December 05, 2022
Gold was up 2.4% this week to US$1,796/oz as the Fed Chairman signalled in a talk that less aggressive rate hikes could come through as early as December 2022, although a strong US jobs report indicated that inflation could still remain high.
This week we look at the gold stock bull and bear markets from 2019 to provide context for the recent run up in the sector and show how a contraction in the US money supply could be a key negative driver that curbs the recent rally.
Gold jumped 2.4% to US$1,796/oz this week mainly after comments by the US Federal Reserve Chairman that it could reduce the pace of its rate hikes, which had been running at an aggressive 75 bps over the last four consecutive meetings, to just 50 bps in the December 2022 meeting. This drove a 3.0% jump in the equity markets on Wednesday, and then a jump in gold, also by 3.0%, on Thursday, propelling gold stocks. However, on Friday, there was US jobs data that appeared contrary to the idea that the economy was cooling, and therefore inflation with it, which would allow for a less aggressive hikes from the Fed.
The US non-farm payrolls came in at 263,000 for November 2022, much higher than the 200,000 consensus estimate (Figure 4). With the Fed's dual mandate to both keep inflation under control, but also maximize employment, they may see this data as indicating that the economy is still running hot, and that high inflation risks remain. The Fed remains under little pressure to pull back from the unemployment side of their mandate, with the rate still near forty-year lows of 3.70% over in October and November 2022, having ticked up from just 3.5% in September 2022 (Figure 5).
Such a low level of unemployment is rare, having only been reached twice since 1970, just before the global health crisis, and in 2000 prior to the dot.com crash. This strong employment coupled with surging inflation has also driven up wage inflation, with the jobs report showing US average hourly earnings up 5.1%. This is well above the 4.6% consensus estimate, and the highest level over the past fifteen years excluding the extraordinary moves in the global health crisis (Figure 6). This suggests that a phenomenon may be arising that hasn't been seen in the 1970s; a wage-price spiral.
A wage-price spiral develops when inflation is so high and persistent that employees
start to anticipate inflation in their wage demands. This drives companies to need to
boost the prices of their goods and services to offset this, further increasing inflation,
further prompting workers to expect more inflation and demand more in wages,
creating an upward spiral. This occurred in the 1970s when the developed economies
had difficult controlling inflation for most of the decade and into the early 1980s. While
US rates were hiked in the mid-1970s, this was relatively brief, and at the first signs
of inflation easing rates were lowered, causing inflation to rapidly rise again.
Inflation was only completely crushed when the Fed hiked US rates to by far their highest levels ever in 1980. This led to a forty-year period when inflation remained low, and perhaps more importantly inflation expectations by workers remained low, so no wage price spiral developed. This is why the recent rise in wage inflation is such a concern for the Fed, with it not wanting a repeat of the mid-1970s where rates are lowered too quickly at the first sign of lower inflation, allowing for a wage price spiral to get out of control. This could mean expectations for a dovish Fed may be dashed.
Another data point potentially against the Fed really becoming much less aggressive
is the US GDP growth for Q3/22 released earlier this month, up 2.9% after a twoquarter decline, with such high growth tending to be inflationary (Figure 7). Along with
the low unemployment numbers, this raises the issue of the lagged effect of interest
rate changes on the economy. While the GDP and unemployment numbers look
strong now, we will not see the overall economic effect of the interest rate hikes
already made until well into next year. It may turn out that the very low unemployment,
higher wage demands, and recent rebound in the US economy would have had the
effect of driving continued high inflation into 2023, had the Fed not intervened.
In this case, the Fed would have, in hindsight, proved correct in its aggressive rate hikes so far, and even if pulling back to 50 bps for the next few meetings, would be correct in continuing to hike rates well into 2023. However, the rate hikes are already likely to be driving businesses to pull back on investment and consumers to start considering reducing purchases, and we are already seeing layoffs from major companies in the US. The downward spiral that could result from these decisions may not show up in the form of a slowing economy, rising unemployment and lower inflation until next year, and in hindsight could show that the Fed had tightened too fast and too strong. It shows the problem the Fed has in using current data which is really the result of a lagged effect from economic decisions made many months ago.
