Our Gold Framework (April 2013)

7/28/2019 Our Gold Framework (April 2013)

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bienvillecapital.com

PORTFOLIO STRATEGY UPDATEAPRIL 2013

M. Cullen Thompson, CFAPresident & Chief Investment [email protected]

Our Framework for Gold

In evaluating gold, we consider the following:

1. The Fundamental Case Should we own gold? If so,how should we size it?

2. The Technical Backdrop How is gold currentlytrading? Where is the technical resistance and support?

3. Sentiment How does the market currently feel aboutgold? Who is buying and selling?

4. Portfolio Construction What is the risk of a majorinflation or currency crisis? Is gold trading in a correlatedor uncorrelated manner to the other assets in our portfolio?

In what environments does owning gold enhance portfoliodiversification? What does the symmetrythe upside vs.downsidelook like?

The Fundamental Case

Because of differing views on what gold representsan

investment or alternative currencythe fundamental case

for gold is intensely debated among investors. We view

gold as a currency, a role it has played for over 3,000

years. Only since 1971, a little over 40 years ago, when the

US dollar was delinked from gold, has it been featured

less prominently in the minds of investors.

Unlike a bond that pays interest, a business that generates

profits and cash flow, or a commodity with industrial use,

golds value is tied directly to policymakersthat is,

golds desirability is derived from its perception as a store

of value.

Market participants attempt to anticipate the future fiscal

and monetary environment. Large and rising fiscal

deficits introduce the prospect for rising inflation and

central bank monetization. This inflation of the

monetary base is an effective devaluation of the domestic

currency. In such a scenario, similar to the environment

that has existed since 2008, one could debate whether goldis actually rising or the currency is simply falling.

Regardless, burgeoning deficits and hyperactive central

banks have historically provided the fundamental

justification for owning gold. Gold, as we have said, tends

to be inversely correlated with the confidence in our

elected and unelected officials.

In periods of financial repression, similar to today,whereby interest rates are lowered to zero, owning gold is

less of an opportunity cost. It can also serve as a prudent

hedge to a portfolio of financial assets whose value can be

printed away in real or inflation-adjusted terms.

Historically, gold has performed well in environments of

negative real interest rates, a reality we have experienced

off and on since the turn of the century. In fact, from

January 2000 through December 2012, golds cumulative

return was 482.0%. This compares to the S&P 500s price

return of -3.0%.

However, since the price of gold peaked at $1,920 inSeptember 2011, it traded poorly through the end of the

first quarter of 2013. Reasons often cited were:

The unwinding of investments in a number of safehaven assets, including the Swiss franc and Japaneseyen following the ECBs stabilization of Europe

The expectation that real interest rates would rise asthe global economy seemingly improved, makinggold a less attractive investment

The expectation that the Federal Reserve would soontaper their asset purchases, exiting their quantitativeeasing program ahead of schedule

Although we were aware of these views, and therefore

understood why gold had been trading down, we

disagreed with all of them.

First, we believed Europe was only temporarily stabilized.

Economic data has since deteriorated, particularly in

France. We continue to view the Eurozone as highly

fragile. Although Mario Draghi is a highly capable central

banker, monetary policy is limited in solving Europes

underlying fundamental imbalances.

Second, as the global economy continues to delever,

deflationary pressures remain, and both money and credit

growththe transmission mechanism of monetary

policyremain weak, especially in Europe. We therefore

believe its unlikely central banks will allow interest rates

to rise anytime soon, which would weaken demand for

credit and possibly halt the nascent recovery in housing in

the US. Although its always possible that inflation


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expectations become unanchored, causing interest rates to

rise, such a scenario should prove positive for gold.

Nonetheless, our base case view is that financial

repression will remain with us for years to come. Loose

monetary policy is the countervailing force to

deleveragings deflationary pressures.

Finally, we also view an early exit from QE by the Fed as a

low probability. Although a number of Federal Reserve

officials have recently made public their desire to taper

asset purchases, our interpretation is that many of these

comments may be nothing more than a warning shot

targeted towards credit markets, where overheating is

once again evident in certain areas. Since 2009 the Fed has

been threatening an exit from their unconventional

policy.1 But since Chairman Bernanke first authored an

op-ed on the topic, the Federal Reserves balance sheet has

increased by $1.22 trillion, or 61%. As the old adage goes,watch what they do, not what they say.

What is not debatable, however, is that despite pervasive

fears of money-printing, both inflation and inflation

expectations have remained anchored in the US, as well as

in other advanced economies.

Therefore, with no fear of an imminent inflation, along

with improving economic growth and a rising US dollar,

the near term fundamental case for owning gold has

become less attractive. And although it may not be

evident from the negativity present in the news cycle, the

fiscal situation is also improving. Our estimate for the

current years budget deficit is around 4.0%, on par withnominal GDP growth. This would not only stabilize the

debt/GDP ratio, but it also represents a substantial

improvement over the past four years.

