The SA Bullion Gold Report | Third Quarter 2022

 

  The SA Bullion Gold Report

   Third Quarter 2022

 

A TOUGH FEW MONTHS FOR GOLD

 

In the early weeks of February 2022 Vladimir Putin lied to Ukraine and the World about his big military build-up around Ukraine, and his intentions. On 24 February he invaded his neighbor when the gold price was $1,904.70. When a huge Russian force rumbled into Ukraine with the objective of decapitating the Ukrainian government and seizing the country, Europe and the rest of the World began to panic.

In 13 days the gold price shot up to $2,039.05, peaking on 9 March. With the war still raging seven months later, and with no imminent end in sight, the gold price has slumped. At 30 September gold was priced at $1,654.80.

Putin’s invasion caused gold to rise 7% and then retreat 19%.

‘Why the slump in the gold price?’ – you might ask. The full answer is complex but we will attempt to distil an easy-to-read version here.

First, to be clear: the gold price may be considered in any currency, not just the US Dollar. As a relevant example: on 24 February the gold price was R28,703.80 in the South African currency. At 30 September it was R29,891.80, up 4%.

 

MARKET DYNAMICS THAT HAVE HURT THE GOLD PRICE

 

For some time we have been writing about inflationary forces building up in the system. These forces received an almighty push from government responses to the Covid-19 pandemic in 2020 and 2021 (as previously reported), and then again from Putin’s invasion of Ukraine in 2022.

With inflation surging in the United States, the Federal Reserve has been aggressively hiking interest rates in a bid to tamp down inflation, which remains stubbornly high, especially as the war in Ukraine bolsters food and energy prices.

The Federal Reserve increased rates by three-quarters of a percentage point in three recent consecutive meetings. Furthermore the Fed also signaled that significant hikes could be expected in November and December.

Fed actions have pushed the Dollar to a two-decade high. The Dollar is up 16% against a basket of major currencies so far this year.

These massive Fed Funds Rate and Dollar movements have been hurting US equities, US bonds, and gold. And of course Fed actions always infect the whole world. The Bank of England has pushed UK rates to their highest levels since 2008, and the picture is repeated the world over. Central banks mean to get inflation under control by raising rates.

 

THE SPECIAL CASE OF OIL (AND INFLATION)

 

Simplistically, one can consider Russia as a giant petrol station. Where a petrol station might make a little money from selling cool drinks and chips, it’s real business is moving hydrocarbon fuels. Russia produces and exports a few bits and pieces, but its real business is moving hydrocarbon fuels.

Russia is a massive producer and exporter of oil and gas. As a source of ‘clean power’, Europe has strongly tied itself to Russian gas supply over the last few decades and the enormous gas pipelines running through Ukraine and under the Baltic Sea (Nord Stream 1 and 2) have become widely known.

Putin’s invasion of Ukraine set off a chain reaction of problems for oil and gas supply, and therefore for oil and gas prices, and therefore for inflation.

Europe and the West (‘West’ meaning Western-style Democracies – including countries like Japan, South Korea and Australia) have not only assisted Ukraine in it’s military defence against Putin’s invasion, but have also heavily-sanctioned Russia and mean to move away from consuming Russian hydrocarbons as quickly as possible. These ‘demand-side’ actions have caused a drop in Russian oil and gas consumption, but more importantly, Putin has weaponised Russia’s oil and gas supplies in order to inflict ‘supply-side’ punishment on Western nations. The combination of these actions has caused hydrocarbon fuel prices to take-off worldwide and this has set inflation racing.

The US Fed response to multi-decade high inflation rates has been to raise interest rates to cool the economy, tamp down fuel demand, and in this way induce fuel prices to reduce. And hey presto!: For two and a half months oil prices have been declining. Oil prices have fallen from $120/barrel to $80/barrel.

To be fair, there has been another major force at play here. The Fed has had a lot of assistance – and here we get to the intersection of politics and economics.

The US is heading into mid-term elections in November, and whereas the Democratic Party presently controls the Presidency, the Senate, and the House, it is statistically likely that they will lose the Senate and the House. (The Presidency only comes up for elections in 2024)

The state of the economy plays an outsize role in US elections, and more specifically, the oil price takes centre stage. In order to “double-team” with the Fed and tamp down oil prices, President Biden has been using his presidential prerogative to release oil from the US strategic reserves.

President Biden has released 350 million barrels of oil from strategic reserves and this has had a very significant role to play in bringing oil prices down by $40 per barrel.

