Research Watch

After one of gold’s largest falls in history, there are concerns the fierce selling could pose a new systemic risk — watch out for an ETF meltdown. As for the question of what’s weighing on bullion, theories abound: Has the fear bubble finally burst? Is George Soros shorting the precious metal? Or could China’s corruption crackdown be making an impact? Goldman Sachs, which made a timely “sell” call on gold last week, is back to identify two new safe havens in its place, while Westpac thinks the Australian dollar might be in for a fall too. Elsewhere, equity bulls argue the party is just getting started, while bears see a major “wipeout” ahead. On video, learn how a secretive group of commodity traders earned more this decade than Goldman Sachs, JPMorgan and Morgan Stanley combined.

Gold’s collapse might pose a systemic risk...

“After seeing threads of contagion connect asset to asset in the crises of the last decade, we can’t help but wonder if the decline in gold prices could act as a catalyst in some unexpected corner of the markets. What would be the financial transmission mechanism? If we were betting, we’d put our money on exchange-traded funds, or ETFs. … We wouldn’t be super concerned about [popular] ETFs like the SPDR Gold Trust (GLD). It’s a so-called ‘physical’ ETF, which means the fund actually owns the underlying asset that it offers exposure to. There’s another kind of ETF, known as a ‘synthetic’ ETF, which which isn’t quite as straightforward. Synthetic gold ETFs don’t actually own gold. They generate a return that mirrors the gold prices through a series of agreements—or bets—typically with some sort of bank. Last year, Bank of England analysts wrote ... [these] synthetic structures might pose funding liquidity risk to banks acting as swap counterparties if there is a sudden withdrawal of investors from the ETF market. What might prompt such a withdrawal of investors from the ETF market? How about a gobsmacking 14% drop in the price of gold, which we’ve seen this month. … Synthetic ETFs are more popular and widely used in Europe than in the US. So if we were looking for someone to take a hit, we’d be looking for European banks that act as parent entities for synthetic gold ETFs.” (Quartz, April 15)

Indeed, the ETF outflow has already begun...

“You can see the incredible rise out of nowhere, and you can see that although there have been blips, the recent decline is unprecedented.”

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(Goldman Sachs via Business Insider, April 11)

Has the fear bubble has finally burst...

“The biggest problem in the markets right now is that they’re still far too risk-averse. Fear-based assets like gold, Treasury bonds, and cash are in high demand, while there isn’t enough money flowing through greed-based assets like stocks and bank loans and into the economy as a whole. … What the system needs, then, is a stark reminder that fear-based assets can be just as risky as greed-based assets. Rising interest rates can eat away the value of your bond portfolio, inflation can erode your cash, and as for gold (or bitcoins, for that matter), well, it can plunge in value literally overnight. My hope is that the price of gold will continue to fall, that goldbugs will look increasingly silly, and that as a result Americans with savings will conclude that the best thing to do with those savings is to put them to work in a productive manner, rather than self-defeatingly trying to protect what they have. At the end of the 1990s, and again in the mid-2000s, we had greed bubbles. Both those bubbles burst, and the weird result was a fear bubble, which manifested itself in negative risk-free real interest rates and a soaring price of gold. Let’s hope that what we’re seeing right now is the fear bubble bursting. It’s what the world needs.” (Felix Salmon of Reuters, April 15)

Or is Soros to blame for the selling?...

“Over the last week or so, the one rumour I keep hearing from different hedge fund people is that George Soros is currently massively short gold and that he’s making an absolute killing. … I have no way of knowing if this is true or false. But enough people are saying it that I thought it worthwhile to at least mention. And to me, it would make perfect sense:

1. Soros is a macro investor, this is THE macro trade of the year so far...
2. Soros is well-known for numerous market aphorisms and neologisms, one of my faves being ‘When I see a bubble, I invest.’ He was heavily long gold for a time and had done well while simultaneously referring to it publicly as a speculative bubble.
3. He recently reported that he had pretty much exited the trade in gold back in February…
4. The last public interview given by George Soros was to the South China Morning Post on April 4th. He does not mention any trading he’s doing in gold but he does reveal his thoughts on it having been ‘destroyed as a safe haven’.”

(The Reformed Broker, April 17)

Perhaps it’s China’s corruption crackdown...

“Commodities came under severe pressure yesterday, in part driven by some negative news out of China, the world’s largest single consumer of natural resources. … Many point to China’s lackluster industrial production as the cause for this weaker than expected growth. But there is a new theory emerging to explain China’s negative surprise. Some analysts believe that the latest anti-corruption campaign is having a chilling effect on the nation’s economy. … Worried about being accused of spending excesses, local officials have cut down on extravagant parties and gifts used to entice (and essentially bribe) central government bureaucrats. Restaurants and luxury goods have been hit especially hard. ‘Abalone, baby birds, sharks, big prawns, sea cucumbers and geoduck clams are just some of the creatures who can breathe easier, for a bit at least,’ says Bill Bishop, a commentator in Beijing and author of the influential Sinocism newsletter. ‘But [food and beverage] businesses should expect more pain.’ Can a slowdown in these sectors really have a significant effect on China’s overall growth? Some economists are convinced that the impact is quite real and is indeed responsible for slower growth. … ‘The anti-corruption action by Xi is creating unprecedented phenomena, including an absolute fall in high-end restaurant sales,’ said Shen Jianguang, chief Asia economist at Mizuho Securities Asia Ltd. in Hong Kong, who previously worked for the European Central Bank. ‘It’s certainly a big factor dragging down short-term growth.’” (Sober Look, April 16)

In any case, watch for a similar decline in the the Australian dollar...

