Consolidation in Gold Market on U.S. Dollar Strength
It looks as if goldis now consolidating the losses experienced since the November U.S. presidential election. Gold reached its lows for the month of December at $1,137 per ounce following the Federal Reserve’s (the “Fed”) December 14 announcement to increase the targeted federal funds rate1 by 25 basis points. The Fed’s decision also caused the U.S. Dollar Index (DXY)2 to jump to new highs. Gold finished the month at $1,152.27 per ounce, down $20.98 (1.8%). Net redemptions in the gold bullion exchange traded products (ETPs) continued their post-presidential election slide, although the pace tapered at yearend. Since the Trump victory, there have been net outflows of 7.2 million ounces in global bullion ETPs, bringing net inflows for the year to a still impressive 11.8 million ounces.
Gold stocks were also in consolidation mode, as the NYSE Arca Gold Miners Index (GDMNTR)3 gained 1.1% and the MVIS Junior Gold Miners Index (MVGDXJTR)4 fell 2.0%.
Although Ignored, Markets Events Could Add Long-Term Support
There were two unrelated developments in December that the markets largely ignored which we believe could have positive implications for gold in the longer term. On December 4, Italian voters rejected a constitutional referendum that effectively became a vote of no-confidence for Prime Minister Matteo Renzi, who promptly resigned. This is the latest in a string of populist victories around the globe driven by voters frustrated with established political parties that have been unable to bring policies that generate needed jobs. Instead, post-crisis policies have brought an unprecedented coordination of regulations, monetary experiments, austerity, and debt expansion. The outcome of the referendum has empowered opposition parties in Italy who question whether the country should remain in the European Union (EU). The implementation of Brexit in 2017 poses significant risks to the European economy and the Italian referendum is further evidence of a broader movement that undermines the EU. Important elections will be held in the Netherlands (March 2017), France (April 2017), and Germany (August – October 2017). Gold could benefit if risks of an EU breakup increase.
On December 5, a second potentially favorable development for gold occurred when the Shari’ah Standard on Gold (the “Standard”) was released by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI).5 The Standard, for the first time, sets out specific rules for the use of gold as an investment in the Islamic finance industry.
Until now, there have been no such rules which has led to confusion over whether or not Islamic households are permitted to invest in gold. Those who wanted to own gold were compelled to invest only in jewelry. The Standard also rules that it is permissible to invest in gold mining stocks. This opens a significant segment of the global population that already has an affinity for gold to initiate potential investments in gold bars, coins, ETPs, and stocks.
2016 Should Be Remembered as Strong Year and Turning Point for Gold
While the post-election performance of gold and gold stocks has been disappointing, 2016 overall remained a strong year and a major turning point for gold investments. Gold gained $91 per ounce or 8.6% in 2016 for its first annual gain in four years. But gold stocks stole the show, with gains of 54.4% for GDMNTR and 75.1% for MVGDXJTR.
There are several reasons for the spectacular performance of gold stocks including:
A rebound from 2015 bear market levels that were very oversold as the industry fell out of favor with investors who had been avoiding the sector, driving valuations to record lows
Gold companies impressed investors with their cost controls, operating results, and overall financial discipline
Earnings leverage to the gold price
Strong performance like what was experienced in 2016 is common at major turning points in the gold market. For example, the GDMNTR gained 80% in 2002 and in 2009 the Index rose 37%.
Be Wary of Consensus Opinion and Short-Term Overreaction
If 2016 taught us anything, it is that whatever the consensus says is going to happen in economics, investments, or politics in the coming year will probably be wrong. This year the Fed is again showing optimism towards the U.S. economy, guiding for three rate increases in 2017. The market responded in December by selling gold and driving the U.S. dollar higher. The Fed, however, has had a dismal forecasting record and we see no reason to believe that 2017 will be any different. At this time last year the Fed was guiding for four rate increases in 2016, yet there was only one.
