China’s Reforms Open New Path to Equities

by Stuart Rae

For investors in China equities, there have traditionally been two ways of approaching the market: through expensive growth stocks, or risky contrarian plays. Now, thanks to China’s reforms, there’s a third way which may offer a better balance of risk and return.

Despite the headlines about slower growth, credit tightening and the potential for corporate defaults in China, the country’s medium- and long-term prospects continue to interest investors. One reason for this is that opportunities to gain access to Chinese equities are increasing—helped, for example, by the government’s allocation of licenses and quotas under the Renminbi Qualified Foreign Institutional Investor program, and the impending launch of the Shanghai-Hong Kong Stock Connect program.

Moving Beyond High-Growth Stocks

The range of strategic approaches open to investors is broadening too, enabled by changes in the economic and financial environment. Traditionally, investors in China have focused on either growth or contrarian plays, or a combination of the two. Even now, it’s possible to find stocks in China that offer exciting growth potential—for example, in areas of disruptive progress, such as the media and Internet, or in niche sectors that will continue to benefit from economic development and demographic change, such as the environment and healthcare. The downside is that these stocks typically trade at very high multiples and can be hard to find. Governance can be an issue, too: think of accounting problems in the past at some US-listed Chinese companies.

The contrarian play involves buying very cheap stocks which are high-risk but—if all goes well, and the companies not only survive but prosper—may pay off handsomely. Such risks are not for everyone.

Focus on State-Owned Enterprises

Now—thanks to reforms introduced since the government of President Xi Jinping and Premier Li Keqiang came to power last year—a third approach to investing in China is possible. It may not promise the dazzling returns some hope to achieve from China’s growth stocks, but it may be a less risky proposition than those contrarian plays.

It’s a result of the government’s plan to improve the profitability of state-owned enterprises (SOEs). The plan includes a range of measures, such as better incentives for management, corporate restructuring, spin-offs and mergers—any of which can create opportunities for investors.

Historically, investors have been wary of China’s SOEs because their returns on assets are inferior to those of the private sector, and the gap between the two has been widening in recent years (Display). We believe that the government’s reforms could lead to a narrowing of that gap, suggesting that this could be a good opportunity for investors to position themselves to take advantage of improved profitability among SOEs.

Looking Across Sectors

Examples can be found across diverse sectors. Sinopec, the country’s largest refiner, is spinning off its service stations into a separate entity. This is a huge business that consists of tens of thousands of outlets and associated retail operations. The restructuring is drawing private capital into the business and focusing management on unlocking its inherent value.

In the telecom sector, the government is driving a plan for the three major companies—China Mobile, China Telecom and China Unicom—to pool their mobile phone tower assets. The move will lead to the companies sharing costs, and is designed to help improve their profitability. The assets will eventually be housed in a stand-alone entity.

Investors need to bear in mind that the government’s dominance of SOE share registers leaves private shareholders with little control over important matters such as the appointment of boards and key managers. On the plus side, the lines of publicly available stock in SOEs are typically large and liquid; they trade at modest multiples compared with growth stocks and are less risky than contrarian China plays.

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The Fed's Ice Bucket Challenge

By: Michael_Pento

Unless you have been living under a rock for the past month, you have more than likely heard of the ALS Ice bucket challenge. But, just in case you have been living under that rock--the challenge dares nominated participants to be filmed having a bucket of ice water poured on their heads and challenging others to do the same. The stipulation is that the nominated people have 24 hours to comply, or forfeit by way of a charitable donation to ALS. It is an ingenious marketing campaign that has thankfully raised awareness and millions of dollars for ALS.