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(Westpac, April 16)

And consider Goldman’s new global safe havens...

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“Over the previous five years the two highest conviction trades in the commodity complex were being long gold in response to the debasing actions of central banks around the world and short natural gas in response to the shale revolution. These two trends have now likely reversed (see Exhibit 1) and our conviction in these new trends has risen significantly over the past month as we have introduced both short gold and long natural gas trading recommendations. Further, these shifts in trends represent a significant departure from the past decade and are implicitly interrelated. The shift in gold represents a more confident economic environment where there is a flicker of light at the end of the tunnel to this period of easy money while the shift in natural gas represents the ability for trend natural gas consumption in the US to near 3.0%. This underscores how the shale revolution has helped shape the improving economic environment in the US – making US natural gas and the US economy the new safe haven.” (Goldman Sachs, April 16)

Equities could be in for another a boost...

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"Since gold was floated in 1970, it has exhibited a low (and often inverse) correlation with common stocks.  Remarkably, both assets have been supported by a 6.7% rising slope.  Yet their ascending paths are almost a mirror image, with equities outperforming during secular bull markets and gold outperforming during secular bear markets. Why should this be? At a most rudimentary level, equities are residual claims in the capital structure. Gold, on the other hand, expresses confidence in the financial system. Confidence in banks, currencies, governments and Wall Street seems necessary for a secular bull market in junior claims – i.e. common stocks – to occur. The behavior of gold, then, helps confirm the stock market’s secular trend.  A sustained move in the S&P 500 above its 13-year range, corroborated by a sustained downturn in the dollar price of gold, would suggest the beginning of a new secular bull market.” (Advisor Perspectives, April 15)

In fact, some say the party’s just getting started...

“Strategists at Bank of America Merrill Lynch posed a set of (rhetorical) questions suggesting that the party in global asset markets might get a whole lot wilder before Japan reaches the end of its economic and monetary stimulus under the regime of Prime Minister Shinzo Abe:

• Shouldn’t Abe stand for Asset Bubble Economics?
• Is Abe the anti-Thatcher?
• If the markets don’t correct in Q2, could we ‘melt up?’
• If the central banks are ‘all-in,’ why aren’t you?

… The strength of the quantitative easing the Bank of Japan unveiled last week will likely resonate outside Japan as well as within the country, the Merrill analysts said. Of the 600 trillion yen ($6 trillion) in assets currently held by Japanese insurance and pension companies, very little is invested in foreign bonds, while a ‘considerable’ amount is allocated toward Japanese government bonds. As the Bank of Japan scales up its JGB purchases over the next two years, ‘even a small shift in the asset allocation from JGBs to foreign bonds can be a source of significant duration demand globally,’ they said. … They added that unless the markets see a correction in the second quarter, there is also the risk of a ‘melt-up’ in global stocks and other risk assets under current conditions that include excessive liquidity and benign inflation. ‘This would cause laggards such as BRIC resources, commodities and Europe to catch a [second-quarter] bid,’ they said.” (Market Watch, April 11)

But others are waiting for a market ‘wipeout’...

“We examined the S&P 500 price series from Shiller’s publicly available database to understand the duration and magnitude of all bull (a rise of at least 50% from the bottom of a bear market, over a period lasting at least 6 months) and bear (a drop in prices of at least 20% from any peak, and which lasted at least 3 months) market periods in US stocks since 1871. … The core hurdle is that the current bull market has (through end of February) already delivered 105% of gains, against the median 124% bull market run through history (using monthly data). Of course, this means that, should this bull market deliver an average surge, investors can hope for less than 20% more growth from this cycle. Further, given that the median bull market has historically lasted 50 months, and we are currently in our 49th bull month, we are about due for a wipeout. It’s troubling enough that the current bull market has already delivered 85% of the gains, and lasted about as long, as the median historical bull market. More disconcerting still is the fact that, when the bear market comes, …it is likely to wipe out 38% of all prior gains. And this has profound mathematical implications for current equity investors.” (Advisor Perspectives, April 16)

Video of the Week: Commodity traders’ $250 billion harvest...

“The world’s top commodities traders have pocketed more over the last decade, making the individuals and families that control the largely privately-owned sector big beneficiaries of the rise of China and other emerging countries. The net income of the largest trading houses since 2003 surpasses that of the combination of mighty Wall Street banks Goldman Sachs, JPMorgan Chase and Morgan Stanley, or that of an industrial giant like General Electric. They made more money than Toyota, Volkswagen, Ford Motor, BMW and Renault combined.”

(Financial Times, April 14)