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Sell gold, buy base metals at the End of Fear

In case you missed it, 2012 is finishing as a dud year for gold. And according to RBS Morgans economist and analyst Michael Knox, 2013 is going to be worse as we enter the “World at the End of Fear”.

After this week’s dip, gold in Australian dollars is up just 2.17 per cent since January 1 – below the inflation rate. Over 52 weeks, gold is actually down 3.13 per cent. Even in US dollars it’s been poor – ahead only 0.67 per cent.

But that’s just taking a cheap (yet irresistible) shot at the gold bugs as such random calendar points as 12 months don’t mean much. Pick another set of dates and you can engineer another outcome. Much more important for all investors is the big forecast sent out to clients by Knox last Friday, before gold took at tumble to a four-month low and iron ore prices continued to firm.

Despite various on-going headlines, Knox argues that we’re entering the end of fear, that financial markets in 2013 will see their lowest volatility since 2006.

In brief, after two international banking crises in five years, we’re getting over the fear that there’s another one around the corner. With central banks pumping out liquidity, keeping interest rates down, lower volatility and less fear will mean investors will have less demand for “precautionary assets”, those  that are held out of fear, “just in case”: gold and US treasuries.

Knox says that on the RBS Morgans models, gold and US treasury bonds in 2012 were the most overvalued that they have been for more than 30 years. With a decline in fear, those assets will tend to be sold by investors to buy assets that will make a living for them in the long term – equities and industrial metals. Says Knox:

“The last five years have seen two international banking crises. What is remarkable about this is that prior to 2007, the world had not seen an international banking crisis for 70 years. The problem is that after two international banking crises in five years, we begin to think that the world is normally like this, looking over our shoulders and waiting for the next bank to crash. The truth is the world is not normally like this. Prior to the 1930’s, we had to go right back to the period before the Federal Reserve was born to find the previous banking crisis.”

Knox clearly thinks, as the markets are betting, that the US fiscal cliff won’t result in another banking crisis. With the enormous liquidity being provided by central banks, financial market volatility should return to something more normal in 2013.

“This lower volatility world will mean that as investors become used to living in a world of less risk, they will have less demand for precautionary assets… Investors bought them because they were scared. When investors live in the world of the end of fear, they will tend to sell these precautionary assets and instead buy assets which will allow investors to make a living in the long term.

“Our models tell us that these assets will include equities. They also tell us that instead of holding precious metals, investors will be better off holding base metals. These might be metals like copper and aluminium and nickel. These are all important industrial materials in a world which is behaving normally. This means the world is not behaving as if we are surrounded by banks which are about to crash.”

Parts of the world still have a way to run to emerge from fear – Knox doesn’t expect Europe to get there until 2014 – and the recovery of economic growth is by no means immediate, but the impact on asset classes doesn’t wait for that.

“The European banking panic of 2011 and 2012 generated a selloff in world commodity prices. The banks put their money in their socks. They did not want to lend it to people financing international trade. The result was a sharp fall in commodity prices beginning in 2011 and reaching its low in 2012. This whole process was merely repeating what had happened when the US banking crisis of 2008 generated an earlier selloff in commodities in 2009. After 2009, commodities rallied again.

“Just so, the commodities selloff seemed to reach its low in 2012 with the end of the European banking panic and commodities began to rally again in late 2012. The first commodity to obviously rebound was Brent oil. This appeared to reach its low in about May 2012. By the second half of 2012, Brent oil was again strong and getting stronger. We think that US domestic oil or West Texas Intermediate grade will follow the recovery path earlier set by Brent.

“The second half of 2012 has seen bottoming action in commodities such as copper, aluminium and nickel. Our models of these commodities suggest that these should turn into major rallies in 2013. Selling precious metals and buying base metals will be the great trade of 2013.”

Models are never guaranteed, but it is an interesting call that is not without logic. As for the impact on domestic equities:

“Australia saw a slowdown in earnings for the ASX200 in 2012. This reduces our model estimate of the ASX200 to 4750 points. Even at this level, there is still almost 200 points of upside in the closing days of 2012. Current estimates of earnings of 2012-13 suggest that the value of the ASX200 will rise to 5200 points in 2013 as these higher earnings are reported. This tells us that the Australian equities market should move up further as the US market recovers in 2013.