However, we all know that while many made a monetary contribution, others just dumped a bucket of water on their head under the guise of helping the cause, simply because everyone else was doing it. In social media circles, this is known a slactivism. A pejorative term that describes "feel-good" measures, in support of an issue or social cause, that have little or no practical effect other than to make the person doing it take satisfaction from the feeling they have made things better.
And in a similar, but far more dangerous fashion, the Fed is engaging in its own form of "slactonomics". It forces new dollars into the economy in order to stoke inflation, with the hope that rising asset prices will give the illusion of a booming economy. Therefore, the Fed's specific Ice bucket challenge is: Put your cash in stocks, bonds and real estate assets; or watch your money earn no interest while it loses its purchasing power against those same assets. And, just like the herd mentality of humans causes us to dump ice water on our heads, the lemmings in the market are loading up on stocks despite the fact that equity valuations have become far removed from the underlying anemic fundamentals of the economy.
But here is the catch--the Fed thinks it can escape its huge marketing campaign that involved years of market manipulation with impunity. But, it has made an egregious miscalculation.
Wall Street has completely bought into the fantasy that the Fed can end its $3.5 trillion dollar QE programs and also normalize interest rates after having them near zero percent for over six years without hurting GDP growth or having a negative effect on equity market prices.
However, one of the unintended consequences from normalizing interest rates is the effect on the U.S. dollar. The dollar is already rapidly rising as the Fed winds down QE3; just imagine how high it would rise if interest rates were to rise here in America.
Beginning in early 2009, asset prices in the U.S. increased in tandem with that of the developed world, as most global central banks depreciated the intrinsic value of their currencies in concert. However, we now see the dollar rise and asset prices in the U.S. begin to fall (S&P Case-Shiller Home Price Index now down two months in a row) as the Fed winds down its latest $1.7 trillion dollar QE program and sets the table for a lift off from a zero percent Fed Funds rate in the first half of 2015. In fact, the dollar index has already increased from 79 in May, to over 82.6, which is a 52 week high.
The real estate market is starting to factor in the end of QE and the rise of the dollar, but equity prices seem to be still in a state of denial. The Fed's Ice bucket challenge seems to have frozen investors' brains into believing the exit from QE will be a smooth one for equities and the FX market.
While it is true that a strong and stable currency is the cornerstone of a healthy economy, it is also true that the journey from a massively manipulated currency to one that is subject to free-market forces is never a smooth ride. The Fed cannot tighten monetary policy unilaterally without causing massive disruptions in currency valuations.
The BOJ continues to monetize 7 Trillion yen per month of Japanese assets and the ECB is expected to begin its own substantial QE program very soon. If the U.S. attempts to raise rates while the developed world is printing money to keep rates low, the dollar will skyrocket against our major trading partners.
A surging dollar will crush commodity, real estate and equity prices, as it causes the reporting earnings of U.S. based multi-national corporations to plunge.
This is just one example of the volatile and disruptive ramifications associated with the normalization of interest rates; many of which appear to be out of the Fed's risk calculations. In a very short time from now asset prices should undergo a sharp correction in an amount north of 20 percent because of the end of QE and the tremendous volatility in the U.S. dollar.
But, the Fed's number one fear is deflation. Ms. Yellen and Co. will do everything in their power to make sure inflationary expectations are permanently anchored into the U.S. economy.
Therefore, the Keynesian mind-warped Fed will interpret the surging dollar and plunging stock prices as a catastrophic threat of deflation -- even though the rebalancing of capital and asset prices are the only viable solutions to our economy. And is why, in the final analysis, the Fed will not venture very far into its tightening cycle -- if it even attempts a serious effort to raise rates at all.
Investors should then use this upcoming correction in asset prices and cyclical period of deflation to position their portfolios in hedged positions that profit from an inexorable increase in the rate of inflation.

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China’s Property Market: The Risks for Banks

by Hayden Briscoe

Despite worries about a collapse in China’s property market, we think the financial system will navigate the coming credit cycle if banks can buy time to resolve loan problems—and receive government support if needed.

As we’ve noted, fundamentals in the property market remain strong. But what about the risks from the standpoint of banking and finance? Among China’s financial institutions, banks lend the most to the property sector: by 2013, they had provided RMB9 trillion (US$1.46 trillion), compared with RMB5.4 trillion from the shadow-banking sector. For property developers, though, banks aren’t the main source of liquidity. Nearly 70% of their liquidity comes from nonbank sources, 39% from their own cash and 28% from customer deposits, so they don’t rely too much on bank funding.

We think that this is a crucial point about the Chinese property market that many investors might miss: it’s not really overleveraged, even though it might face some supply/demand headwinds.

From the banks’ perspective, the risks from their exposure to the property sector alone seem manageable. Loans to the property and construction sector as a percentage of total loans outstanding have been capped at between 11% and 12% for the last six years, and residential mortgages have been capped at around 14%. Given that there hasn’t been a significant upturn in nonperforming loans (NPLs) for properties despite two downturns in prices (Display 1), banks seem unlikely to reduce their exposure to the property sector.

