Sprott Asset Management USA, Inc. January 2016

Sprott Asset Management USA, Inc.
January 2016
Strategy Report
December 2015 produced little movement in prominent asset classes. During the month, the S&P 500 Index
declined 1.75%, the DXY dollar index declined 1.54% and 10-year Treasury yields rose 6 basis points to 2.27%. In
this tepid environment, spot gold was virtually flat, declining three-tenths-of-one-percent to $1,061.42 per ounce.
While December’s small increments of change seem to imply stability in market fundamentals, we would suggest a
confluence of underlying developments has actually increased probabilities for elevated market volatility in early
2016, especially in the precious-metal complex.
After posting annual increases in U.S. dollar terms during twelve consecutive years through 2012, spot gold
(measured in dollars) has now declined three years in a row. As investors look forward to 2016, the relevance of
gold as a portfolio-diversifying asset faces legitimate debate. Do the declines of the past three years represent
logical correction of prior strength, or do they signal that gold’s bull market since 2000 has reached conclusion.
Has gold lost its investment utility, or do recent declines present a spectacular entry point? In this report, we
review three litmus tests in assessing gold’s ongoing portfolio relevance, and then present our “top ten” reasons
gold may be shaping up for a surprisingly strong performance in 2016.
1.) The most powerful litmus test for gold’s ongoing relevance is an honest assessment of whether the U.S.
financial system could endure normalization of interest rate structures. Should the Fed raise fed funds to
3%-to-4%, or should 10-year Treasury yields trade back to 6%-to-8%, without significant negative impact to the
U.S. financial system, we would concede constructive progress might have been achieved in rebalancing U.S.
financial markets. We would assess current probabilities for either of these developments to be somewhat remote.
In such an environment, gold remains an important portfolio-diversifying asset.
2.) We believe gold will remain a productive portfolio asset until a process of debt rationalization is allowed to
proceed in the United States. Since 2000, the Fed has now interceded to forestall this rebalancing process on three
prominent occasions. To us, normalization of the relationship between claims on future output and productive
output itself will eventually return ratios such as debt-to-GDP and HHNW-to-GDP to historically sustainable
levels, say below 200% and 350% respectively. Because prevailing GDP levels would imply (respectively) $20
trillion and $30 trillion in either debt defaults or depreciation of financial asset prices, we suspect the Fed will do
everything in its power to postpone this rebalancing. Given implications for declining intrinsic value of U.S.
financial assets, as well as ongoing Fed efforts to debase outstanding obligations, gold remains a mandatory
portfolio asset.
3.) Should the U.S. economy resume a GDP growth rate between 3%-to-4%, with a net national savings rate in the
8%-to-10% range (now roughly 1%), there would no longer be a need for the $2.0 trillion-or-so in annual U.S.
nonfinancial credit growth now necessary to service outstanding debt and drive consumption. As is now being
revealed in the oil patch and related industries, trillions-of-dollars-worth of economic decisions undertaken with
nonfinancial credit unbacked by savings, in an environment of ZIRP, are now being revealed as classic Austrian
malinvestment. We believe a default-wave of enormous proportions has already begun, precisely as GDP is
stalling under the weight of still burgeoning debt levels and prior nonproductive growth. Until the relationship of
healthy GDP and high net national savings is restored, gold remains a mandatory portfolio asset.
We would suggest litmus tests for gold’s portfolio relevance have never before registered such strong readings.
Given gold’s weak performance for now three years running, however, we recognize many investors perceive little
urgency for a gold allocation at this juncture. We present for consideration our “top ten” fundamental
developments which suggest the performance of gold is likely to be surprisingly strong during the coming year.
We believe a perfect storm is gathering in gold’s favor, and we expect explosive performance in the gold complex
during 2016. We will utilize this framework of fundamentals to assess gold’s progress during 2016 and look
forward to continuing the gold conversation with all Sprott clients.
