Would you believe me if I told you that this week’s market action could be all summarized in one chart? For you doubters out there, have a look at this.
While simply a chart of the US Dollar / Chinese Yuan fx pair since early May (when President Trump first threatened and then made good on an initial round of tariffs), the major weakening of the yuan at the beginning of the week, reflective of the ongoing US-China trade war, set the tone. And that tone was decidedly risk off.
How risk off was it? If you’ve ever watched Jim Cramer’s Mad Money, Jim tends to emphasize his point in triplicate. If he really likes a stock, he’ll say Buy! Buy! Buy! I can only imagine what he’d say about this week because the market swings were both sharp and exaggerated, requiring such emphasis. If I were in his shoes, I’d summarize the week with Gold! Gold! Gold! And as we’ll discuss in more detail later, #yield matters even more than it did last week.
Before we explore this week’s news as it relates to central bank policies, economic data and corporate earnings, let’s dig a bit deeper into the geopolitical events hinted at in our first chart. On Monday, the Chinese yuan fell to its lowest level against the US dollar in more than a decade. Allowing the yuan to fall past the psychologically important barrier of 7:1 was seen as a retaliation for President Trump’s announcement last Thursday of 10% tariffs on another $300BN of Chinese goods starting September 1st. After the markets closed Monday, the US countered by having the Treasury Department formally label China as a currency manipulator. The move sent futures tumbling post Monday’s sell off until China set a stronger than expected level for the yuan in its daily fixing on Tuesday. However, Tuesday’s daily fixing provided only a brief respite as the fx rate appeared to be managed weaker (although not in a straight line) over the balance of the week. Each day’s market tone seemed to be set by whatever happened with the daily yuan fixing. Finally, on Friday, President Trump announced that the US government would no longer do business with Huawei Technologies. This latest salvo was in part a response to China halting purchases of American agricultural products last week. As you can see, the two sides are continuing to move further apart.
With global manufacturing continuing to show signs of stress and no end in sight to US-China trade tensions, central banks around the world continued to ease and expectations around future Fed action became more pronounced. On Wednesday, central banks in India, New Zealand and Thailand cut rates more aggressively than most economists predicted. On Thursday, the Philippines cut its benchmark interest rate by 25bps. As for Fed Funds futures, just prior to last week’s interest rate cut, the market was expecting a 39% chance of 75bps of easing by the end of 2019. With 25bps of easing now already in the bag and given this week’s escalation in the trade war, those probabilities have shifted dramatically. By year end, the market now expects an 86% chance of an additional 50bps of easing (i.e. 75bps total and compares to the 39% probability mentioned above). The probability for an additional 75bps of easing (i.e. 100bps total) has risen to 41%. Just prior to last week’s meeting, the chance for 100bps of cumulative easing was in the single digits. I believe that recent economic data do not support such aggressive easing and therefore, the market must be anticipating a significant weakening in future releases.
Speaking of economic data, last week did little to change estimates for Q3 GDP (still tracking in the range of 1.5% – 2.5%). What about corporate earnings? With 90% of the S&P 500 now having reported, the song remains largely the same – corporate earnings continue to come in better than expected. Of note, while the expected year-over-year decline continues to improve, we may fall short of actually turning positive which some prognosticators had predicted. Earnings surprises (both in number and magnitude) continue to be above the 5-year average per FactSet. Revenue beats, however, are below the 5-year average in number and in line with the 5-year average in magnitude. Consistent with last week, forward guidance continues to shrink analysts go-forward estimates. This will be my last in-depth review of earnings until Q3. Note: A red shaded cell indicates a negative week on week change while a green shaded cell indicates a positive revision. Yellow indicates unchanged.
Even though future estimates continue to shrink, my confidence in the level of expectation reductions is sinking. In my opinion, this week’s escalation in trade tensions increases the likelihood that revenue and a return to earnings growth will be challenged in the face of a global slowdown and a drawn out US-China trade war. Clearly, Fed Fund futures, as discussed above, believes this to be true. While companies are again ramping up their discussion of tariffs as it relates to their earnings, it is unlikely that the full impact from the additional 10% tariff that starts September 1st or a further escalation from here is fully accounted for.