While the credit exposure to property alone doesn’t appear alarming, exposure to the property and related sectors—through local government financing vehicles (LGFVs) and shadow banks, for example—could be substantial.

If a property market crash were to occur, we think that banks would prove to be resilient if allowed to manage their NPLs over a number of years. Their NPL coverage ratio (280% at the end of 2013) is high, and they’re very profitable. This profitability is helped by the fact that interest rates haven’t been fully liberalized, so banks can keep their deposit rates artificially low. Due to this virtually guaranteed margin, which accounts for 70% of banks’ revenues, their pre-provision operating profit margin (on-balance-sheet resources used to absorb credit losses other than loan loss provisions) is 60%—one of the highest in the world.

Our research suggests that banks’ NPL ratios could increase by 8% or 9% in a single year without exacting a toll on their equity bases. If banks were allowed to resolve NPLs over a number of years, they could possibly absorb even more.

Shadow-Banking Risk

Outside the banking system, the main risk is in shadow banking. This sector is more exposed to the lower-quality property and LGFV credits than traditional banks are, in terms of incremental funding. If tighter regulation or credit defaults cause dramatic shrinkage of the shadow-banking sector, it could trigger a liquidity problem that would lead to more defaults, including by property companies and LGFVs. Since much of the shadow-banking sector is directly or indirectly financed by banks, risk in the shadow-banking system could spread to traditional banks.

This risk should still be manageable, in our view. If shadow-banking exposures were consolidated into banks’ balance sheets, we would expect banks’ loan-to-deposit ratios to increase from the reported 69% to 78% (Display 2). One reason for the shadow banks’ rapid growth has been that traditional banks use them as a form of regulatory arbitrage to work around the 75% cap on their loan-to-deposit ratios—one of the lowest caps in the world.

The government (rightly, in our view) is paring back the shadow-banking sector, and a quick solution to the instability this poses might be to raise or remove the cap so banks could provide liquidity directly where needed, taking some of the heat out of the shadow system. This is only a suggestion, but it’s yet another illustration that policy risk, rather than fundamentals, is the real issue with China’s property and banking sectors.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Hayden Briscoe is Director of Asia-Pacific Fixed Income and Hua Cheng is a Research Analyst for Corporate Credit, both at AllianceBernstein.

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Dissezione della deflazione in Italia: uno sguardo ai dettagli

by giulio zanella

L'Istat ha comunicato il 29 agosto 2014 che durante gli ultimi 12 mesi i prezzi al consumo in Italia si sono ridotti dello 0,1%. Il paese è quindi in deflazione, prima volta negli ultimi 45 anni. È utile guardare i dettagli del comunicato Istat per interpretare correttamente questo dato, cosa che purtroppo molti commentatori non sembrano aver fatto avendo preferito stracciarsi le vesti di fronte allo spettro tanto evocato che finalmente si materializzava. I dati suggeriscono invece che la riduzione dei prezzi è dovuta a espansione dell'offerta mondiale, mentre la domanda nazionale continua ad esercitare una (seppur modesta) pressione sui prezzi.

In un precedente post abbiamo fatto notare che diversi episodi di deflazione possono avere natura diversa. In particolare, poiché ogni mercato è costituito da due parti (la domanda da un lato e l'offerta dall'altro), abbiamo argomentato che è importante capire quali sono le forze sottostanti la riduzione dei prezzi durante episodi di deflazione prima di trarre la conclusione affrettata che "è come durante la grande depressione degli anni 30 del 1900". Presumibilmente, osservavamo in quel post, ci sono anche pressioni "buone" dal lato dell'offerta (non solo pressioni "cattive" dal lato della domanda) sotto il rallentamento dell'inflazione osservato in Italia e in altri paesi europei. I dettagli del comunicato Istat offrono alcuni utili indizi per riflettere sul punto. Questo post non offre un'analisi tecnica dettagliata (purtroppo in questo periodo non ho il tempo neppure di imbastirla) ma si limita a un breve commento per evidenziare questi indizi.

La tabella rilevante è la seconda, che scompone la variazione dell'indice dei prezzi al consumo per tipologia di prodotto e che riproduco qui sotto. Concentriamoci sulla colonna che riporta la variazione annuale, agosto 2014 su agosto 2013. Gli indizi importanti da notare sono due.

