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Macro/FX/Equities Market Research

Updated: Jan 28, 2019

Authors: Phoenix Li Macro/FX/Multi-Asset Strategies Analyst, Justin Lam Equities Analyst, Chris Jin Co-VP Education/Research, Jason Sohal Co-VP Education/Research

Equities Market Update – Justin Lam


U.S. and Canadian equity markets finished lower this week, reversing the gains on the U.S. midterm elections. The theme of slowing global growth, seen in China, Europe, Japan, and emerging markets this year, is catching on in the United States. Investors had plenty of news to worry about, including the free fall of oil prices into a bear market and in the U.K. over the proposed Brexit deal.

Trade concerns seemed to be the primary issue moving the markets this week. News that the White House was circulating a draft of plans for new tariffs on imported vehicles and car parts triggered a sell-off on Monday. The domestic auto industry was already hit hard when President Trump previously enacted tariffs on aluminum and steel. Fears died down later in the week, after Trump reported that Chinese officials had sent him a list of 142 items in response to his demands for trade reforms. He remarked that the list was “pretty complete” and that the next round of tariffs may not be necessary. The Dow jumped over 220 points after his words were reported.

Big drops for big tech

Amazon and the “FANG” stocks – Facebook, Apple, Netflix, and Google – have led the market’s gains over the past few years. In the past few weeks however, these stocks have led the market’s decline. Investors have been looking to protect their gains by selling off these assets, as uncertainty increases over their continued high growth rates amid a slowing global growth. Despite the declines since October, Apple, Netflix, and Amazon still have positive double-digit returns YTD, making them particularly vulnerable to the “risk off” rotation. Apple shares fell sharply after news that one of its suppliers, Lumentum, had received a request from a major customer to “materially reduce shipments”. Lumentum did not mention Apple in its report, but Apple is known to be their largest customer, accounting for a third of revenue.

On Friday, Nvidia plummeted 19% in its worst day in over a decade. Nvidia’s Q3 results and Q4 outlook fell far below expectations, hurt by a weak gaming division and a loss of demand for cryptocurrency miners. Nvidia reported having trouble clearing its inventory of older gaming chips, after releasing a new generation of chips in Q3. During the cryptocurrency mining craze, customers bought gaming chips and pooled them together to mine cryptocurrencies. The passing of the fad has flooded the secondhand market with Nvidia’s last-generation chips, which is expected to reduce profitability only temporarily for the next few quarters.

XAU/USD Drivers and Outlook – Phoenix Li

XAU/USD. Let’s try to answer the question of why gold prices have slipped, even as the U.S.-China trade war negotiations deteriorate. Is the gold still a “safe haven”, which should perform better when there is uncertainty around Trump and U.S. – China Trade war?

Strong USD

Given how the instrument is designed, XAU has a negative correlation to the USD since the worldwide price of gold is measured in USD. When the USD is strong, 1 ounce of gold worth less in terms of USD. Historical data also proves that gold prices rarely soar when USD is in a period of appreciation. A more in depth analysis of the USD and gold prices can be found in an earlier article.

It is worth noting that as a Canadian investor, if you use CAD to invest in gold, either through ETFs or physical gold bullion, a drop in the XAU/USD doesn’t necessarily mean you lose money. More often than not, both CAD and gold depreciated against USD. If CAD/USD deprecates more than XAU/USD, then you effectively make money on your gold investment in terms of Canadian dollars.

Can the USD continue the strength that it’s been exhibiting? The answer is far from certain. But with the rest of the world winding down QE or starting its hiking cycle (namely EU and Japan), the rate differences will continue to narrow, which will help the Yen and Euro regain some value against the USD.

Increasing real interest rate?

Real interest rate = nominal interest rate – inflation rate

Holding gold bullion doesn’t yield anything as there is no interest payment from holding gold. As the real interest rate increases, the opportunity cost of holding gold increases as well. In turn, investors will prefer to hold interest paying fixed-income products rather than gold. The historical data also supports this relationship. Even though a -0.44 correlation is not perfect, it is enough to demonstrate the negative correlation between the two assets. More detailed data analysis can be found here.

