(Caution advised, very very long post ahead!)
Before I begin my post proper, I’ll just like to say how relieved I am
to be back writing this post after an arduous 3 weeks, breaking this blog’s
hiatus at long last. Three weeks worth of news, movements in the market and
volatility have played out while I was away, and I’ve just been trying to
digest all of that.
While away, a headline about spot gold prices falling
below US$1300/oz caught my eye, during one
of those fleeting moments when I was connected to the world via my smartphone.
It set me thinking – are precious metals, namely gold and silver (and to
a lesser extent platinum and palladium), worth an investment in
2017?
Following the madness of the bubble
in precious metals back in 2011, with its fair share of media drama,
zealous analysts and gold investment scams, prices of precious metals, most
notably gold and silver, have remained at levels way beneath their 2011 highs. In
fact, gold and silver prices have remained subdued since the bubble burst, not garnering much attention until earlier this year
when the stock market crashed.
When investors took notice of precious metals this year, the response
was swift and brutal, charging gold
up by 20% year-to-date, and silver by 28%. While both gold and silver are off their 2016
post-Brexit highs, the fundamentals which drove their prices remain, and thus I
have good reason to believe that gold and silver would continue to rally into 2017.
The Negative World We Live In
We’ve all heard about negativity. The litany of negatives and how they
can ruin our lives goes on and on: negative emotions, negativity in
relationships, negative savings, and wait for it… negative interest rates. Yes,
apparently a steady diet of dense academic
material and crash courses in performing economic CPR couldn’t stop the world’s
central bankers from turning negative as well. They too, have turned depressed and blue in
this bleak world of economic stagnation, and have all appeared to have thrown
in the towel, in their struggle to spur economic growth.
Jokes
aside, negative interest rates are a real thing, and they’re here to stay until
God-knows-when. Some of the world’s major central banks have given up hope in “pump-priming”
their economies, cutting their interest
rates to below zero in valiant effort to combat stagnant economic growth
and low inflation rates. Currently, the European Central Bank (ECB), the Bank
of Japan (BoJ), the Swiss National Bank (SNB), Denmarks Nationalbank, Sweden’s
Riksbank (all highlighted in red in the graphic below) all have the dubious
honour of being the few central banks in the world adopting negative interest
rate policy.
 |
| Source: Travel Map Generator |
|
In economics, we were taught that governments would cut interest rates and increase spending in response to economic slowdowns,
to prompt spending and consumption which would boost growth. But the real world
paints a starkly different picture, where massive
quantitative easing and record-low
interest rates have failed to
jump-start major economies. Desperate
central bankers were forced to shrug off the notion of orthodoxy and have
adopted negative interest rates.
How does the sorcery of negative interest rates work then? In the “normal”
world, we would charge someone a certain positive
rate of interest for borrowing our money, let’s say 2% per annum. But in our
current world, things have become reversed – we pay people for the privilege of borrowing our money.
In the
central bank context, commercial banks which place funds on deposit at the
central bank get charged a fee, rather than receiving interest on that deposit.
In essence, the objective here is to incentivize
these commercial banks to lend out the money, rather than place it on
deposit. Increased lending leads to increased spending, thereby
stimulating the economy.
Phew! That was some dense economics lesson there, condensed into a
little more than 100 words, and you can thank me for that.
But before we diverge and turn this post into a boring economics lesson,
let’s get back to the topic at hand. Gold and silver are likely to perform better in periods of low interest rates, due to
the lower opportunity costs of
holding them. Precious metals are an asset class with “negative carry”, meaning that they cost money to own even after the initial purchase, as they need to
be physically stored and insured.
Conversely, fixed-income assets such as bonds,
annuities and fixed deposits pay out interest. How decent this level of
interest may be is directly correlated
to interest rates in the particular economy. In the “normal” financial
world, investors stand to earn interest on their money, be it through bank
deposits, or investments in bonds. Therefore, the allure of precious metals increases when interest rates are low,
since the opportunity cost of owning them
is lower compared to when interest rates are high.
Right now, with more than $10
Trillion (yes you read that correctly) of negative-yielding
sovereign debt worldwide (more on that soon), and interest rates at an all
time low, precious metals are shining like never before as suddenly the opportunity cost of owning them vanishes.
This is the primary macroeconomic factor that’s been propelling the price of precious
metals higher this year.
Not to mention that central banks in other major economies are becoming
wary of the global economic stagnation and have turned defensive by lowering,
or planning to lower, interest rates. The list includes nearly every major economy in the world: the Reserve Bank of
Australia (RBA), the Bank of England (BoE), the Bank of Canada (BoC), the
Reserve Bank of New Zealand (RBNZ), the Reserve Bank of India (RBI). With so
many central banks turning dovish on monetary policy, only more interest rate cuts can be expected in 2017 and beyond, thereby
further boosting the appeal of precious metals.