Although the risk of a future inflationary episode remains,

its unlikely to occur in the next few months. And with

1The Feds Exit Strategy; Ben Bernanke;http://online.wsj.com/article/SB10001424052970203946904574300050657897992.html

respect to gold, its the next few months we are concerned

about.

The Technical Backdrop

As seen in the following chart, gold has been trading

poorly of late. Its inability to rally on the back of several

key macro developments has been both surprising and

baffling.

$0

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$500

$750

$1,000

$1,250

$1,500

$1,750

$2,000

Aug-92 Aug-94 Aug-96 Aug-98 Aug-00 Aug-02 Aug-04 Aug-06 Aug-08 Aug-10 Aug-12

Gold

The key macroeconomic events that failed to catalyze gold

include:

Italy

The most recent Parliamentary election in February left

Italythe largest debtor nation in Europe and a core

member of the EMUwithout a working government.

Particularly concerning was the strong showing by the

populist 5 Star Movement, a party with many memberswho have publicly called for debt repudiation and exit

from the euro.

Cyprus

As part of the Cypriot bailout, initially both insured and

uninsured bank deposits were to be haircut (i.e.,

confiscated). However, the plan was ultimately revised

to only include uninsured deposits over 100,000. This is

part of a policy shift in Brussels to move away from

bailouts of debtor banks and governments and towards

bail-ins, where equity holders, creditors and even

depositors share losses in the Eurozone crisis. Such adecision increases the probability of capital flight across

Europe and a destabilization of the European financial

system.

Slovenia

Slovenia is likely to be the sixth Eurozone government to

request a bailout in order to cover the government's

deficits and resolve its insolvent banks, likely continuing

Source: Bloomberg

Source: IMF


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the trend of European bailouts to avoid sovereign

defaults.

Japan

On April 4th, the Bank of Japan, under their new

Governor, Haruhiko Kuroda, unveiled radical newmonetary policy measures, including his intention to

double the monetary base in Japan by the end of 2014.

These policies are explicitly intended to create inflation in

the Japanese economy. Such a large increase in liquidity

will have considerable effects across the global economy.

North Korea

North Koreas new leader, Kim Jong Un, has increased

his belligerence with all of his neighbors. This rhetoric,

along with a nuclear bomb test and specific timelines for

threats of force, has kept Asian investors on edge.

Any of these individual events would suggest a rally ingold. But collectively, one would anticipate a powerful

rally. That gold hardly moved was alarming, suggesting

either a shocking degree of complacency or a declining

desire to own gold as a safe haven. Regardless, it failed to

act as a store of value.

Sentiment

Sentiment over the past few months has been persistently

negative, which from a contrarian perspective is quite

positive. Periods of exuberance are often followed by

declines in gold, and times of pessimism frequently

precede strong rallies.

But whereas open futures contracts consistently swingfrom long to short, reflecting professional participants

who trade tactically, steady trends in retail flows have

recently collapsed.

We believed the recent outflows by the retail community

served as an important signal of investor disinterest in

currently owning gold. With equity markets rallying, it

seems gold became viewed as an opportunity cost.

0

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300,000

350,000

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450,000

500,000

Nov-04 Nov-06 Nov-08 Nov-10 Nov-12

(GLD) Gold ETF Shares Outstanding

Portfolio Construction

The absence of visible and rising inflation, combined with

the reduction of the federal budget deficit, the perception

of an improving global economy and the anticipation of a

normalization of the Feds current loose monetary policy,

has clearly reduced the desire to own gold. Even in the

presence of key events posing systemic risk, gold failed to

rally, indicating something was awry.

On Friday morning, gold broke key support levels at

around $1,550, at which point we cut our holdings

considerably. At the time we believed it could quickly fall

into the low $1,300sthe next level of supporttriggering

stop-loss targets of various institutional investors along

the way. At that level, we may consider re-entering some

positions.

Gold has had a phenomenal run, rising for 12 consecutive

years and contributing meaningfully to our portfolios (in

terms of both return contribution and diversification in

times of market stress). While it may be too early to call

for the end of the structural bull market, the price action

alone warrants a much smaller allocation. With long-term

structural themes where we believe a sizable opportunity

exists, it is never our intention to try to precisely time the

various tops and bottoms.

Bienville prides itself on constructing a diversified

portfolio of high-conviction themes and investments, andsizing them accordingly for our clients. Given the recent

price action and evolving economic environment, we no

longer have that conviction in gold. We intend to shift the

proceeds to opportunities where we believe the symmetry

is better (i.e., upside target vs. downside risk).

As always, please feel free to call us with any questions.

Source: Hulbert Gold Sentiment Index

Source: Bloomber


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Our Gold Framework (April 2013)

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