Interestingly enough, the U.S. debt has a much higher correlation to the gold price, which is 87.7%. The logic behind this is that the more U.S. debt outstanding, the less the USD is worth, so the same amount of gold should be priced higher in USD terms. The correlation was almost perfect from 2000 to 2011. There is a divergence after that. My guess is that other strong forces, such as high valuations in the stock markets and the Fed starting their hiking cycle.

It is hard to say if the correlation between U.S. debt and gold will hold in the future. But we know the U.S. debt has no other direction but to keep growing. The possibility of convergence gives some reasons to believe gold is undervalued at the current price.

The trickiest part to analyze however, has to go back to the real interest rate argument. There was hope for inflation to pick up because of the trade tariffs. However, with the recent slide in oil prices, this seems unlikely. If the Fed continues to hike rates and equities continue to perform well (less money in fixed income markets -> bond price decrease and yields high), the real interest rate will increase, which could be an important headwind for gold prices.

Trade gold as safe haven or an alternative asset class?

Gold has always been seen as a safe haven asset. The most relevant and extreme case I can think of to support this argument is during wartime, property and businesses are easily destroyed, so people want to preserve their wealth in something with greater mobility and preservation of value. There is nothing better than gold to meet those two criteria. (Bitcoin actually has better mobility, so it is actively traded in the regions with chaos. But the preservation of the value part is hard to justify.) With less extreme cases, the narrative also holds true. Therefore, people generally think gold is a safe haven to go when there is uncertainty.

Let’s take a closer look at what happened at the beginning of the year. During peacetime, the safe haven property of gold shifts slightly, where investors consider gold as an alternative asset to the stock market. In order to make a positive return on gold in a risk-averse scenario, one has to expect the stock market to be highly volatile or to crash, ultimately changing the investors' risk appetite. This is hardly the case when U.S. economy is doing great with the lowest unemployment rate in history. However, not even the worst scenario of the trade war at the beginning of the year was not able to shake the booming economy. (In a quantitative approach, a Monte-Carlo simulation on all the potential scenarios of the trade war with a combination of U.S. economy would draw a possible outcomes distribution graph). A booming economy translates to higher corporate earnings, which ultimately translates to positive stock returns. There is little reason for investors to switch to the “alternative asset” gold when the economy and stock markets are doing great.

To summarize, from the “alternative asset” property of gold, the bad news has to be bad enough to shackle the fundamental drivers of the stock markets, and then to persuade investors to move money from stock markets to the yellow metal.

Though the U.S. economy has no sign of slowing down, the high overall market valuation puts a ceiling on an equity investor’s returns. As time goes, any bad news on the U.S. economy could be fuel for the gold price to recover.

The following chart is inflow and outflow of gold ETFs. After the selloff in the middle of the year, the demand for gold ETFs has recovered.

Supply and Demand

Lastly, let’s briefly talk about supply and demand as precious metals are some of the best real-world manifestations of supply and demand theory. The industrial use of gold is less than 10% of the total consumption. On the demand side, unlike the rest of metals, gold is less cyclical. China consumes 984 metric tons of gold per year and India consumes 849 metric tons of gold per year. In third place is the U.S., who only consumes 193 metric tons of gold a year. So the prosperity in Asia, especially China and India, definitely supports the gold price. The China economic slow-down is no doubt a headwind for gold prices. However, with the Indian economy booming, the long-term demand for gold should be stable.

On the supply side, a gold mine takes 10 years from building infrastructure to actual production. In the foreseeable future, the supply of gold is less of a concern.

In conclusion, holding some exposure of gold in the portfolio to against a potential market crash is never a bad idea.

The above information does not constitute the provision of investment, legal or tax advice. Any views expressed reflect the current views of the authors, which do not necessarily correspond to the opinions of University of Waterloo Finance Association (“UWFA”). Opinions expressed may change without notice. Opinions expressed may differ from views set out in other documents, including research, published by UWFA. The above information is provided for informational purposes only and without any obligation, whether contractual or otherwise. No warranty or representation is made as to the correctness, completeness and accuracy of the information given or the assessments made.