The Trump honeymoon with the stock market is in full bloom, as the financial media prepares to celebrate should the Dow Jones Industrial Average (DJIA)6 cross 20,000 points. The stock market is reflecting a consensus for robust economic growth, and the Trump administration certainly has the potential to implement policies that promote growth. However, it seems the market is ignoring many potential risks the new administration may face. These include attempting to change trade treaties, immigration policies, Democrats and deficit hawks in Congress, the national debt, and Fed tightening. Potential moves by China or Russia, disarray in the EU, and strife the Middle East could also impact the administration’s efforts. We believe many of these risks will surface in 2017, reversing the positive sentiment in the stock market and U.S. dollar to gold’s benefit.
Forming the Base of a Long-Term Bull Market
Through most of 2016 we had been very bullish on gold, believing it had embarked on a new bull market. This belief was based on fundamentals, which included unprecedented levels of peacetime sovereign debt and monetary policies, such as quantitative easing7 and negative rates, which distort markets and pose systemic risks. While we were premature in forecasting a new gold bull market, we continue to believe these risks will ultimately drive gold to new highs. However, the turn the markets took following the U.S. presidential election took us entirely by surprise. The positive sentiment towards gold proved to be fickle and it appears the market will need more substantial evidence that the risks we see coming are in fact imminent.
We now characterize 2016 and 2017 as a base-forming phase for gold, probably a precursor to a bull market. The bear market trend from 2011 to 2015 has clearly been broken and 2016 showed us that investors are becoming quite skittish of systemic financial risks.
The following chart shows where gold might be in the context of similar markets of the past. Gold has a strong negative correlation8 with the dollar. This is shown by the peaks and troughs on the gold chart roughly correlating with the troughs and peaks respectively on the U.S. dollar chart. The U.S. dollar has been in a bull market since 2011 that is now similar in magnitude to bull markets of the early eighties and late nineties. These all correspond to bear markets for gold. As the dollar approached its peaks in 1985 and 2001, gold formed a double-bottom before embarking on new bull markets. In 1985, gold began a cyclical bull phase within a longer-term secular bear market. In 2001, gold began a historic secular bull market. It now looks like December 2015 was the first low for gold in this cycle. What remains unclear is whether the second low in a double-bottom was set in December 2016 or whether there is further weakness to come. In any case, it looks like gold is forming a base and historical analysis suggests that downside is limited.
(click to enlarge)
1In the U.S., the federal funds rate is “the interest rate” at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis. Institutions with surplus balances in their accounts lend those balances to institutions in need of larger balances.
2U.S. Dollar Index (DXY) indicates the general international value of the U.S. dollar. The DXY does this by averaging the exchange rates between the U.S. dollar and six major world currencies: Euro, Japanese yen, Pound sterling, Canadian dollar, Swedish kroner, and Swiss franc.
3NYSE Arca Gold Miners Index (GDMNTR) is a modified market capitalization-weighted index comprised of publicly traded companies involved primarily in the mining for gold.
4MVIS 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.
5The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) is the recognized world leader in Islamic finance standards, and its rulings are widely accepted across the majority of Islamic markets.
6The Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange (NYSE) and the NASDAQ.
7Quantitative easing (QE) is an unconventional monetary policy used by a central bank to stimulate an economy when standard monetary policy has become ineffective.
8The correlation coefficient is a measure that determines the degree to which two variables’ movements are associated and will vary from -1.0 to 1.0. -1.0 indicates perfect negative correlation, and 1.0 indicates perfect positive correlation.
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.
1In the U.S., the federal funds rate is “the interest rate” at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis. Institutions with surplus balances in their accounts lend those balances to institutions in need of larger balances. 2The correlation coefficient is a measure that determines the degree to which two variables’ movements are associated and will vary from -1.0 to 1.0. -1.0 indicates perfect negative correlation, and 1.0 indicates perfect positive correlation. 3U.S. Dollar Index (DXY) indicates the general international value of the U.S. dollar. The DXY does this by averaging the exchange rates between the U.S. dollar and six major world currencies: Euro, Japanese yen, Pound sterling, Canadian dollar, Swedish kroner, and Swiss franc. 4The ISM Manufacturing Index is an index based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders and supplier deliveries. 5A survey of consumer confidence conducted by the University of Michigan. The Michigan Consumer Sentiment Index (MCSI) uses telephone surveys to gather information on consumer expectations regarding the overall economy. 6The U.S. consumer confidence index (CCI) is an indicator designed to measure consumer confidence, which is defined as the degree of optimism on the state of the economy that consumers are expressing through their activities of savings and spending. 7NYSE Arca Gold Miners Index (GDMNTR) is a modified market capitalization-weighted index comprised of publicly traded companies involved primarily in the mining for gold. 8MVIS 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.