This puts the expected earnings rebound projected to start in Q4 2019 and further accelerate in 1H 2020 in jeopardy. In order for a recession to be in play, guidance would have to indicate the potential for a decline in revenues. While we are not there yet, given this backdrop, I continue to advocate for investor alert and a rotation towards a more defensive portfolio.
Before I look at each individual market, I’d like to remind our readers that anyone who is thinking about buying gold as an investment or buying gold’s more volatile sibling silver as an investment and who is worried about initiating a new position at current prices should carefully develop their own view and consider their expected holding period. There are many and varied drivers of the gold money relationship. In support of developing that view, let’s review the major markets that precious metals take their cue from.
The S&P finished lower on the week, declining 0.45% to finish at 2,918. As alluded to in my opening, the market zigzagged with the movement in the yuan. Monday’s shock devaluation drove the index to close below both its 50-day and 100-day moving averages, creating technical damage in its wake. The market rebounded on Tuesday with a better than anticipated yuan daily fixing only to struggle to a flat close on Wednesday after another early morning sell off related to the fx rate. Of note, the market seemed to find support at the 2,825 level, a practical double-bottom with Monday’s weakest levels. Near-term and without further catalysts, I see the S&P confined to a price band delineated by the 50-day moving average (2,936) to the upside and the 200-day moving average (2,792) to the downside.
From a fundamental perspective, at current S&P 500 index levels, the forward 12-month P/E ratio is 16.7x which is above both the 5-year (16.5x) and 10-year (14.8x) averages per FactSet. The inverse of the P/E ratio is the S&P earnings yield which currently sits at 6.25% (simply 1 divided by the 16.7x P/E multiple). With 10-year Treasury Notes currently yielding 1.74%, this puts the risk premia associated with equities at a hair above 4.5%. This comparison and the associated risk premia attributed to equities is known as the Fed Stock Valuation Model. While there is much debate over this model given the change in correlations between the two asset classes around the turn of the century (see chart below), Wall Street strategists who think recession can be avoided have left in place their S&P price targets in part due the excess risk premia currently on offer.
Volatility, as measured by the VIX, increased from 17.61 to end the week at 17.97. Monday’s yuan devaluation sent the VIX spiking to a closing level of 24.59, nearly 1 standard deviation higher than the long-term average using log normal data. Over the balance of the week, the VIX declined daily with the exception of Friday. This was related to the market sell-off based on President Trump’s Huawei announcement. Of note, the intermediate part of the VIX futures curve ended the week in backwardation, indicating continued levels of stress in the market. Normally, VIX futures are in contango where the futures price is higher with each successive contract.
#yield matters! Bond yields continued to fall this week with the 10-year Treasury declining an additional 12bps from 1.86% to 1.74%. 3-month T-bills, on the other hand, only experienced a decline of 6bps to end the week at 2.00%. As a result, the yield curve inversion as it relates to these two maturities ended the week at -26bps, a second straight weekly move towards greater inversion. The early part of this week saw this same inversion as wide as -32bps, a new cycle low. With the Fed Funds rate now in the range of 2% – 2.25%, a T-bill yield of 2.00% sits on the precipice of predicting lower future rates. As discussed in my overview, this is clearly still far from being in sync with where Fed Funds futures ended the week. Only time will tell which of those two markets has it right.
Briefly, looking at the 10s – 2s part of the yield curve, we saw that spread shrink further this week to +11bps from +14bps. While this portion of the yield curve has yet to invert, the spread is getting perilously low and bears monitoring.
US Treasury – German Bund spreads also had an exciting week. On the surface, with the spread ending the week at +231bps, slightly tighter than the +233bps from the prior week, it doesn’t appear so. However, market surprise surrounding the significant weakening of the yuan at the beginning of the week drove this spread as tight as +223bps, a new cycle low. The German bund component of this spread, at a yield of NEGATIVE 0.567%, continues to hover near all-time lows. A continued tightening of this spread is a key component to my recession watch list.