1.) U.S. Dollar is a Crowded Trade
U.S. dollar sentiment among western investors has become close to unanimously bullish. The Bernstein Daily
Sentiment Index for the U.S. dollar registered a 90% bullish reading on 1/5/15. MacroMavens reminds us in
Figure 1, below, that combined net speculative longs for the euro, yen and pound have almost regained their
January 2015 all-time high. Somewhat counter-intuitively, examination of Fed tightening cycles since 1986 reveals
that, without exception, the date of first rate-hike marked an effective six-month peak in dollar strength. Figure 2,
below, demonstrates that average troughs for the trade-weighted dollar index during the six months following
“liftoff” measured 5% to 10% declines. We would suggest global trends including central bank F/X liquidation and
declining importance of the petrodollar float help to explain why the DXY dollar index has now stalled four times
since this past March in rallies toward par.
Figure 1: CFTC Combined Net Speculative Longs Euro, Yen and Pound (1999-Present) [CFTC, MacroMavens]
Figure 2: Performance of Trade-Weighted U.S. Dollar Following Initial Fed Rate Hikes since 1986
[Thomson Reuters, Credit Suisse]
2.) Foreign Demand for U.S. Treasuries is Declining
Foreign demand for Treasuries has collapsed in recent quarters, despite persistently wide spread-premiums to
competing global sovereigns. During the past twelve months, net foreign Treasury demand fell below zero for the
first time since 2001 (Figure 3, below). Perhaps more ominously, net transactions by foreign central banks during
the same span amounted to an outright sale of $203 billion (Figure 4, below), the worst 12-month sum in the
history of this series (initiated 1978). The PBOC reported 1/7/16 that Chinese F/X reserves fell by $107.92 billion
in December, the biggest monthly drop on record (despite increasing reported gold reserves by 19 tonnes during
the month). During 2015, China’s F/X reserves fell by $512.66 billion, the largest annual decline on record
(despite increasing reported gold reserves by 708 tonnes during the year). With global F/X reserves having doubled
to $12 trillion during seven years of Fed QE programs, we expect dollar-denominated reserve assets to endure
consistent pressure during the next few years as foreign central banks draw down F/X reserves in an effort to offset
reversing capital flows.
Figure 3: Net Foreign Treasury Purchases (12-month sums 1993-Present) [TIC, Meridian Macro]
Figure 4: Net Foreign Official Treasury Purchases (12-month sums 1993-Pres.) [TIC, Meridian Macro]
3.) U.S. Recessionary Warnings are Flashing
Growing numbers of economic indicators in the United States are beginning to flash red. The Cass Freight Index,
Association of American Railroads carload and intermodal statistics, and orders for trucks and rail cars have all
experienced sharp declines in recent months, traditionally reliable recessionary indicators. Recent readings for
industrial production, construction spending, factory orders, retail sales, housing starts and existing home sales have
disappointed consensus. On 1/15/16, the Atlanta Fed cut its GDPNow forecast for Q4 GDP to 0.6%. On the same
day, JP Morgan cuts its Q4 GDP forecast to 0.1%. As shown in Figure 5, below, the ISM Manufacturing Index has
declined to contractionary levels during the past two months, matching the lowest levels since June 2009. While
weakness in the ISM Manufacturing Index is frequently dismissed due to the limited direct contribution of
manufacturing to U.S. GDP calculations, we would point out that all ten of the past ten instances of a rapid PMI
decline in the context of flat U.S. equity markets correctly identified recessions, with zero false signals. As
MacroMavens points out in Figure 6, below, the largest inventory build of the past 50 years is just beginning to
unwind, and will burden GDP significantly in coming quarters. Even more ominous, rising revolving credit during
periods of decelerating retail sales has generally been a reliable recessionary indicator. As shown in Figure 7,
below, the slopes of the current divergence between revolving credit and retail sales are startling. And finally, even
credit-fueled car sales appear to have hit a wall this past week.
Figure 5: ISM Manufacturing Index (2002-Present) [Institute for Supply Management, Meridian Macro]
Figure 6: U.S. Inventory-to-Sales Ratio (12 mos.
Sums 1965-Present) [MacroMavens]
Figure 7: U.S. Revolving Credit Gr. vs. Retail Sales Gr.