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.
ETF Securities Asset Allocation Research: Underweight US, Europe and precious metals
Summary
For October, in the equity space, the tactical portfolio continues to reallocate its weights from developed countries into emerging market stocks.
In the commodity space, we tactically underweight gold, platinum and palladium, increasing allocation across the board to keep commodities at 10% in the portfolio. Our tactical portfolio has much lower volatility than its strategic benchmark since 2005, returning 5.2% per year and enhancing the Sharpe ratio by 65%.
In this second edition of our asset allocation strategy, we will review the performance of our tactical portfolio compared to its strategic benchmark over the past quarter. We will also detail our tactical positions for October 2016.
October 2016 positioning
The following table highlights how our positions have changed over the past quarter in the tactical portfolio compared to the strategic benchmark. It also shows our positioning for October, based on the output of the aforementioned model recommendations as of end of September 2016.
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While market volatility measured by the VIX index is heading toward its lower band, the equity-bond relative trade model continues to suggest underweighting equities by 1,000bps to 45% for October and overweighting bonds by 1,000bps to 45% as well. If the volatility index continues to decline, the model will likely match the 55/35 split of the strategic benchmark in favour of equities accordingly.
The CAPE model suggests to remain underweight the US, France, the Netherlands, Italy and Denmark. The CAPE of these countries rose by 10% on average since end of June except for Denmark. While at 60% above its 10-years median, Denmark’s CAPE fell 21% over the period. On the other hand, based on the model, Canada, Brazil, Russia and two new countries: Turkey and Singapore should be overweight. Brazil’s CAPE is 54% below its 10-years median and continues to decline while Turkey’s CAPE is 7.1% below its historical median but rose 33% since the end of June.
The CDS model tells the tactical portfolio to remain neutral on all bond components, using the weights set by the benchmark.
The ETFS contrarian model was the most active over the past quarter, overweighting precious metals in July and August before underweighting the sector in September. For October, the commodity model is reducing the weight of gold, platinum and palladium, increasing the weight of lead, cotton and coffee.
As the UK is heading for a hard exit of the European Union, as a rate hike by the Fed is imminent and as China continues on its soft landing, our fundamental-based equity and commodity models are telling us to underweight US stocks, selective European stocks and precious metals in our tactical portfolio, three areas where we see higher risk for near term uncertainty to affect potential returns.
Q3 performance
Whilst underperforming its strategic benchmark in Q3, the tactical portfolio continues to post a much lower level of volatility at 1.3% annualised versus 3.9% for the benchmark, allowing for an increase of the Sharpe ratio by 28% from 0.22 for the benchmark to 0.28 for the tactical portfolio.
A closer look at each asset class shows that commodities and equities were the main contributors to the improved Sharpe ratio of the tactical portfolio compared to its benchmark while bonds contributed to both portfolios in the same way.
(click to enlarge)
Model performance
The tactical portfolio has the lowest level of volatility compared to the 60/40 and strategic benchmarks, improving the Sharpe ratio by 48% on average.
(click to enlarge)
Whilst underperforming the 60/40 benchmark, the tactical portfolio outperforms its strategic benchmark by 0.3% per year since January 2005.
(click to enlarge)
Each asset class in the tactical portfolio also outperforms their equivalent in the strategic benchmark, by 0.3% for equities and bonds and 2.8% for commodities, illustrating the efficiency of our fundamental-based models in improving the risk/return profile of their respective asset class as well as the portfolio.
The tactical portfolio also provides higher protection from the downside risk with a maximum drawdown of -21.6% only compared to -38.5% for the 60/40 and -39% for the strategic benchmark. Finally, the tactical portfolio recovers faster to its previous peak (2 years versus 3.25 years for the benchmarks).
The portfolio methodologies
This section provides a short description of our strategic and tactical portfolio methodologies.