Major Central Bank Interest Rates
|
US Federal Reserve
|
0.50%
|
|
European Central Bank
|
0%
|
|
Bank of Japan
|
-0.10%
|
|
Bank of England
|
0.25%
|
|
Bank of Canada
|
0.50%
|
|
Reserve Bank of Australia
|
1.50%
|
|
Reserve Bank of New Zealand
|
2.00%
|
|
Swiss National Bank
|
-0.75%
|
To further highlight this point, the graphic below shows countries with
negative interest rates, or those already cutting rates, in blue.
 |
| Source: Travel Map Generator |
|
As a side note, I believe that it is highly likely the Bank of England (BoE)
cuts rates into negative territory. When Article
50 is eventually evoked and the act of Brexit
happens for real, the UK’s economy is bound to take a hit, especially if the
terms of exit are unfavourable for Britain. While signs of economic slowdown
have not completely materialized yet, the BoE has already taken precautionary
measures by cutting interest rates to a
historic low of 0 to 0.25% this year, as well as stepping up asset
purchases. The BoE is inclined to act should the economic slowdown become more
severe, and cutting interest rates to below zero seems the likely solution.
Because of the distortive effects
of negative interest rates, the yields (or annual returns) on many developed-country
government bonds, considered one of the safest investments in the world, have
collapsed, especially in Japan and the Eurozone, where government bonds of up to 10 years in maturity yield
less than nothing.
Major Economies 10-year sovereign debt yield
|
Country
|
10-Year Yield
|
|
USA
|
1.78%
|
|
Germany
|
0.03%
|
|
Japan
|
-0.07%
|
|
UK
|
1.10%
|
|
Canada
|
1.17%
|
|
Australia
|
2.27%
|
|
New Zealand
|
2.59%
|
|
Switzerland
|
-0.50%
|
*Data as of 25/10/16
The yields on corporate bonds and junk bonds have also declined
substantially this year, as investor
money shunning negative-yielding government debt has nowhere else to go. The
distortive effects of negative rates are immensely felt – pension funds
restricted to buying only the safest, highest-rated government debt are making a loss on their investments,
retirees are earning next to nothing
on interest on their hard-earned savings stashed in bank fixed deposits, bank profit margins are squeezed as
they absorb the cost of negative interest rates rather than pass them on to
depositors.
All the investor money sloshing
around the world, waiting on the sidelines is perfect for a rally in
precious metals. With nowhere else to go, investors are likely to put their
money into gold and silver, driving their prices higher.
The Brink of Recession
So much for blabbering on and on about interest rates, I promise to keep
the rest of the post short and concise. Promise!
With all that talk about sluggish global economic growth, the threat of recession looms over the
horizon, and I believe there is a chance we (Singapore) may dip into
recession in the coming two years. With quarterly GDP growth in developed
economies excluding the US averaging less than 1%,
bearing in mind that a recession is defined as three consecutive quarters of
negative GDP growth, the outlook is grim.
Traditionally, gold (and silver) is seen as not just a hedge against inflation, but also a safe haven
to seek refuge in times of economic turbulence. While of course there is no
guarantee that gold will always rise in times of economic uncertainty, it does
have a fairly decent track record, rising
in value in 5 out of the previous 7 recessions since 1970. Clearly, even
the notion of incoming recession has sent investors scurrying into the safety
of gold this year. Should a recession actually arrive, with the stock market
out of bounds as companies perform badly and the bond markets already yielding
so low, gold looks set to shine as a viable investment, taking the other
precious metals along for the ride up.
In fact, one of the closely-watched and hotly-debated indicators of a
looming recession is starting to signal that one may be coming. Gulp! The
dreaded flattening yield curve is
here. I shall use the US Treasury yield curve for simplicity, though this
phenomenon is happening in many countries as well. As seen in the graph below,
the slope of the curve now is less steep than what it was a year ago. This
implies that the difference between
short and long term borrowing rates have narrowed.
 |
| Source: US Department of the Treasury |
Below is a similar graph, comparing the current yield curve to 3 years
ago. As can be seen, the yield curve has slowly
been flattening (becoming less steep) throughout these years.
 |
| Source: US Department of the Treasury |
|
A final graph showing the yield curve from 2007, just before the Great
Recession. Notice how flat the curve was back then? This is what’s been getting
all the prophets excited, a flattening
yield curve foreshadowing a looming recession.
 |
| Source: US Department of the Treasury |
The exact reasons for a flattening yield curve are complicated, which I
shall not discuss here. But there is evidence to suspect that a recession, or
simply just economic tough times are ahead. Gold (and precious metals by
extension) offers a safe haven to hide in to ride out these times.
