Gold and China: Where the Bulls and Bears Square Off

By Frank Holmes
CEO and Chief Investment Officer
U.S. Global Investors

To paraphrase the great Steve Martin, today’s investors are very passionate people and passionate people tend to overreact at times. An overreaction is exactly what’s happened in gold and global markets in recent weeks. While market bulls have been sniffing out data points to support their case, market bears have continued to take a glass-half-empty approach.

Gold and China are two areas that have been caught in the bear trap this week, but we believe the gold and China bulls still have room to run.

Short-Term Challenges for Gold

Rising bond yields, a stronger U.S. dollar and an improving U.S. economy have squelched expectations for a third round of quantitative easing (QE3) and consequently, spelled trouble for gold. Since late February, gold has declined more than 7 percent.

As confidence improves, UBS says the yellow metal is losing the dual role of safe haven and risk asset: “Gold is moving off center stage, while growth assets are moving to the fore.” Earlier this month, we saw the largest weekly contraction in long gold positions on the Comex since 2004.

As I wrote in my blog this week, the selloff has pushed the price of bullion below its 200-day moving average for only the 30th time over the past 10 years. Over this time period, gold has declined on average 2.1 percent over the 10 days following the cross-below date. This means we’re likely only one-third into the correction in terms of price and duration.

All is not lost for gold. In his latest Gold Monitor, Dundee Wealth Economics Chief Economist Martin Murenbeeld lists 10 positive factors for gold, one of which is monetary reflation. We are currently experiencing one of the greatest global liquidity booms the world has ever seen. Over the past seven months, there have been 122 stimulative policy initiatives from central banks around the world, according to ISI Group.

You can see from Canaccord’s chart below that injecting liquidity into the global monetary system has been a steroid for stronger gold prices over the past decade. The global monetary base has ballooned three times larger, with gold increasing nearly six-fold.

While we are seeing strong signs of improvement in the global economy, it’s important to remember that the recovery has been built upon a mountain of printed money that cannot be hastily unwound. Dr. Murenbeeld explains, “money doesn’t grow on trees; it will have to be borrowed by some government and/or it will have to be printed by some central bank.”

This is why we believe the bull market for gold remains intact.

Overreaction on China

Indication of a Chinese economic slowdown and negative comments from BHP Billiton regarding its outlook for Chinese demand caused anxiety for investors this week.

The March HSBC Flash Manufacturing Purchasing Managers’ Index (PMI) fell 3 points from the previous month due to weakening domestic and external demand.

However, Macquarie says, “it’s not that bad out there.” The firm’s research shows that relatively strong demand from China during the first two months of the year has had a positive impact on global commodity prices. Macquarie says, “while there is undoubtedly a slowdown taking place in Chinese economic growth as a result of domestic policy tightening and weaker export growth, the impact on commodities demand has been negligible.”

As for the BHP comments, Barclays says that they were misconstrued, stating the “BHP executive was by no means bearish on near-term Chinese demand prospects and comments referring to a softening in Chinese steel demand were largely focused on the scenario post 2025 … the notion that iron ore and steel demand growth is unlikely to grow at a double-digit pace forever is not a surprise to the market.”

Bright spots in China’s economy aren’t hard to find. Barclays reports that the backlog of manufacturing orders saw its largest month-over-month increase since 2005 from January to February of this year. Supported by an all-time high in gasoline demand, Chinese oil demand reached a record high in February. Gasoline demand was resilient despite Beijing hiking prices by 4 percent in February due to higher oil prices. The Chinese government followed that up with an additional 7 percent hike earlier this month. Auto sales increased nearly 24 percent year-over-year (13 percent sequentially) in February, the largest increase since November 2010, according to UBS.

While rising fuel costs are a hot-button issue here in the U.S., CLSA’s Andy Rothman says that the higher fuel prices will only modestly impact Chinese consumers because few come in direct contact with unsubsidized gasoline. CLSA estimates that fuel accounts for only 2 percent of China’s Consumer Price Index (CPI) basket, compared to 5.4 percent in the U.S.

We’re also seeing positive developments in an area where Chinese consumers are vulnerable—housing prices. According to CLSA and China’s National Bureau of Statistics, home prices fell in 27 cities on a year-over-year basis during February, three times the volume in December. In addition, none of the 70 cities tracked reported more than a 5 percent increase in new home prices. A gradual reduction in home prices is exactly what the country needs to prevent a major housing crash, but don’t expect the Chinese government to let the bottom fall out.