Our strategic benchmark follows a long-only strategy with 60 investments across three asset classes: commodities (25), equities (28) and bonds (7). The initial weights as illustrated below are based on the weighting methodology of:
The Bloomberg Commodity Index for commodities
The MSCI AC World Index for equities
The Barclays bond indices for bonds
(click to enlarge)
The strategic portfolio represents a balanced portfolio with 55%, 35% and 10% allocated in equities, bonds and commodities respectively. Every month, the strategic portfolio rebalances into the weights set by the above benchmarks.
Our tactical portfolio aims to outperform its strategic benchmark by applying fundamental-based models to reflect our expertise in each asset class and our views of the global economy. The tactical portfolio rebalances every month to a new set of weights determined by the models below:
The equity-bond relative trade model sets the weights at the asset class level between equities and bonds while commodities will remain at 10% all the time
The CAPE model sets the weight for equities
The CDS model sets the weight for bonds
The ETFS contrarian model sets the weight for commodities
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Russia, Land of Education and a Growing Tech Industry
Russia, Land of Education and a Growing Tech Industry Authored by David Feygenson, Senior Analyst, Emerging Markets Equity Strategy, and James Duffy, Product Manager, ETFs
Russia, Land of Education and a Growing Tech Industry. Given Russia’s need to diversify its economy away from both energy and basic materials, the country’s technology and telecommunications industries — increasingly fueled by entrepreneurship among the country’s well educated — offer considerable potential.
The Russian stock market, as measured by the Market Vectors® Russia Index (MVRSXTR), performed particularly well over the first quarter of 2016. Starting the year at 417.9, the Index ended the first three months of the year at 471.1 on March 31, an increase of 12.7%.
Much of this growth can be attributed to technology stocks. Of the 29 stocks that currently make up MVRSXTR, seven are involved in tech or telecom. In terms of market capitalization, these seven stocks make up approximately 17.5% of the overall market as defined by the Market Vectors® Russia Index.
Russia’s Tech Growth is Fueled by a New Generation of Highly Educated Workers
Russia has one of the highest proportions of university graduates in the world, eclipsing levels in Asia, Europe, and North America. Partly due to the Soviet legacy of a focus on education, Russia is still endowed with an excellent education system that produces thousands of university graduates each year.
(click to enlarge) Source: Organization for Economic Cooperation and Development (OECD), ”Education at a Glance 2015: OECD Indicators”, for the year 2014, except for Russia, Chile, Saudi Arabia, and Brazil, which are for the year 2013.
Of young men aged 25-34, about half have completed tertiary education, much higher than the 35% average among OECD countries, and, after Korea, the second highest proportion. Of young women in the same age bracket, about 65% have completed tertiary education, much more than the 46% average for most OECD member and partner countries where data is available.
While some of Russia’s best educated have left the country for greener pastures, many have remained and contributed to a growing tech industry. In recent years, a number of Russian technology companies have gone public, including Yandex (YNDX), the leading search engine in Russia, and Mail.Ru Group (MAIL), the leading portal, social networking, and gaming site in Russia.
Perhaps Russia’s young and educated demographic will continue to foster a growing number of startups that will help to stake its claim as a global player in technology. The Russian market can be accessed through Market Vectors® Russia ETF (RSX®) and Russian small-cap companies through the Market Vectors® Russia Small-Cap ETF (RSXJ®). As of March 31, 2016, Yandex and Mail.Ru comprised 4.04% and 2.41% of RSX, respectively.
Source: FactSet, VanEck, and Market Vectors Index Solutions (MVIS).
ETFs is authored by VanEck thought leaders. VanEck is the sponsor of Market Vectors ETFs and is currently among the largest providers of exchange traded funds (ETFs) in the U.S. and worldwide. Market Vectors ETFs empower investors to help build better portfolios with access to compelling investment themes and strategies. Our ETFs span many global asset classes, and are built to be transparent, liquid, and pure-play reflections of target markets.
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Doha – Desert storm in a teacup Expectations at the Doha OPEC Summit were for a simple rubber stamping of the agreement to freeze OPEC production but this didn’t happen. The scaling up or Iran’s production is unlikely to have much impact on global supply in the short-term with global supply falling into deficit in Q3-Q4 2016.