(12-mos. sums 1993-Present) [MacroMavens]
4.) U.S. Credit Cycle is Turning
Valuations of high-yield debt and leveraged bank loans have been deteriorating since this past summer. At yearend, $482 billion worth of U.S. corporate bonds traded at distressed levels (yielding 10% or more). Contrary to
consensus views, rising credit stress is not contained within the energy sector, but is actually spreading across a
wide range of industries. As shown in Figure 8, below, the majority of economic sectors have experienced during
the past year a more than doubling of the percentage of bonds trading at distressed ratios. One of the byproducts
of Fed liquidity programs has been abnormally low corporate default rates. Credit Suisse suggests in Figure 9,
below, that the soaring percentage of North American companies operating in the red is likely to boost default rates
significantly in coming quarters. Prominent short-term liquidity measures are also flashing stress readings—junk
spreads, TED spreads and LIBOR-OIS spreads are all trading at four-year wides.
Figure 8: Percentage of U.S. High-Yield Bonds Trading in Distress (Option Adjusted Spread > 1,000 bps)
by Industry Group (Nov 2014 & Nov 2015) [Deutsche Bank, Thomson Reuters]
Figure 9: Percentage of N.A. Companies Losing Money vs. Moody’s LTM U.S. HY Default Rate
(1985-Present) [Credit Suisse, Bloomberg]
5.) U.S. Equity Markets are Richly Valued and Breadth is Thin
By many prominent measures, U.S. equity markets are historically overvalued. Figure 10, below, depicts the
current status of the venerable Buffett indicator—the ratio of U.S. corporate equities to GDP. After hitting a high
of 129.8% in 2015 (87% above the 65-year historical mean of 69.5%), the ratio has now dropped swiftly to 114.4%.
From such rarified heights, the two prior corrections since 2000 have returned this measure all the way to mean
levels. The S&P 500 CAPE ratio (cyclically adjusted price earnings ratio during the past 10 years) now sits at 25.5.
During the past 125 years (Figure 11, below), the CAPE ratio has only been higher on three occasions: 1929, 2000
and 2007. By the same token, breadth measures are registering strong warning signs. Amid these doubly strained
market conditions, U.S. equity averages posted during the first week in January their worst opening-week
performances in history!
Figure 10: Buffett Indicator—Ratio of U.S. Corp. Equities to GDP (1950-Present) [Advisor Perspectives]
Figure 11: S&P 500 Cyclically Adjusted P/E Ratio (1890-Present) [Bonner and Partners]
6.) Gold Complex Experiencing Bullish Divergences
Since the onset of gold’s bull market in 2001, the interplay between spot gold, gold equities and broad U.S. equity
averages has proved volatile. As demonstrated in Figure 12, below, the cumulative advance of the S&P 500
(dividends reinvested) totaled 107.56% during the past fifteen years, virtually identical to the 106.24% increase in
the GDM Gold Mining Index during the same span (dividends reinvested). Spot gold has out-performed both
equity indices handily, increasing 290.01%. Throughout the past decade-and-a-half, gold equites have generally
performed well during years in which spot gold has posted double-digit gains and the S&P 500 has stalled. At
seminal inflexion points along the way, gold equities have traditionally proved to be a harbinger for spot gold’s
future prospects. During the past three months, important technical indicators in the gold complex are signaling
perhaps the most important divergence of the past 15 years. Since late-November, spot gold has set three separate
closing 52-week lows unconfirmed by all broad gold equity averages (GDX, GDXJ, XAU, HUI), a development
which has not transpired since 2001. Should this emerging divergence hold, especially now that spot gold is
approaching the $1,100 per ounce level, a new leg of appreciation for gold equities may have begun. Prior cycles
have been explosive.