Remember, the minimum cash down payment for a Chinese home buyer with a mortgage is 30 percent. Investors are required to put 60 percent down in cash. Currently, about one-third of home buyers are paying all cash, according to CLSA. Andy says the government is poised to relax the country’s strict housing policy measures as soon as this summer if the decline accelerates.

 

Index Summary

• The major market indices were mixed this week. The Dow Jones Industrial Index fell 1.15 percent. The S&P 500 Stock Index dropped 0.50 percent, while the Nasdaq Composite finished 0.41 percent higher.
• Barra Growth outperformed Barra Value as Barra Value finished 0.66 percent lower while Barra Growth fell 0.37 percent. The Russell 2000 closed the week with a slight loss of 0.02 percent.
• The Hang Seng Composite fell 3.65 percent; Taiwan gained 0.27 percent, while the KOSPI declined 0.37 percent.
• The 10-year Treasury bond yield fell to 2.23 percent, falling 6 basis points for the week.

 

Domestic Equity Market

 

The S&P 500 Index was down 0.50 percent this week as a growth scare is developing in China which led to the sell-off of cyclicals, particularly energy and industrials.

 

Strengths

• The S&P 500 consumer discretionary sector was the best performer this week, as brick and mortar and internet-based retailers rallied. Best performers included Netflix, Best Buy, Priceline.com, Amazon.com and Tiffany & Co. Tiffany’s reported earnings that were well received and the market liked Amazon’s purchase of Kiva Systems, Inc.
• Within the S&P 500 technology sector, Western Digital was the best performer, rising nearly 11 percent.
• Watson Pharmaceuticals was up nearly 11 percent for the week on reports the company is in talks to buy Actavis, a Swiss drug company.

Weaknesses

• The energy sector was the worst performer this week, as investors are becoming increasingly concerned about an economic slowdown in China. Compounding this was an announcement from Baker Hughes that pressure pumping is weak and margins have been negatively impacted.
• The industrial sector was weak for similar reasons, as Joy Global and Caterpillar were among the worst performers due to the China slowdown fears.
• Sears Holdings was the worst performer in the S&P 500 this week, falling by more than 12 percent. Going into this week, the stock had risen by 160 percent this year and it appears to be a normal pull-back after such a strong run.

Opportunities

• While the market was down modestly this week, the current bull market appears to be intact.

Threats

• The S&P 500 is arguably overbought in the short-term and could be vulnerable to profit-taking.

 

The Economy and Bond Market

 

Treasury yields reversed course this week and headed lower as concerns surrounding a slowdown in China intensified. A combination of weaker factory data out of China and talk of slower steel and iron ore demand from China by global mining giant BHP Billiton was a catalyst for investors to rethink last week’s move in treasury yields.

Strengths

• Initial jobless claims continue to improve, hitting the lowest level since March 2008.
• Inflation data in China, Brazil and the U.K. all indicated a slowing trend this week.
• The Conference Board’s Leading Indicator Index continues to grind higher for the fifth month in a row.

Weaknesses

• The HSBC Flash China Manufacturing Purchasing Managers’ Index (PMI) fell to 48.1, confirming other recent weak data and comments by government officials.
• Signs of weakness in the auto area are starting to build as gasoline demand fell 7 percent and some indicators are pointing to a slowdown in auto sales.
• FedEx announced earnings this week and lowered its global growth forecast.

Opportunities

• Should a growth scare resurface due to the lack of an announcement of further quantitative easing from the Federal Reserve, bonds may rally again as investors flee to safety, similar to what happened in mid-2010 and mid-2011 when the QE1 and QE2 programs ended.

Threats

• Rising oil and gasoline prices combined with liquidity implications of global easing, led by Europe, may raise the prospect of the reappearance of higher inflation going forward.

 

Gold Market

 

For the week, spot gold closed at $1,661.90 up $1.90 per ounce, or 0.1 percent. Gold stocks, as measured by the NYSE Arca Gold Miners Index, fell 0.4 percent. The U.S. Trade-Weighted Dollar Index slid 0.6 percent for the week.

 

Strengths

• U.S. Mint gold and silver bullion coin sales rebounded from disappointing lows in February. As of Sunday, March 18, gold bullion sales totaled 30,000 ounces, while overall gold bullion coin sales in all sizes were reported at 31,500 ounces. In February, these sales were 20,000 ounces and 21,000 ounces, respectively. Sales of one-ounce silver bullion coins were 1,647,000 ounces, a substantial increase over the 1,490,000 ounces reported for the entire month of February.
• According to an industry source and a Financial Times report, the fall in gold prices has prompted one or more central banks to buy as much as four tons of bullion in recent weeks. The purchases, worth about $250 million at current prices, were reportedly made through the Bank for International Settlements (BIS). The FT said banks have bought between four and six tons in the over-the-counter physical market last week.
• Zambia’s Finance Minister said that the country will not bring back the 25 percent mining windfall tax it scrapped in 2009 because it may force mine closures. This is the first that we have heard in some time of a country realizing the negative implications for demanding an increased share in the mining companies’ profits.