Uncertainty, the New Normal
There’s no denying that today’s world is fraught with uncertainty, and
ironically, unforeseen events are bound to happen. Today’s interconnected financial markets means that uncertainties only exacerbate volatility in markets across the
world, with “contagion” as the new buzzword.
Just flash back a few months to the British Referendum, whose outcome
eventually led to the much-dreaded “Brexit”. Before June 24 2016, the financial
world as a whole did not take the probability of a Brexit seriously enough. As
the vote counts started rolling in, the British Pound took a huge plunge,
dragging with it the euro, European and global stock markets. In the midst of
the chaos, gold prices skyrocketed to their highest level this year, as frenzied investors rushed into safe haven
assets.
Looking back, gold has been a safe haven whenever things unexpectedly go south,
attracting large inflows in the immediate aftermath of terrorist attacks
(9/11), natural disasters (2011 Japan Earthquake) and political uncertainty/war
(Gulf War). I certainly do not claim to be clairvoyant and try to predict such
events, but it is very likely that gold prices will spike in times of
uncertainty, which 2017 will likely see no shortage of.
Coming up on the calendar we have the 2016 US Presidential Elections, and which candidate wins will have
implications on the economy. Both France and Germany, the two largest economies
in the Eurozone, go to the polls in 2017. The UK is expected to formally begin
the act of leaving the European Union in 2017. Japan’s central bank could
introduce the much-discussed policy of “helicopter
money”. The UK or Canada could cut interest rates into negative, with current rates
already so low. The list of events that have uncertain outcomes goes on and on,
but I believe that the single most important event will be the UK departing the
EU. Should the UK not be able to negotiate favourable economic terms for its
exit, global markets will react negatively, sending safe haven gold soaring.
While uncertainties will definitely not be the key driver of precious
metal prices in the long term, they certainly do boost prices in the short term, which could serve as useful
catalysts to push prices past significant technical levels, assisting the gold
bulls.
A Glance at the Charts
Gold
Gold has previously been stuck in a downtrend,
defined by lower highs and lower lows, since the
burst of the gold bubble in 2011. However, 2016 price action may suggest that the trend has turned, with gold managing
to forge out what looks like higher highs and higher
lows. Could this be an indication of an uptrend in gold? It does look
likely that the trend has turned after prices bottomed out in late 2015. At
this point it looks logical to jump on the gold bandwagon as prices reverse
from their higher low – possibly a good point of entry for long term gold
investors.
A shorter term chart of price action provides insight into the key price
levels that form possible zones of support and resistance. $1200 seems like the line in the sand for most of
2016, as prices have remained above this level since it broke through it
February. Prices are currently taking support from the 61.8% Fibonnacci
retracement level at about $1250. The next major
hurdle to clear for the uptrend to resume would logically be $1300. Beyond that, prices would have to breach the
2016 highs at $1375 and press on to challenge $1400 for the longer term uptrend to be intact. If
not, gold is likely to remain range
bound.
Silver
Silver shows nearly the same price action as gold, as both are closely correlated. However, moves in
silver are more pronounced than gold,
making it more volatile. Longer term
interim support lies at $16 – which can be said
to be a make-or-break level. Prices are currently taking support at around $17.35, the 50% Fibonnacci retracement level, forming what could potentially be the higher low in
the longer term uptrend.
Palladium
Less-traded palladium has the hallmarks of a strong uptrend beginning in
early 2016, with a clearly defined
rising trendline. Prices are currently taking support at $625. If this level breaks, the trendline connecting
the 2016 lows will be challenged next. Prices have to hold above the June lows
at $525, a level of strong support, for the long term uptrend to remain intact.
Platinum
Platinum is the only one to buck the trend of
higher highs and higher lows, putting in what seems like a lower low in
October, with prices slightly below the April lows of $945.
It is also the worst performing of
the four year-to-date in terms of percentage increase. Ultimately, prices have
to hold and reverse higher from this level to challenge $1025 for the long term uptrend to remain intact. A break below $900 would be of concern, as it would threaten
resumption of a long term downtrend.
The Flip Side: Central Bankers
rejoice! – Unexpected Pickup in Growth
There are always at least two sides to any argument, therefore I feel
obliged to provide the opposing view as well. The single greatest threat to any
potential rally in gold would be interest
rates picking up, and central banks cutting or removing their quantitative
easing programs (or essentially money printing) altogether, in response to a
pickup in economic growth.
Central bankers may heave a sigh of relief that their policies have
finally started to work, but previous metals investors will groan in agony as
prices fall in response to rising rates and bond yields. With the US economy slowly strengthening and once again
returning to become the world’s engine of growth, a similar resurgence may
happen throughout major economies such as the Eurozone. This would bode well
for stocks, but its impact may not be favourable for previous metals. However
unlikely this may seem, given the circumstances at present, we cannot discard
this possibility altogether.