1. Sono i prezzi dei beni a essersi ridotti, dello 0,6%. I prezzi dei servizi, invece, sono aumentati in uguale proporzione, dello 0,6% (nota: la media è negativa, -0,1% perché i beni hanno nel paniere Istat un peso maggiore dei servizi, 54,7% contro 45,3% -- colonna "Pesi").

2. Tra i beni, quelli il cui prezzo si è ridotto sono gli alimentari non lavorati, i beni energetici, i tabacchi, e i beni durevoli. I primi tre hanno una cosa in comune: sono beni scambiati sui mercati mondiali delle commodities. Tra i servizi, invece, si è ridotto sostanzialmente il prezzo delle comunicazioni, che hanno però un peso piccolo nel paniere Istat.

Cosa suggeriscono questi indizi? Il primo, anche senza considerare il secondo, suggerisce che la riduzione dei prezzi è in buona misura importata. La suddivisione beni/servizi è infatti per un paese come l'Italia una buona approssimazione della suddivisione beni commerciabili (tradables)/beni non commerciabili (nontradables). Se consideriamo per un momento il solo lato della domanda, le variazioni dei prezzi dei primi riflettono la domanda su mercati più ampi di quello nazionale (e rispetto ai quali quello italiano è un mercato relativamente piccolo), mentre le variazioni dei prezzi dei secondi riflettono la domanda nazionale, essendo servizi domandati quasi interamente da residenti in Italia. Se la deflazione italiana fosse dovuta prevalentemente alla debolezza della domanda interna, allora dovremmo osservare deflazione anche (e soprattutto) nei prezzi dei servizi. Invece non la osserviamo: al contrario, osserviamo un aumento dello 0,6%. A meno che l'offerta di servizi non si stia contraendo, questo aumento suggerisce una modesta pressione della domanda interna.

Il secondo indizio conferma e rafforza il primo. Negli ultimi dodici mesi i prezzi delle materie prime e dei prodotti alimentari non lavorati si sono ridotti sui mercati mondiali. Da un rapido sguardo ai listini di questi mercati si impara che il prezzo del petrolio greggio è diminuito di quasi il 15% dal picco dell'estate 2013, il prezzo dei cereali e del riso si è ridotto di circa il 20% negli ultimi 12 mesi, quello dello zucchero di circa il 10%, quello del mais addirittura del 40%, eccetera. Queste riduzioni sostanziali non riflettono certo la debolezza della domanda italiana e neppure di quella europea. E' vero che sia l'Unione Europea sia gli Stati Uniti influenzano pesantemente il prezzo dei prodotti agricoli, ma non mi pare ci sia stato durante l'ultimo anno alcun drastico taglio dei sussidi all'agricoltura. Piuttosto, queste riduzioni riflettono il lato dell'offerta, l'offerta mondiale di commodities in questo caso. L'eccezione importante nella tabella dell'Istat sono i beni durevoli, il cui indice di prezzo al consumo si è ridotto dello 0,4% negli ultimi dodici mesi. Qui è dove si può forse vedere la debolezza della domanda interna (ma anche l'espansione dell'offerta mondiale di automobili ed elettromestici), ma non è una novità che durante una recessione si rimandi l'acquisto dell'auto o di una nuova lavatrice.

Nel gruppo dei servizi, è interessante notare la forte (6,7%) riduzione nel prezzo dei servizi di comunicazione, riduzione che è il più limpido esempio di deflazione indotta da innovazione tecnologica e, probabilmente, concorrenza (tra i gestori di servizi di telefonia, per esempio) in un mercato in rapida espansione e altamente contendibile. Moltiplicando questa riduzione per il suo peso nel paniere Istat (6,7%*1,82%) si scopre che il contributo alla deflazione italiana di questa voce è dello 0,12%, ossia un pelino di più dell'intera deflazione.

In conclusione, grattando la superficie del dato sbattuto a caratteri cubitali sulle prime pagine di sabato 30 agosto si scoprono indizi che suggeriscono la presenza anche di quella che abbiamo chiamato nel precente post "deflazione buona". Purtroppo l'Italia naviga da 15 anni in cattive acque, quindi mi rendo conto che questa è ben poca consolazione a fronte di, per esempio, il conseguente aggravio delle conseguenze di un elevato debito pubblico. Quantomeno, però, è utile riconoscere che le forze in azione non sono solo gli spettri degli anni 30 del 1900.