Weaknesses

• After closing up shop for five days over the introduction of an additional tax on gold imports, bullion traders across India decided to open their shops on Thursday, following late-night developments with government officials to end the impasse. More than one hundred thousand bullion dealers across the country had shut their shops as a form of protest, and traders estimate they could have suffered a revenue loss of over $700 million in sales.
• Bernanke’s speeches haven’t been falling on deaf ears, with Turkish, Indian and Vietnamese governments wary of gold. The governments of the three countries are facing weakening currencies, widening trade deficits, and a population buying more and more gold. In line with Bernanke, all believe gold should bear much of the blame.
• Thursday morning, news quickly spread of a military coup in Mali, as reports emerged that soldiers had overthrown President Amadou Toumani Toure’s government and seized power. The stated objective from the Malian army has been to end an “incompetent regime,” condemning the government of its inability to fight terrorism. Randgold Resources, which owns three mines in Mali, plunged as much as 17 percent in London on the news before rebounding to about 12 percent off. The CEOs of IAMGOLD, Randgold and AngloGold Ashanti all have maintained that production has yet to be affected.

Opportunities

• The Financial Times reported this week that Deutsche Bank has plans to open a new precious metals vault in London next year, seeking to cash in on booming investor demand for physical gold and silver. In London, which is the center of the global bullion market, vault space is running low even as the growth in exchange-traded funds (ETFs) backed by precious metals has led to a steep rise in demand for vaults.
• Although India may have increased taxes for gold, the move could present an opportunity for silver, the poor man’s gold, to shine. After escaping India’s budget reforms, investors have shown a keen interest in buying one kilo silver bars. On Friday, India’s Finance Minister exempted branded silver jewelry from excise duty. Silver coins of purity 99.9 percent and above were also exempted from excise duty. However, the excise duty on refined gold was doubled from 1.5 to 3 percent. “Silver has clearly been exempted for a reason,” said Prithviraj Kothari, president of the Bombay Bullion Association. “Out of $50 billion worth of imports of precious metals into India, silver imports were just $4 billion, while that for gold was the other $46 billion,” he said.
• According to a survey of fund managers, the era of quantitative easing, a process by which central banks buy assets such as government bonds to inject funds into the markets, may be coming to an end. According to a March survey by Bank of America Merrill Lynch, investors are “more upbeat about the future and the prospects for growth and they no longer expect further quantitative easing measures to be taken by the Federal Reserve or the European Central Bank.” The report, however, did find that fund managers still see sovereign debt as the biggest tail risk to the global recovery. Investors foresee higher inflation, with a net 13 percent expecting it to rise in the coming year. All in all, the uncertainty could continue to bode well for gold prices continuing to rise.

Threats

• In another move to control mining companies’ financials, Zimbabwe ordered mining firms to bank locally this past week, depositing their export earnings with local banks. This comes as the government’s latest move to exert pressure on miners as it tries to address the dollar crunch afflicting its economy. Last week, Impala Platinum, the world’s second-biggest platinum producer, bowed to pressure and said it would surrender a 51 percent stake in its Zimplats unit to local black investors.
• The implications of a silicosis class action suit for the South African mining sector are very serious, but no one yet knows how it will all play out. On Tuesday, a South African lawyer said that he was preparing a class action lawsuit against leading gold mining firms on behalf of thousands of former miners who say they contracted silicosis, a debilitating lung disease, through negligent health and safety practices. The principal targets of the suit would be AngloGold Ashanti, Gold Fields and Harmony Gold—South Africa’s three biggest gold miners—and minor producer DRDGOLD. The implications for the gold mining industry and for its relations with the government—already strained by past talk of nationalization—could be huge.

