • Structural headwinds and accommodative foreign monetary policies will likely limit the rise US yields over the medium term.

Since last November, investors’ sentiment has turned into ‘risk-on’ mode, favouring risky assets and equities relative to bonds. The rise in global yields and the steepening of yield curves has fuelled fears about the end of the 35-year bond bull market.

US yields drive up global yields

Since the early 2000s, the rise of global financial integration (i.e. the increase movements of capital between economies) has been reflected in higher co-movement in global yields. The chart below shows that almost 60% of the changes in bond yields of advanced economies (US, UK, Germany, and Japan) may be explained by a common factor.

The recent rise of global yields was predominantly driven by the rise of US yields along with cyclical factors (such as inflation, geopolitical risk and market volatility). However, we believe the ongoing accommodative monetary policies in Europe and Japan are likely to keep bond yields low in these regions, limiting the rise of US yields over the medium term.

What is driving US yields higher?

Long-term bonds yields are a function of the expected future short-term interest rates and the bond term premium that investors require to buy long-term bonds rather than roll over a series of shorter maturity bonds (i.e. inflation risk premium). The trend decline in global yields in the past 35 years mostly reflects the trend decline in bond term premium, while expected short-term interest rates fluctuate along with the changes in monetary policies.

Expected short-term rates started to increase in December 2013 when the Fed announced the tapering of its monthly bond purchases. However, US bond term premiums continued to decline and then slipped into negative territory in the first half of 2016 – for the first time in history. Deflation fears fuelled by the 70% drop of energy prices between 2014 and 2015 negatively affected inflation risk premiums, which declined from 0.5% to -0.5%. The sustained rebound in energy prices since February 2016 enabled inflation premiums to bounce back in Q4 2016, leaving both forces – bond term premium and expected short-term rates – trending upward. As a result, US long-term yields started to rise.

We evaluate the current mispricing of the 10yr treasury yield at 10bps tighter than its estimated value, based on the gap between the current 10yr yields and the sum of its two components. Thus, we believe most of the expected three rate hikes from the Fed this year have already been priced into 10yr yields. However, we expect higher rates volatility amplified by elevated volatility in energy prices and geopolitical risks. The MOVE index (an indicator of bond markets volatility) has increased 20% since Q4 2016.

Structural headwinds push yields down

The recent tightening in US financial conditions has been driven by the prospect of a better economic outlook in the US, reflecting current expectations of larger fiscal policy stimulus. In our opinion, the efficiency of the fiscal stimulus and its effects on bond markets will crucially depend on its fiscal neutrality and on its capacity to boost productivity and labour force growth. While the labour force growth has rebounded since 2012 under the accommodative monetary policy of the Fed, US productivity growth remain low from an historical perspective and continue to weigh on the economy.

Historical data reveals a strong positive relationship between investment and labour productivity.

The decline trend of investment in advanced economies can be partly explained by high credit constraints. The Debt Service Ratio (DSR) or the share of income used to service debt has not yet return to the pre-crisis levels, weighing on consumption and investment.

Subdued long-term economic trend limit yields’ rise

The gradual decline in the US GDP growth trend has led to gradual similar decline in the neutral real interest rate (i.e. the federal funds rate that neither stimulates nor restrains economic growth), which, in turn, has caused the decline in long-term interest rates. The US Congressional Budget Office (CBO) forecasts a stable 2% potential real GDP growth – the highest level of real GDP that can be sustained over the long term – for the US economy over the next 10 years. Accordingly, the neutral real interest rate for the US is expected to pick up and move in tandem with the potential real GDP. Although, both remain lower from a historical perspective.

This analysis is consistent with the gradual downward revision of long-run projections from the FOMC. From 2012 to today, the FOMC gradually revised downward its estimates for the long-run potential GDP growth rate and the terminal fed funds rate (or neutral interest rate) from 2.4% to 1.8% and from 4.25% to 3.00% respectively. Fed Chair Yellen reiterated in January1 that the Fed expects to increase Federal Funds rate target a few times a year until, by end of 2019, it is close to its longer-run neutral rate of 3%. Accordingly, we expect the Fed to hike rates three times this year.

We expect the trend rise of the US yields to be gradual over the medium term toward 2019 amid higher volatility. The upside risks to this view would come from a significant and quicker-than-expected rebound in productivity growth and inflation.
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