Another major lagged factor, and in many ways possibly the single most important factor for the economy and stock markets, is the expansion of credit, for which one measure is the US is M3 Money Supply, the broadest measure of the money supply. When the money supply is expanding, it tends to propel the economy and stock markets, and when it is contracting, it tends to the have the opposite effect. There has been a critical recent change in this indicator, driven especially by the Fed's aggressive rate hikes, with it declining for the six months to September 2022, and such an extended fall is historically rare (Figure 8).
The year on year growth in the US M3 money supply has plummeted from a 26.9%
high in April 2020 to just 2.4% (Figure 9). This is very low historically, with M3 growth
falling below 3.0% only three times in seventy years, after the global financial crisis
(GFC) in 2011, in the early 1990s recession and in 1969-1970s recession. Also
important is the recent month on month downtrend, with a several month consecutive
decline, which also drops below zero, having few precedents in history, again during
the GFC, the early 1990s and late 1960s-early 1970s (Figure 10).
While this reduction in liquidity is an obviously an issue for the overall economy, it is especially an issue for the equity markets, with much of the huge gains from 2011- 2019 and from 2020 to 2021 having been driven by a monetary surge. There had always been much talk in the mid-2010s of what would happen when the Fed 'took way the punch bowl', from the seemingly non-stop equity market party, likely causing to end and forcing the onset of a massive 'hangover'. Over the last six months, really for the first time since the GFC, the punch bowl has been clearly removed, and while the performance of equity markets has shown that the hangover is here, the question is will it worsen, or will it abate.
So all of this still leaves us with many questions. Is the US economy booming or not,
and are the Fed's hikes justifiably cooling an overheating economy? Or have they
already put in motion a slowdown for an economy that was more fragile than current
numbers indicate that will only be realized in 2023 data? And have we reached the
bottom for equity markets and will the gold price continue to rise, propelling gold stocks?
Overall, as we have for the entirety of 2022, we see the risk still for the economy and equity markets weighted to the downside and believe that the recent stock market rally has likely gotten ahead of itself. The recent pickup in the equity market seems to be pricing in only the positives that potentially lower inflation could mean lower interest rates, but not the economic slowdown that would likely be driving the potentially lower prices.
The market also seems to be not fully pricing in that rates are still high and rising aggressively, even with 50 bps hikes instead of 75 bps, which is more than enough to wreak significant havoc. It also seems to be underpricing the likelihood that the Fed will keep rates high through 2023 to make sure inflation does not resurge, given hints of a wage price spiral emerging, and the lagged potential negative economic effects from the hikes already made that could be coming through next year.
There is also the fact that recent upward market swings have been so abrupt, with both a 5.0% and 3.0% single day gain in the S&P 500 over just the past month, which is historically very rare. As we showed in our November 14, 2022, Weekly 'Manic Depressive Markets', these major single day swings are not historically the sign of a healthy market, but usually occur within the overall downtrend of bear markets. Also, that these huge moves have been driven only by news that the Fed may be become moderately less aggressive makes them seem overblown; it is hardly the case that the Fed in on the verge of a major rate reduction cycle.
All that said, the market seems to have decided for now that all is rosy, and that the
Fed will somehow engineer the much vaunted 'soft landing' of the economy,
balancing the factors we have discussed above with minimal economic fallout. From
October 2022, this bullish thesis has driven up the S&P 500 5.2%, gold, 9.6%, the
GDX ETF of producing miners, 23.8% and GDXJ ETF of junior miners, 26.2% (Figure
11). This week we put these recent moves within the broader context of the anatomy
of the gold stock bull and bear markets of 2019-2022.
Figure 11 starts from the tail-end of the previous gold stock bear market, which started in 2011 on a plunge in the gold price driven by a rare combination of extremely low interest rates and persistently low inflation, sending investors heavily into risk assets and eschewing inflation safe havens like gold. This dragged on until 2018, when the US Fed started to pullback on a relentless monetary expansion. This in turn started to have a negative lagged effects on the global economy by 2019.