Of course the successes of the Fed and President Bid en are not in Putin’s interest. Putin wants to hurt Western countries, he wants to hurt President Biden and the Democrats (he would like his old pal Donald Trump to regain the White House in two years’ time) and he would like maximum oil revenues flowing into Russia while his country proceeds rapidly backwards.

As with the US and Russia, Saudi Arabia and the Democratic Party-led US are not great friends either. Ex-President Trump had been fine with the Mohammed Bin Salman (“MBS”)-led Saudi Arabia murder and dismemberment of a US resident, but President Biden had an entirely different position and expressed stern words for MBS when he came to office. MBS had not appreciated Biden’s position and words, and since then there has been no love lost in that relationship.

In recent days a collaboration of the Saudi-led OPEC+, and Russia, have announced that they are cutting oil supplies to world markets by two million barrels per day – equivalent to approximately 2% of total global production. This enormous reduction in supply in a market that is already beset by supply problems will put extremely significant upward pressure on oil prices. It has become outright war between the Western central banks and Russia/Saudi Arabia.

Much of the world’s hydrocarbon fuel supply is controlled by despotic regimes. In the current geo-political state of play this has left western-style democratic countries and their democratic systems seriously at risk. In western democracies, anti­democratic rightwing populists have the wind at their backs as they are able to exploit their friendly relations with tyrants in order to address their supply-side oil challenges

 

LOOKING AHEAD  

 

There are many interweaving factors that can play a big role in the future direction of the gold price. We will summarise what are arguably the three most important factors.

1. The Mighty US Dollar

The Dollar is at its strongest in 20 years and the reason lies with the Fed and its extraordinary interest rate hikes. The extremely strong US currency has caused outsized problems for other countries. Many leading currencies have been dramatically weakened by the Dollar – currencies including the Pound, the Euro, the Yuan and the Yen. In local currencies Dollar-denominated fuel prices have become disproportionately expensive, exacerbating the inflationary problems of most countries. As one would expect, capital has cascaded out of poorer performing currencies and into the Dollar.

One of the attractions of gold is that it is the counterweight to the Dollar. This means it does well when the Dollar does poorly, but it also means that it does poorly when the Dollar does well. For this reason gold has done poorly in the last six months. In addition, capital has exited gold to go into Dollar cash. The combined effect has been to put severe downward pressure on the gold price. This strengthening Dollar scenario might have some legs left in it due to likely rates hikes in November and December, although we think that the market has now already priced-in these likely future rate hikes.

2. The Fragile US Economy

High rates in the US are putting damage into the economy. The major component of US GDP is consumer spending, and consumers have become worn out by a year of rapidly rising prices and declining wage growth.

Following zero rates and a cascade of pandemic-relief cash in 2020 and 2021, consumers are now experiencing a hangover with tightening monetary policy, and the outcome is likely to be recession.

At some stage the Fed will become concerned with faltering economic growth and the impetus will be to cut rates to stimulate spending.

3. Retreating Asset Markets

The prospect of a poor economy and poor business conditions has left asset markets reeling. US Equities have lost approximately 25% of their value this year and other capital assets have experienced similar losses.

Capital has had few safehavens in 2022, with the primary one being Dollar cash.

Most people have suffered capital losses in 2022 in their shares, bonds, currencies and gold. Looking forward the immediate outlook for the world economy is bleak. But, it is the hour before dawn that is the darkest.

Markets are forward-looking and capital assets get priced looking well into the future.

Recession is almost inevitable, and has been priced into asset prices. But severe recession has not. We expect that the Fed will be fine with a recession but that they would take steps to support asset markets and GDP in the event of severe recession.

IN SUMMARY

 

Fed actions have surprised us and the markets. Furthermore, the degree of Dollar strengthening has surprised us and the markets. To be sure, for the past six months one would rather have been in Dollar cash than in gold. But of course from a South African perspective and knowing the Rand weakness of the past six months, gold has been a good investment.

This recent past experience talks to our general position regarding the cash component of one’s total portfolio – we like a mix of gold, Dollar, and for South Africans – some Rand.

It is not possible to repeatedly and successfully guess short term price directions, and we do not attempt to do so. We look to long term directions and a total portofolio view. Our position regarding the cash component of one’s total portolio remains unchanged. It has been a highly successful strategy for the past 20 years and we believe it will remain so as we continue with this experiment that began in 1971 – this experiment of totally unbacked currencies.

 

Hilton Davies

10 October 2022

Download First Quarter 2022 Report