“Much of the decline in Australian earnings in 2012 was caused by a decline in commodity prices caused by the European banking panic. We have noted that this European banking panic is now a thing of the past. This means that commodity prices will recover in 2013. This in turn suggests that the recovery in Australian earnings will be at least as good if not better than currently believed.”

With Australians’ superannuation funds sitting on record amounts of cash and the yield on cash falling, it’s further grist for the equities mill. But there’s always an alternative view of a world still in fear, a view that you can generally rely on the nearly-always-bearish Gerard Minack to supply.

In a note to Morgan Stanley clients today, Minack seems to argue that 2013 won’t be good because 2012 was:

“One reason to expect lower returns in 2013 than in 2012 is that asset prices now are significantly higher than a year ago. The problem is most obvious in debt markets: Current low yields point to low nominal returns. Equities have also seen a big re-rating that likely will mute future returns. It may be that flows out of debt could push equity valuations higher. This is not our base case, but if 2013 equity returns match those in 2012, it will almost certainly be due to valuation expansion.”

Minack is writing primarily about the US market, but the point he makes at further length about debt markets, especially sovereign debt markets, fits with Michael Knox’s story on precautionary assets. And bear Minack does make a concession about his 2012 forecast, while turning into ammunition for his gloomy 2013 outlook:

“Absolute returns in 2012 will be better than we expected a year ago. These returns were driven by significant valuation expansion in most major asset classes. The result, however, is that current above-average valuations point to below-average returns ahead.”

Knox instead concentrates on a lift in US corporate earnings:

“By the end of 2012, the earnings of companies in the US S&P500 had first recovered to and then exceeded the previous historic peak of 2007. This growth in earnings had occurred for two reasons. The first was the enormous expansion in the earnings of energy companies associated with the US shale gas revolution. This is so remarkable that the US may again become energy self-sufficient. The second was the enormous expansion of earnings of technology companies. The US national accounts data showed that 2010 and 2011 saw the largest increase in investment in equipment and software that the US had seen since the tech boom period of the 1990s. Most of us have seen this in terms of the enormous growth in profits and sales seen by Apple Corporation.

“The combination of these earnings bring estimated earnings per share for the fourth quarter of 2012 to an estimated $US25.77. This brings 12 month rolling operating earnings per share for the fourth quarter of 2012 to $US99.81. Our model of the S&P500 tells us that at this level of earnings, the S&P500 is worth some 1650 points. This means that there is still more than 200 points of upside in the S&P500 in the closing days of 2012.”

Devoted bulls and bears will continue to believe what they choose to believe, but the argument has become considerably more encouraging – as long as you’re not a hard-core gold bug.

Michael Pascoe is a BusinessDay contributing editor who happily admits to being wrong about gold in seven of the past 30 years, albeit expensively so in the seven of the last eight. 

31 comments

  • As we enter our 21st year of uninterrupted economic growth, the naysayers and the 'our housing is a bubble, china is unsustainable, the euro will collapse, a govt deficit will ruin the middle class, p/e ratios are at historically high levels, the double dip recession is just around the corner, the global banking system is collapsing, the terms of trade are way off, we all hate apple fan boys, the collapse is just around the corner and way can't those fools see it brigade' - will point out that the collapse is just around the corner and why can't you fools see it in response to this article

    For the past 20 years each day I have said that our economy will continue to do Ok - I've been right 7300 times.

    Those who say the collapse is just around the corner have been right how many times?

    I prefer my batting average.

    Commenter
    egbert
    Date and time
    December 21, 2012, 12:24PM
    • Credit Suisse latest research note:

      "Underweight banks in anticipation of job cuts,payment shocks and declining house prices"

      "We are quite pessimistic about the prospect of house price inflation. Housing is 20%-40% overvalued by historical standards. Also, housing demand is extremely low, because potential buyers are very concerned about unaffordability and rising unemployment. If demand remains low relative to supply, house prices could fall substantially. Average home equity could fall disproportionately, making the re-financing of loans more difficult."

      http://www.scribd.com/doc/117494670/117438327-document-1005619251

      Hang on... 40% falls?? Isn't that what Steve Keen said?

      Oh dear.

      Oh and a collapse in house prices and wages is needed to kickstart the non resources sectors of the economy. As it is the high dollar and high house prices have turned Australia into a one trick pony with a limp.