Investors started to become more risk averse and this and started to drive up gold, especially by the end of 2019. However, the real surge in the gold price did not occur until the global health crisis erupted in early 2020, when hedging risk became suddenly much more important to the market, sending gold up 49% from the start of 2019 through to July 2020, and the GDX ETF of gold producers and GDXJ ETF of gold juniors followed, up 89%, and 83%, respectively.
However, as peak fear over the global health crisis passed, the gold price began to
slide. This was interesting, as this was coincident with a massive surge in liquidity in
response to the crisis, which might have been expected to continue driving up gold.
However, instead this liquidity flowed into risk assets, like stocks, with the S&P 500
up 45% from July 2020 to August 2021, and crypto, rather than the safe haven gold,
as inflation at this point still remained quite low.
Nonetheless, while gold was well down off its peak fear surge, it was still doing relatively well, with its decline nothing like the 2011-2013 downturn, and it held at an average US$1,836/oz throughout Phase 1 of the gold stock bear market from July 2020 to August 2021. However, the decline in the gold price still drove gold stocks down, with the GDX declining -25% and GDXJ down -31%.
Phase 2 of the gold stock bear market was different because it appeared to have been driven more by the decline in overall equity markets, with the S&P 500 down - 19% from December 2021 to October 202, than issues with gold price, although gold did decline a further -9%. There has especially been pressure on small caps through this period, as investors have become more risk averse, which has also hit the gold juniors, with the GDX down -25% and GDXJ down -29%.
It is unclear whether the bottom was really reached in October 2022 and a new bull
phase for gold stocks has begun, but we view this rally and the overall equity market
as still a bit shaky and suspect a retracement is coming. The equity rally could
conceivably continue into the end of 2022 with the effects of 'window dressing',
where fund managers may temporarily buy stocks to increase their reported annual
returns a bit, a series of buybacks by major companies, and the typically light trading
moving into the holidays.
However, we see much greater forces working against the equity markets than these minor short-term drivers for early 2023, including the money supply contraction outlined above. In equity market boom times, it was often said 'don't fight the Fed' indicating investors should not short markets when the Fed was keeping rates low and increasing liquidity. As this should also hold true when the Fed is boosting rates, it seems to indicate that the market, with its drive upward of the last several weeks, has indeed been fighting the Fed, with a slight pullback from extremely aggressive rate hikes to just moderately aggressive rate hikes hardly a dovish situation.
While the dip in the gold price in September and October 2022 had concerned us,
the recent moves have brought us back to the thesis we held for most of 2022 that
gold would hold up reasonably well. We expect that there is enough fear, uncertainty
and inflation in these markets that holding gold is looking much more attractive than
it was in the mid-2010s gold and gold stock bear market.
Rather it is the broader equity markets that we have been concerned with, not gold itself, since the start of the year, and remain so. We see potential for a continued broader equity market decline to pull down the overall valuations of most stocks, offsetting the potential gains from a strong gold price for the gold producers and junior miners heading into early 2023. We anticipate a difficult first half of next year overall for the economy and stock markets, but we could start seeing some gold stocks bargains develop as early as second half 2023, especially if the gold price continues to hold up.
The producing gold miners were all up but large cap TSXV junior gold was mixed (Figure 12). Alamos and SSR Mining reported drill results from Island West and Marigold, respectively, and Lundin released guidance (Figure 14). For the Canadian juniors operating domestically, New Found Gold and Osisko Development reported drilling results and Laurion made its final payment to Jubilee Gold for an option on the Brenbar Project (Figure 15). For the Canadian juniors operating internationally, Rupert released a PEA for Rupert Lapland, Robex reported Q3/22 results and drill results from Central Mansounia and Thor reported Q3/22 results (Figure 16).
Disclaimer: This report is for informational use only and should not be used an alternative to the financial and legal advice of a qualified professional in business planning and investment. We do not represent that forecasts in this report will lead to a specific outcome or result, and are not liable in the event of any business action taken in whole or in part as a result of the contents of this report.