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Gold Stocks and Gold – Potentially Bullish Developments

by Pater Tenebrarum

Gold Stocks Reach New High Relative to Gold

As we have mentioned in previous updates on the gold sector, few things are more important for its likely future performance than how gold stocks are performing relative to gold. The action in the stock market this year is in many ways increasingly reminiscent of the final phase of the technology bubble of the late 1990s. Concurrently, the recent action in gold, silver and gold stocks is also exhibiting similarities to the lows that were made at the time.

To elaborate a bit on this: the action in the stock market and the fundamental backdrop are of course only similar to the 1999/2000 period in certain respects; no two historical periods are ever completely similar. From a technical perspective, the parallels are the following: relative weakness in small cap stocks, an increasingly narrow advance driven by fewer and fewer stocks during each new rally leg over recent months, new all time highs in the Rydex bull/bear asset ratio and a noticeable increase in volatility in the ratio, multiple intra-market divergences over recent months with strength focused on the tech sector, and extremely lop-sided bullish sentiment readings in both positioning and survey data over recent months.

Fundamentally, the main similarity is a tightening of policy by the Fed. Note here that even though the Federal Funds rate remains pegged at the 0-0.25% corridor (and due to the mass of excess reserved held by banks effectively trades just below 0.1%), the so-called “tapering” of QE still amounts to a tightening of monetary policy. However, while the Fed has reduced its monetization activities, commercial banks have stepped up their inflationary lending. As a result, y/y money supply growth (TMS-2) has oscillated around the 8% mark since mid 2013. This is still quite brisk, and as such is a fundamental datum that can be considered as supportive for the market. Note though that it represents a sharp slowdown from the peak growth rates recorded in 2010 (approx. 17%) and 2011 (approx. 16%) and that the willingness of banks to continue to expand credit greatly depends on the economy's performance (there is a feedback loop between the two).

We have discussed some of the parallels between today's and the 1999/2000 situation in the precious metals sector before (see “Gold and Gold Stocks – Looking Even Better” for details). The technical aspects appear highly relevant to the current situation. A chart showing the move beginning from the year 2000 low in the sector can be seen here.

Regarding the fundamentals, one must keep in mind that gold and gold stocks are highly sensitive to changes in the fundamental backdrop. This is to say, they often reflect future changes in the fundamental situation with a very long lead time. As a result, the long drawn out bottoming action in precious metals and gold stocks in 1999/2000 started while the stock market was still roaring higher and the Fed was actually in tightening mode. Similarly, the decline from the peaks in 2011 and 2012 (apart from the fact that it involved a pricing out of the euro area debt crisis premium) accelerated in 2013, even while the Fed was printing more money than ever before. In recent months, a bottom seems to be in the process of forming while the Fed is actually once again in tightening mode.

Gold stocks as represented by the HUI index and the HUI-gold ratio, which has just made a new high for the move – click to enlarge.

The fact that the HUI-gold ratio is making new highs even while gold and silver are under short term pressure is very important. As always, we must stress that we are only talking about probabilities here, not certainties. However, new bull markets in the sector tend to follow a certain pattern: First, the mining stocks strengthen, then gold begins to follow them higher, and after a variable, but often long time lag, silver also begins to rise and gain in relative strength. Other commodities tend to follow even later.

GDXJ, GDX, gold and silver. The blue quadrangles show that while the metals have returned to the consolidation range of April-June, gold and silver mining stocks have established a higher consolidation range. Moreover, there is now yet another divergence between gold and silver in evidence at the most recent low relative to the preceding low. We have discussed this “multiple divergences” phenomenon previously, see this chart from June 21, which also shows the divergences with the 2013 lows – click to enlarge.

Why are these Divergences Occurring?

We now want to briefly turn to the reasoning behind the sequence of events that is usually observed when the precious metals sector bottoms out and turns up. In other words, there are fundamental reasons for the technical divergences mentioned above. In order to understand them, one first needs to consider what happens when gold has transitions from a cyclical bull market to a cyclical bear market. Gold miners begin to mine lower grade portions of their deposits during bull markets so as to extend the life of mines, which is in principle not a bad approach. However, as gold bull markets mature, mining costs tend to rise ever more, as other commodities prices are usually also rallying strongly at the time. This leads to a sharp rise in input costs, including labor costs (which are a very large part of total costs), for all mining businesses.