The acrimony between Iran and Saudi was evident as Iran did not even attend the meeting. Iran has refused to freeze production and Russia has sympathised. Saudi has picked up market share lost by Iran when sanctions were imposed and Iran sees that it is only right that they have the opportunity to regain this share. We believe the Saudi Arabia has taken such a hard-line to protect its own interests, the current oil price is painful for them given that their fiscal costs of production are around $100/bbl, pushing their budget balance to -19% of GDP for 2016 according to the IMF.
Currently Iran has managed to scale-up production from 2.88mbpd in December 2015 to 3.29mbp in March (404k change), slightly below the consensus expectations of 500k. In the short-term we believe production in Iran is unlikely to move substantially higher as production is close to maximum potential with current infrastructure. A couple of projects assisted by China could push Iranian production up by 200kbpd in 2017.
The Saudi/Iran proxy war in Syria and Yemen isn’t helping stability within the region and there is a general skepticism amongst international banks and oil exploration and production companies over Iran’s nuclear deal. It is therefore likely that additional production infrastructure will not come online in the shorter term.
June 2nd is the next OPEC meeting but it’s unlikely a production freeze will be agreed at that point either. The oil price initially dived 7% reflecting a knee-jerk reaction by investors but has since settled at -2.5% at time of print. We expect little impact on market balances and we expect a global supply deficit by either Q3 or Q4 2016.
James Butterfill, Head of Research & Investment Strategy at ETF Securities
James Butterfill joined ETF Securities as Head of Research & Investment Strategy in 2015. James is responsible for leading the strategic direction of the global research team, ensuring that clients receive up-to-date, expert insight into global macroeconomic and asset class specific developments.
James has a wealth of experience in strategy, economics and asset allocation gained at HSBC and most recently in his role as Multi- Asset Fund Manager and Global Equity Strategist at Coutts. James holds a Bachelor of Engineering from the University of Exeter and an MSc in Geophysics from Keele University.
The latest IMFs report highlights how important emerging markets are
The latest IMFs report highlights how important emerging markets are. Developments in emerging markets (EMs) account for more than a third of the variations in stock market and foreign exchange market returns worldwide, according to the IMF’s Global Financial Stability Report released last Monday. The financial spillovers – the extent to which EM equity returns are reflected in developed markets equity returns – have risen 28% (IMF estimates). For the largest emerging economies (Brazil, China, India, Russia and South Africa), they have risen by 40%. The spillovers on bond markets are less clear because bond flows have been strongly affected by monetary policies in advanced economies. (click to enlarge)
Why do EMs get so much attention today? It is because EMs are far more invested now than ever, with the financial crisis being a catalyst to investor diversification. EMs share of global equity market capitalization more than doubled in the last twenty years amid declining market segmentation. The growing trend in EM financial integration is likely to continue until reaching a level consistent with the extent of their contribution to the global economy. EMs contribute to 38% to the global GDP but represent only 13% of the global financial system, according to data compiled by the IMF.
EM’s role in the global financial system is likely to continue to grow at a steady pace along with EM’s share in investors’ portfolios. First, EMs have demonstrated financial and economic resilience despite financial turbulences. Second, the quantitative easing programmes from developed economies have accelerated their integration into the global financial system by pouring liquidity into EMs. We believe the unconventional central bank policies are not likely to terminate any time soon. When they eventually end, it most certainly will not be in an abrupt manner. For these reasons, we think EMs are becoming a permanent and an influential financial players. In our view, current credit spreads are overcompensating investors for the credit and liquidity risks.
Morgane Delledonne, Fixed Income Strategist at ETF Securities
Morgane Delledonne joined ETF Securities as Fixed Income Strategist in 2016. Morgane has an extensive experience in Monetary policy, Fixed Income Markets and Macroeconomics gained at the French Treasury’s Office in Washington DC and most recently in her role as Macroeconomist and Strategist at Pictet&Cie in Geneva. Morgane holds a Bachelor of Applied Mathematics from the University of Nice Sophia Antipolis (France), a Master of Economics and Finance Engineering and a Master of Economic Diagnosis from the University of Paris Dauphine (France).