The Flip Side: Uncle Sam’s
Strength
The other major concern here is that the US may hike interest rates more quickly than expected, sending the US dollar soaring and gold into a
tailspin. This could very well happen if the US economy demonstrates sufficient
strength. While each fed member has his/own projections of the number of hikes
in 2017, most predict that rates will be at 1.00%,
implying a 0.50% increase from current rates, or two rate hikes from now till end-2017.
 |
| Source: US Federal Reserve |
While the possibility of a December 2016 rate hike may not have been
fully priced in, let alone rate hikes in 2017, should US economic reports,
especially unemployment and inflation
data, take a turn for the better, the Fed could have the go ahead to hike rates more quickly than expected,
which is bearish for gold.
The Flip Side: Plastic Wedding
Rings?
One should also not forget that precious metals do have their uses as
well, apart from diamond-studded gold wedding rings. Palladium and platinum are
industrial metals, and their demand dynamics relies on the industries that
require them, such as in catalytic converters in cars. Similarly, silver is also
an industrial metal, with applications in electronics and alloys. Gold’s demand
for practical use stems from jewelry, a large and growing proportion of which
comes from China and India. Should a harder economic slowdown hit both
countries, we could see demand for physical gold diminish, as purchases of
luxury items such as jewelry slow.
The Flip Side: The Actual Act
of Buying
The final concern is not with regard to the future price of precious
metals, but how to gain exposure to them. Below I’ve listed some of the methods
of gaining exposure to precious metals, and their advantages and disadvantages.
|
Method
|
Advantages
|
Disadvantages
|
Comments
|
|
Purchase the spot-traded metal outright via forex/CFD broker
Tickers:
Gold – XAU/USD
Silver – XAG/USD
Platinum – XPT/USD
Palladium- XPD/USD
|
-
The most liquid choice, with low spreads and commissions - able to buy or sell easily
-
No need to worry about management fees associated with funds
-
Leverage can work in investor’s favour by increasing gains
|
-
Leverage is a double-edged sword - can exacerbate losses; one
could even lose more than the invested
capital!
-
Spot prices can be very
volatile - the day to day swings in the
market will give you a heart attack
|
This method is more suited for trading rather than
for investing for the long term.
|
|
Buy into an exchange traded fund (ETF) for that metal
|
-
Also very liquid, the case
with gold/silver ETFs
-
Traded like stocks - can be treated to be part of one’s stock portfolio
-
Units can be exchanged for physical gold, since most funds are backed
by physical gold
-
There are even US-listed ETFs for platinum and palladium
|
-
Management fees eat into
returns - some funds have rather high
expense ratio of up to 0.50%
-
Depending on how the ETF is managed, may have tracking error causing
lower returns over the long run
-
Limited selection of ETFs locally - SGX does not have an ETF
tracking silver, only gold
-
Not traded round the clock - can only buy/sell when stock
market is open
|
The best choice for long-term investors.
Offers exposure to every precious metal. Some funds even have built-in
leverage.
|
|
Buy the physical metal itself
|
-
See it, touch it à not buying into “paper gold”, which one may face
difficulties exchanging for the physical metal especially when redemptions
are high
-
Gold/silver coins make a marvellous display piece J
|
-
Storage problems - how to secure the gold/silver
and prevent it from getting stolen?
-
Most dealers in physical gold/silver do not offer the most competitive
prices
-
Illiquidity - not easy to offload, have to
go through a dealer
-
How does one buy and store platinum/palladium?
|
This method works
best for small amounts of gold/silver which the buyer intends to keep for a
long time, or maybe even pass down to future generations.
Not possible for
platinum/palladium.
|
The Final Word
I’m very touched that you made it to the end of my extremely long post.
Do pardon me for the length, but I wanted to go into as much detail as
possible, while explaining key concepts to readers not so familiar with them.
To sum it all up, I do believe that precious
metals will continue to rally in 2017, mainly due to the macroeconomic factor of interest rates.
However, hard as it is to time the market, I don’t think we have reached an
ideal entry point for an investment just yet. I’ll prefer to wait until December where the possibility
of a rate hike would really move prices. Should a rate hike materialize, gold
and silver prices could be expected to take a short term hit, presenting an opportunity to buy in for the long term.
Just my two cents.
Disclaimer: This post is purely the opinion of the author and it is for
educational purposes only. It is not intended to recommend or solicit any
investment in any asset or product. All investments made by readers are at
their own discretion and the author shall not be liable for any loss of capital
resulting from any investment made by the reader.