Pursuing mine plans that include low grade areas of deposits becomes more risky as a result – any unexpected price decline will immediately tend to squeeze margins, and it takes some time to alter mine plans. Near the peak of the bull market, the managers of gold mining companies also tend to become careless. Spoiled by high metal prices, they tend to invest large sums in development projects that would at best be considered marginal at lower prices. In other words, a lot of capital tends to get wasted in this phase. After the transition to bear market conditions, as a rule not only gold's nominal price, but also its real price declines noticeably. Margin compression sets in, and a period of losses and write-offs follows, as reserves are reevaluated to reflect lower prices. Development projects get shelved or downsized, managements are fired and replaced. In short, by the time prices hit their lows, everything has gone fully into reverse and the focus has shifted 180 degrees from production expansion to margin preservation and cost control.

In this phase managements act as if they are expecting prices to go still lower, and the market will also tend to discount this possibility. Prices of mining stocks collapse to very low levels relative to metal prices. As we have pointed out late last year already, the market for some time failed to acknowledge a beginning improvement in costs and the first signs of stabilizing margins. The notion that mining costs would just keep rising was firmly entrenched. Around the time when the reversal in costs took place, a great many downgrades were issued, and analysts were spilling a lot of ink on a trend that had already ended.

Consider now what motivates gold to enter a bull market phase. Usually this involves a budding decline in economic confidence. Subtle signs of this can usually be detected in other markets; e.g. credit spreads will tend to increase. Before nominal gold prices rally, there is usually a reversal in gold's real price. In other words, the margins of gold mining companies tend to increase even before there is a rise in the nominal gold price, as other commodities and various input prices decline relative to gold. This is why in the early stages of a new cyclical bull market, gold stocks tend to rise relative to the gold price, and will remain in a “sweet spot” in terms of margins for quite some time. Note e.g. in the above mentioned chart of the action from 2000-2002 that gold declined for a full four months to a new low for the move between November 2000 and April 2001, while the HUI actually rallied, sending the HUI-gold ratio sharply higher. An imperfect proxy for gold's real price is the gold-CCI ratio shown below.

The gold-CCI ratio has bottomed in May and has trended upward since then. Moreover, gold stocks have diverged positively against the ratio in late May relative to the December 2013 low in gold-CCI

The above mentioned process also explains why silver tends to underperform in the early stages of a new cyclical gold bull market, only bottoms out with a lag and then takes longer before it begins to exhibit good performance as well. Although the two metals are closely correlated, silver has a large industrial demand component in addition to being a monetary metal. Therefore the very things that exert a positive effect on gold stocks and gold in the early stage of the bull market, initially tend to be a drag on silver. It is also worth taking a look at the long term chart of the gold-CCI ratio. This chart shows two things: gold remains fairly expensive relative to commodities, and its long term bull market against commodities appears to be intact. However, the chart also suggests that a retest of the lower of the two trend lines shown cannot be completely ruled out from a technical perspective (file under: potential fly in the ointment).

The secular uptrend in the gold-CCI ratio seems to be intact – click to enlarge.

To summarize the above: if a trend change from bear to bull market in the sector is indeed underway, then we are currently getting all the signals we would expect to see in this case. Multiple divergences between the sister metals gold and silver at their lows, divergences between the mining stocks and the metals, divergences of the mining stocks with their momentum oscillators (which were already established at the 2013 lows), and recently the strong upturn in relative strength in the mining stocks in the face of a correction in the metals. Moreover, the action fits with a possible road map for the economy and the stock market.

Regarding gold stocks, there is one more chart that shows an interesting development, namely the GDM bullish percent index. GDM is a very broad-based cap-weighted gold and silver mining index containing 29 stocks (very similar to the XAU). The bullish percent index shows the percentage of stocks in the index currently sporting a point & figure buy signal. This index has recently reached a new high for the move as well, which shows that the sector is internally even stronger than the cap-weighted indexes are indicating.

$BPGDM vs. the HUI – the bullish percent index has moved to a new high for the year, indicating growing internal strength – click to enlarge.