 

Energy and Natural Resources Market

 

Strengths

• Despite concerns over a slowing economy in China, recent statistics for the first two months of the year indicate rather robust trends for commodity demand. Chinese refined copper imports rebounded from the New Year holidays, up 12 percent month-over-month, reaching 375.8 kilotons in February.
• The latest incoming data from Asia continues to surprise to the upside, with demand in the region posting a year-over-year growth of 373 thousand barrels per day in January. Oil demand in non-OECD countries has also improved significantly, coupled with indications from OECD Asia Pacific being extremely strong. A critical driver for the boost comes from Japanese oil demand (up year-over-year by 297 thousand barrels per day) supported by the loss of nuclear power post-Fukushima.
• South Korean oil demand appears to have benefited from the cold spell in February. Despite a mild winter in January, demand increased by 13 thousand barrels per day. February numbers are also showing further demand pick-up by 173 thousand barrels per day year-over-year. This is one of the strongest growth rates ever.
• China coal imports surged 154 percent year-over-year to reach 17 million tons in February. Coal exports stood at 1.21 million tons last month.
• Chinese oil demand soared to a record high in February, supported by all-time high demand in gasoline and strong diesel demand.

Weaknesses

• There has been more pressure placed on the Indian Government. The FT had a front page story on the alleged $210 billion losses under pricing of coal blocks sold between 2004 and 2009.
• South Africa has suspended almost all oil imports from Iran, its biggest crude supplier, in response to U.S. diplomatic pressure, a senior diplomat said on Thursday.
• The HSBC flash purchasing managers index (PMI) numbers, the earliest indicator of China's industrial activity, fell to 48.1 from February's four-month high of 49.6, and firmly below 50, the threshold that divides contraction and growth. Markit's Eurozone Composite PMI also declined unexpectedly to 48.7 in March from 49.3 in February, a full point below economists' consensus forecast of a 49.7 reading, capping the first quarter of the year in disappointing style. Combined, the weakness in manufacturing continues to provide a headwind to resource performance.

Opportunities

• The Macquarie China Steel Survey, which gauges sentiment on the ground in China from the steel industry, showed a notable improvement in market expectations. Improving orders have been the biggest change, with traders and mills reporting significant month-over-month improvements. In addition to improving orders, mills also are planning to raise production – the first time they have signaled a raise since September 2011.
• China’s aluminum demand will be sustained through the government’s affordable housing projects with the consumption outlook most bullish from the transportation sector, which may use 13.5 percent more of the metal this year, said Wen Xianjun, Vice Chairman of the China Nonferrous Metals Industry Association.
• President Obama has said that he is directing agencies to speed up any regulatory approvals needed to construct the Keystone XL oil pipeline’s southern leg from Cushing, Oklahoma, to the Gulf Coast. Obama has initiated a new process that seeks to speed up the approval of key energy and infrastructure projects such as pipelines, highways, ports and electricity transmission lines.
• The China National Grain and Oils Information Center says China will import about 29 million tons of soybeans in the first half of 2012, up by 25 percent year-over-year, owing to strong demand for livestock feed.

Threats

• China intends to limit domestic output and consumption of coal in the five years through 2015 to reduce pollution and curb reliance on the fuel. Production and demand will be restricted to about 3.9 billion metric tons a year by 2015, according to a five-year plan for the coal industry released by the National Energy Administration at a briefing in Beijing this week.
• Ian Ashby, President of BHP Billiton Iron Ore, gave a presentation at the Australian Journal of Mining, Global Iron Ore & Steel Conference in Perth this week. The newswires picked up on his comments that Chinese demand for iron ore is “flattening out,” and could fall to “single digits” if it hasn’t already. While there was nothing new in the comments, they did spook investors who are already nervous about a lack of recovery in China thus far in 2012.
• Iron ore may decline 8.5 percent this year as global output increases and growth in Asian steel production slows, according to the Australia Bureau of Resources and Energy Economics. Prices may average about $140 a metric ton in 2012 from $153 last year. "Over the remainder of 2012, iron-ore prices are forecast to ease as production increases from new projects in Australia and growth in Asian steel production weakens," the bureau said. China’s crude-steel production may advance 7 percent to 731 million tons in 2012 compared with an 8.9 percent gain last year, the bureau said.
• China's potential house-buyers hit a record low with only 14.1 percent of Chinese residents planning to buy a house in the upcoming quarter and an overwhelming 67.7 percent considering the current housing price too swollen and "too high to be acceptable," according to the first quarter survey report on depositors issued by the People's Bank of China. Only 9.4 percent of those surveyed in Beijing and Shanghai intend to buy an apartment in the next three months.
• China released its plan to cap coal production and consumption by 2015. China’s National Energy Administration has released a five-year plan which will see coal production and demand restricted to about 3.9 billion metric tons per year by 2015. China produced 3.8 billion tons of coal in 2011.