Finally, the US Treasury – Precious Yield spread* continued to favor Precious Yield even further this week with the decline in US yields. The spread widened to -.37% vs. -.28% last week as 2-Year Treasury notes finished the week at 1.62%. Precious Yield continues to offer 2-year physical gold term deposits of 2%. Since Precious Yield offers investors in gold the opportunity to earn interest, the US Treasury – Precious Yield spread is tighter than the US Treasury – gold yield spread. To remind our audience, the gold yield is negative in most other holding forms outside of Precious Yield. This includes paying for storage of physical metal whether investor-owned or via a physically -backed storage program and paying management fees for GLD or similar ETFs. See our white paper for a more thorough discussion. Precious Yield provides a much needed yield alternative in this environment of ultra-low / negative global bond yields. #yield matters!
The US Dollar index fell 1.06% this week as US yields sharply declined particularly in relation to the rest of the world. About half of the loss was felt on Monday in conjunction with the yuan breaking the psychologically important 7:1 barrier and the other half was felt on Friday when President Trump banned the US government from doing business with Huawei (both indicative of the escalating trade war). Once again, however, there was great divergence amongst the major components of the index. The Euro was 0.8% stronger vs. the dollar with US Treasury – German Bund spreads tightening further. The British Pound, on the other hand, was nearly 1% weaker as the election of Boris Johnson continues to impact the future of Brexit. The Yen, the last major component of the index, strengthened 0.9% vs. the US dollar. This was in line with the performance of the Euro and it continues to behave as a market safe-haven. While there appears to be a discrepancy between the individual components and the overall movement of the index, a quick review of the other contributors (Canadian dollar, Swedish krona, Swiss Franc) do not appear to hold the answer.
Last week, I pointed to yuan weakness as a gauge for estimating market expectations surrounding trade talk outcomes. At that point, market expectations had reached new lows given the break in the yuan. With this past week’s action, those expectations are now EVEN LOWER. Said differently, if any actual progress gets made in the trade talks, it should be a very solid positive for risk-on markets at this point. Gold, however, would likely suffer.
As measured by the LBMA afternoon fix, gold had a tremendous week, increasing 3.9% to $1,497.70/oz and once again making new cycle highs. Gold even breached $1,500/oz with Wednesday’s LBMA afternoon fix in the interim. All of the elements for a gold rally were present this week with equity markets declining, volatility increasing and global bond yields crashing – not to mention all of the geopolitical tension. And unlike last week, the US dollar was also weaker.
To follow on from last week’s thoughts, I will continue to monitor the price of gold in other currencies to help determine the likely path forward for gold in US dollar terms. Remember, these breakouts to new all-time highs for gold in other currencies are pointed to by those who are bullish as evidence in support of their thesis. If nothing else, the sharper upward movement in gold prices in these other currencies has likely attracted the attention of non-US investors considering the space. As mentioned last week, gold is nowhere near its all-time high in US Dollar terms. I am once again attaching the chart of the difference between gold in US Dollars and gold in British pounds as a reminder. Given the additional week of data, you can really see the break to new highs in British pounds.
Switching gears, gold volatility (along with most other measures of market volatility) increased to 16.64 from 15.00 the prior week. Intraweek, this volatility spiked as high as 18.16, slightly above the average using log normal data from June 2008. Remember, I use the “Gold VIX” (Ticker – GVZ ) to get a sense for this metric. The Gold VIX measures the market’s expectation of 30-day volatility of gold prices by applying the VIX methodology to options on SPDR Gold Shares (Ticker – GLD). GLD is an exchange-traded fund (ETF) that represents a fractional, undivided interest in the SPDR Gold Trust, which primarily holds gold bullion. As such, the performance of GLD is intended to reflect the spot price of gold, less fund expenses.
While an investment in gold has historically been associated with negative carry, Precious Yield offers investors the opportunity to earn a yield on gold. If you are a long-term holder, turning gold as an asset for diversification purposes into an alternative investment with Precious Yield allows for some cushion against gold price movements via the gold yield. To learn more, please browse our website or contact us for more information. For up to the minute thoughts, please follow me (@CIORobPerry) or Precious Yield (@PreciousYield) on twitter.