Potential Negatives, the Metals and the Dollar

We would be remiss not to mention the potential risks and negatives. In the near term, one risk is given by the fact that a number of gold stocks have in the meantime become overbought. This could be alleviated by sector-internal rotation, which is in fact something that has frequently happened during the recent consolidation period. Another risk is given by the still relatively large net speculative position in gold futures, which is somewhat balanced by subdued sentiment reflected by surveys. However, gold is relatively close to a support level, so one has to be aware of the potential for a break of this support.

As we have noted previously, it seems possible that a number of long positions have been taken on in reaction to the unstable geopolitical backdrop. This always creates potential downside risk. On the other hand, the recent move lower in gold consisted of overlapping waves and has a wedge-like shape. Still, there is no telling yet which way the cookie will eventually crumble. It remains to be seen how gold stocks will react if that happens (as noted above, in 2000-2001, they weren't bothered by gold breaking lower over a period of four months).

A potential danger is also that if there is a stock market decline, it could get out of hand. If the stock market falls slowly, it won't be a negative for the gold sector, but a very fast and hard decline would probably be a drag.

Both gold and silver remain quite close to important support levels – click to enlarge.

The US dollar index is another conundrum. Its recent rally has been very strong and looks impulsive. It is now overbought and ripe for a pullback and curiously, gold has actually held up very well relative to the dollar. The dollar seems driven by the geopolitical news backdrop to some extent as well, but there is also the perception that the due to economic weakness and a sharp decline in inflation expectations in the euro area, the ECB will be tempted to adopt some form of “QE”. This may not happen right away, but there is a widespread expectation that it will happen sooner or later (the ECB is first likely to await the effect of the TLTROs which are scheduled for September and December though).

The US dollar index nominal and relative to the dollar gold price. While the rally in the dollar looks quite strong at present, it has not been confirmed by gold.

In the context of long term inflation expectations (5 to 10 years and longer), it should be mentioned that they are currently declining everywhere. However, nominal bond yields are declining even faster, thus real interest rates are driven lower in spite of the decrease in inflation expectations. Falling inflation expectations are generally a negative for gold, at least for its nominal price (not necessarily its real price – that depends on how other prices in the economy are affected). On the other hand, falling real interest rates are a bullish factor, so these two factors seem to cancel each other out at the moment (note that “inflation expectations” in this context refers to expectations regarding future CPI rates of change).

Conclusion

Many of the factors that usually signal that the gold sector is likely to strengthen remain in evidence, and have lately become more pronounced again. Since we mentioned that there were “signs of life” in the sector in early June, it has acted quite well – surprisingly well, actually. Of course the picture is not entirely clear-cut or without flaws, but uncertainties always exist. Since the sector has a tendency to be very volatile, short term head fakes in both directions can be expected to happen at any time.

The action following the late 2000 low in the gold stocks probably provides us with a good road map. Should gold stocks continue to hold up well relative to gold and silver in the event of a further decline in the prices of the metals, dips should be regarded as buying opportunities. Conversely, a significant weakening of the gold stocks on a relative basis would be a warning that the time is not yet ripe for a resumption of the secular bull market. Even though gold is close to a support level, gold stocks are close to breaking a level of resistance, so it is once again time to keep a close eye on the action.

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Once again we wait for "shock and awe" from the ECB

by Sober Look

The ECB (Eurosystem) balance sheet continues to decline as the LTRO/MRO loans to the banking system are repaid. We've seen a decline of about one trillion euros in the past year and a half.

Eurosystem consolidated balance sheet (source: ECB)

Anywhere else this would have been considered a massive tightening of monetary policy (imagine the Fed selling $1.3 trillion of bonds). But not in the Eurozone. In fact the area has experienced some significant easing recently. Both the euro and the long-term rates have fallen far below ECB's own forecast. The ECB achieved Japan-style easing without the Japan-style QE.

Source: Scotiabank

Source: Scotiabank

Near-term German rates are now firmly in the negative territory (see chart) - you now have to pay the German government to hold your money for 2-3 years. The central bank was able to loosen conditions while reducing its balance sheet as a result of unexpectedly soft economic reports from the area, falling inflation (see chart) and inflation expectations (see chart), as well as Draghi's jawboning.
The ECB got this round of easing "for free", but now markets will be expecting a follow-through from the central bank. And unless we get what amounts to "shock and awe" from the ECB, some of this easing (lower rates and lower euro) could see a sharp reversal.

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