      Commenter
      Allan
      Location
      Prahran
      Date and time
      December 21, 2012, 1:07PM
    • Maybe you have never heard that "past performance does not guarantee future results", or that the future cannot always be predicted by extrapolating the past.

      A once in a century tsunami will still wipe you out. You only have to be wrong once.

      The difference here is that the foundations for financial collapse are well established. Nothing has been fixed since the GFC. Debts have just been transferred from banks and corporations to taxpayers and sovereign nations.

      A true financial recovery (and yes it will eveantually come) can only occur once all of the debts have been written off and mal-investments corrected. Until then, the risks are too high.

      Commenter
      Greg
      Date and time
      December 21, 2012, 1:16PM
    • I am just happiny knowing I do not source my financial information from the same places that Pascoe does.

      Mainstream financial advice is so yesterday.

      With the BOJ, US FED, Swiss CB, BOE, ECB etc, etc now prepared to print money add infinitum in order to return to the 'Glory' days, the world's financial footing is getting shakier by the day. There are no choices left for a world economy saturated with too much debt except for rocks and hard places.

      Learn to think for yourself rather than listen to another Michael Pascoe ant-gold rant.

      Commenter
      In Gold
      Location
      We Trust
      Date and time
      December 21, 2012, 3:16PM
  • Astonishing ignorance from the "economists and analysts", or are they just trying to talk down the price of gold before they buy it?

    It's strange how the gold price gets manipulated lower when trading volumes are low, like in the Christmas - New Year period.

    But with central banks "central banks pumping out liquidity", and with banks taking their money out of their socks, the velocity of money is about to increase dramatically. This is the last prerequisite for hyperinflation, which will send gold prices soaring.

    Save this article, and read it again in 12 months, and use it as an example of why you cannot believe what you read in newspapers.

    Commenter
    Greg
    Date and time
    December 21, 2012, 12:35PM
    • How about you read all the articles at the end of 2011 that were predicting the end of the world in 2012. Or the articles at the end of 2008 that were predicting the end of the world in 2009?

      If you want an 'example' of what to believe, how about you look at history and see that, over the long-term, the bulls are always right!

      Commenter
      Luke16
      Date and time
      December 21, 2012, 1:11PM
    • Luke16, "the bulls are always right" is a meaningless statement. Bulls on which type of investment?

      Stock market bulls are usually misled by survivorship bias and the lack of inflation adjustments in long term stock charts.

      Maybe you need to read some article from 1929, which were predicting permanently high stock prices just before the last once-in-a-lifetime crash. Or maybe from 2000, when the internet bubble promoters were insisting that "this time it really is different".

      There is a time to be bullish and a time to be bearish. Perma-bulls and perma-bears are both wrong sooner or later.

      Commenter
      Greg
      Date and time
      December 21, 2012, 1:28PM
    • @Luke16. The market is about where it was at in 2005, and that's not even accounting for inflation - clearly any bulls since then have been dead wrong.

      Commenter
      Erik
      Date and time
      December 21, 2012, 1:38PM
    • Read this article again after Jan 1 because that's when Gold becomes a Tier 1 asset. It's currently a Tier 3 asset meaning it's value can be counted as collateral by 50%. As a Tier 1 asset it's value can be counted as collateral as 100%. That is a BIG DEAL!
      Next take into account that Central Banks are now net buyers of Gold.
      Then add the fact that China is now the world's biggest Gold producer AND it is one of the worlds biggest buyers of Gold. Also, is illegal to take your Gold overseas if yo are in China. That's a lot of Gold. As an asset it's only just coming back into vogue and around the world it's being considered as REAL money again...not like bits of paper with numbers printed on them that can be created on a printing press or created by central banks by simple keystrokes on a computer.

      Commenter
      GOOD AS GOLD
      Date and time
      December 21, 2012, 3:01PM
    • Greg, I admit that I have no idea whatsoever where we are headed in the next few years so I have a problem when you say inflation is going to the big issue. I don't see any signs of it. Which part of the globe is going to cause this outbreak of hyperinflation? American house prices are going to go through the roof? Energy costs in the US look like they will be in persistent decline. China perhaps, but their government seems to be on top of this. And no inflationary pressure in Europe. They will be stuggling for many years to come.

      Commenter
      Jezz
      Date and time
      December 21, 2012, 3:28PM

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