* Note that while I use the US Treasury – Precious Yield spread as a relative value metric, a better apples to apples comparison of similar instruments would be US Treasuries vs. a fully hedged gold position. For more information on a fully hedged gold position as a yield alternative, please visit our www.kilofutures.com website and read about The Cash and Carry Trade.
Gold 1-Month Price Chart
Silver 1-Month Price Chart
Platinum 1-Month Price Chart
Palladium 1-Month Price Chart
About the Author
Rob Perry is an avid student of the markets and an aspiring tennis player. He is currently Chief Strategist for Precious Yield as well as Chief Investment Officer of Pecan, a single-family office based in San Diego, CA. Most recently, he was located in New York City working as Chief Strategist of and a Portfolio Manager for Kingsland Capital, a multi-billion dollar boutique asset management firm focused on below-investment grade corporate credit. Twitter: @CIORobPerry
Precious Yield, a subsidiary of Kilo Capital, offers long term precious metal investors the unique ability to safely Invest in precious metals and earn a yield on gold, silver, and platinum. Precious Yield deposits are always 100% backed by physical metal. The physical metal balances are regularly verified by EY, one of the largest global accounting firms. Over time, the benefit of earning interest on gold, silver, or platinum balances can meaningfully improve the returns on precious metal investments. At Precious Yield we pay interest on gold, silver, and platinum that is greater than that customarily offered by the large bullion banks. Sign up for our weekly precious metal market commentary and build your bullion market expertise.
Kilo Capital is a specialty finance and trading company that provides tailored financing solutions and risk mitigation tools for companies that trade, deal or invest in precious metals. Our team of experienced precious metals professionals structure the right combination of loans, metal leases, select inventory finance, and hedging services so that our clients achieve their business goals. We work extensively with jewelry manufacturers and wholesalers, coin dealers, metal refiners, industrial users of precious metals and investors in gold, silver, and platinum. For investors considering cash and carry trade strategies, or companies looking to hedge interest rate risk, our colleagues at Kilo Futures can assist.
Kilo Capital Corp, its successors and assigns, and its subsidiaries and affiliates (collectively, “Kilo”) produce newsletter services which, along with any related publications and its website (collectively, the “Newsletter”), are authored and edited from time to time by members of the Kilo team.
You and your affiliates (collectively, the “Reader”) acknowledge that the Newsletter is provided for educational and informational purposes only and is not intended to provide investment, trading, tax or legal advice. Reader should consult a professional financial or investment adviser, CPA, broker or attorney for such advice and should conduct his or her own research and due diligence before making any investment decision.
Investing involves substantial risk and you may lose some or all of your investment. While past performance may be analyzed in the Newsletter, past performance should not be considered indicative of future performance.
To the maximum extent permitted by law, Kilo disclaims any and all liability in the event any information, commentary, analysis, opinions, training or recommendations in the Newsletter prove to be inaccurate, incomplete, or unreliable, or result in any investment or other losses. Reader agrees to indemnify and hold harmless Kilo from and against any damages, costs and expenses, including any legal fees, potentially resulting from the application of any information provided by Kilo in the Newsletter.
The Newsletter’s commentary, analysis, opinions, advice and recommendations represent the personal and subjective views of Kilo and are subject to change at any time without notice. The information provided in the Newsletter is obtained from sources that Kilo believes to be reliable and Kilo is not responsible for any errors or omissions in any Newsletter. Kilo has not independently verified or otherwise investigated all such information.
The Newsletter is not a solicitation to buy or offer to buy or sell any securities. Kilo makes no guarantee that you will profit from trading any market or security.
The Newsletter may contain “forward-looking information” within the meaning of applicable securities laws that are based on expectations, estimates and projections. Any such information is based on reasonable assumptions and estimates of Kilo at the time it was made and involves known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of any investment to be materially different from any future results, performance or achievements expressed or implied in the Newsletter. There can be no assurance that the statements in the Newsletter will prove to be accurate as actual results and future events could differ materially from those anticipated in such statements. Accordingly, Reader should not rely on any forward-looking information. Kilo undertakes no obligation to revise or update information in the Newsletter other than as required by law.