 

Emerging Markets

 

Strengths

• China has cut the required reserve ratio (RRR) for 379 branches of the Agriculture Bank of China to boost rural area loan volumes, signaling fine-tuning monetary easing. The market is currently expecting further RRR cuts for all the banks this year.
• China has raised gasoline and diesel prices by 7 percent and 7.76 percent, respectively. After the increase, the downstream refinery business is closer to breakeven.
• Singapore’s Consumer Price Index (CPI) rose 4.6 percent in February, unexpectedly slowing as communication costs fell in the city state. In Malaysia, consumer prices also slowed, rising 2.2 percent year-over-year in February, down from 2.7 percent in January and well below the market estimate of 2.5 percent. The key reason for the decline in inflation was a drop in food price inflation.
• The Philippines’ budget deficit narrowed to 15.9 billion pesos ($370 million) in January from 101.5 billion pesos the previous month. In Thailand, the Bank of Thailand left its benchmark rate at 3 percent, pausing after two recent reductions. The result was widely expected.
• Nouriel Roubini turned more positive on Colombia, revising his 2012 and 2013 growth forecasts to 5 and 4.5 percent, respectively, citing a dissipation of downside risk from the global economy and a cool-down in domestic economic activity.
• The Brazilian labor market is showing that conditions are getting better for consumers. Although the February unemployment rate inched up to 5.7 percent from 5.5 percent in January and 4.7 percent in December, after stripping out seasonality, the unemployment rate remained at the series' record low of 5.6 percent for the fourth consecutive month. Employment grew 0.6 percent month-over-month (while the number of unemployed workers dropped by 0.5 percent), which coupled with the 0.7 percent increase in real wages, pushed the real wage bill up by 1.3 percent month-over-month or by 17 percent in annualized terms.
• The number of people employed in South Africa’s formal sector inched up 0.3 percent in the fourth quarter of 2011, with the manufacturing sector primarily adding the jobs. Employment rose by 23,000 people during the last quarter of 2011, to 8.381 million, and was up 1.6 percent on a year-over-year basis, Statistics South Africa said.

Weaknesses

• HSBC March China Flash Purchasing Managers’ Index (PMI) was 48.1, down 1.5 from February’s 49.6, indicating industrial activities are further contracting, particularly in export-oriented manufacturers.
• Bloomberg news reports today that CBRC said China banks misclassified RMB1.8 trillion (20 percent) of local government loans as fully-cash-flow-covered due to the inclusion of government subsidies. CICC bank analysts will check whether CBRC people have said this or not, but bank analyst Mao Junhua does not believe the 1.8 trillion number is correct.
• Lending by China’s four biggest banks was less than RMB 50 billion from March 1 to 15, the Economic Information Daily reports.
• BCA research reported recently that India’s capital rationing is deterring growth, and predicts a financial crunch in 2012, which will hamstring much-needed capital spending. The firm suspects that India’s potential growth rate is declining because of slowing productivity gains, which in turn are due to lower savings and investment rates.

Opportunities

• The South African rand gained for the first time in four days on Friday, trimming its worst weekly loss in six weeks, before data forecast to show U.S. sales of new homes rose last month, dampening demand for the dollar as a haven.
• Following a severe contraction in the fourth quarter of 2011, Thailand is in the midst of a solid rebound that should bring back a growth trend by the end of the year with a 5.3 percent annual expansion, Nouriel Roubini said this week.
• Verbal intervention from governments to bring down the price of crude has increased, in addition to rumors of an agreement between the U.S. and the U.K. to tap into strategic reserves. In fact, France has officially said that it and other industrialized nations are considering a strategic reserves release. Furthermore, Saudi Arabia has called present prices “unjustified,” citing a global supply surplus of 1-2 million barrels per day, signaling that it is prepared to increase production by 25 percent to bring prices down if needed.
• Indonesia’s stock market has lagged its peers this year, primarily due to the overhang of rising inflation risk. This is the result of the removal of government subsidies in fuel and power prices, and wage increases this year. However, the drivers of the economy in Indonesia (i.e., rising foreign direct investment, infrastructure construction, and rising middle class consumption) are intact and, therefore, the stock market appears to be a long-term play.

Threats

• The Chinese economy is still in the process of a soft landing, which may cause uncertainties for the economy.
• Poland’s shale gas reserves are about one-tenth the size of previous estimates, a government report showed this week, denting hopes for an energy source that could play a key role in weaning Europe off Russian gas. The long-awaited study estimated Poland's recoverable shale reserves at 346 to 768 billion cubic meters, far less than the previous estimate of 5.3 trillion from the U.S. Energy Information Association.
• South Africa’s foreign affairs ministry said it is reducing Iran oil imports, as its largest supplier of crude oil faces international sanctions. The industry awaits further detail, as a national oil industry group said it hadn’t been informed of the plan.

 

 

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