Figure 12: Annual Performance of Spot Gold, GDM Index & S&P 500 Index (2001-2015) [Bloomberg]
Figure 13: Price Performance of GLD versus GDX (trailing 12 months) [StockCharts, Lewis Capital]
7.) Physical Markets for Gold Establishing Durable Price Floor
During the past twelve months, offtake in the world’s leading physical markets for gold has been exceptionally
strong. The Shanghai Gold Exchange, which has eclipsed the London Bullion Market Association as the world’s
leading physical gold marketplace, reported 2015 physical withdrawals of 2,596.4 tonnes, a new annual record
which equates to 80% of 2015 global mine production. Figures 14 and 15, below, outline monthly and annual
physical offtake statics at the Shanghai Exchange. Roughly speaking, Shanghai withdrawals are composed of the
aggregate total of Chinese imports, scrap recovery and domestic production, representing the broadest
approximation of non-central bank Chinese offtake. Similarly, official Indian imports for 2015 are on course to
exceed 1,000 tonnes, an 11% increase over 2014 levels (not including smuggling totals estimated in the hundreds of
tonnes). Given prospects for extended volatility in both the yuan and rupee, we expect voracious domestic gold
demand in China and India to set a durable price floor in future periods.
Figure 14: Shanghai Gold Exchange Monthly Physical Withdrawals (2008-Present) [SGE, ShareLynx]
Figure 15: Shanghai Gold Exchange Annual Physical Withdrawals (2009-Present) [SGE, ShareLynx]
8.) Gold Price Should Reflect Bloated Fed Balance Sheet and Federal Debt Levels in 2016
Between 2009 and 2013, as shown in Figure 16, below, spot gold was closely correlated to growth in the Fed’s
balance sheet. Between 2000 and 2013, as shown in Figure 17, below, spot gold was closely correlated to growth
in U.S. Federal debt levels and limits. We have always regarded the gaping divergence since 2013 between these
two series and spot gold to be a great mystery. Nonetheless, we expect these traditional correlations to revert
toward longstanding ratios. Because we expect the Fed’s balance sheet and the U.S. federal debt limit to prove
“sticky downward” in future periods, prospects for reversion strongly favor higher gold prices.
Figure 16: Spot Gold versus Fed Balance Sheet (2009-Present) [Lewis Capital]
Figure 17: Spot Gold Price versus U.S. Federal Debt Limits and Levels (2000-Present) [Sharelynx]
9.) Gold is Diverging Positively from the Commodity Pack
During the second half of 2015, amid an accelerating slump in commodity indices, the relative performance of spot
gold separated from the commodity pack. To us, gold’s positive separation from commodity indices is usually
noteworthy for two reasons. First, positive separation signals that gold’s monetary characteristics are being
increasingly coveted by the marketplace. Second, given the commodity-intensive nature of the gold-mining
industry, gold’s positive separation from the commodity complex can signal that earnings prospects for gold miners
are set to improve. In Figure 18, below, we plot the ratio of spot gold versus the S&P Base Metals Index (as a
proxy for miners’ input costs). The commodity collapse during the second-half of 2008, in a year in which spot
gold posted a positive annual return of 5.78%, produced the sharp upward spike in the middle of this graph. Few
recall that this surge initiated a three-year period (2008-2011) during which reported annual earnings for the entire
XAU Index compounded at a 40.07% rate. While it is obviously too early to project where gold’s current
divergence from commodity averages will lead, it is interesting to note that gold’s traditional role as purchasingpower-protector remains intact. As shown in Figure 19, below, the ratio of spot gold to Bloomberg’s
comprehensive commodity index is breaking out to all-time highs. Relatively, an ounce of gold has never bought
so much!
Figure 18: Ratio of Spot Gold to S&P Base Metals Index (5/29/98-Present) [Bloomberg]
Figure 19: Ratio of Spot Gold to Bloomberg Commodity Index (5/29/98-Present) [Bloomberg]
10.) Extended CFTC Positioning Bodes Well for Short-term Gold Prices
Positioning of western commodity traders exerts short-term influence on commodity price-trends. In gold markets,
commercial participants (jewelry manufacturers and bullion banks) are traditionally positioned net short and
speculators (hedge funds and money managers) are traditionally positioned net long. Commercial participants in
gold markets generally exhibit a higher “threshold for pain” from short-term price movements because jewelry
manufacturers are hedging existing inventories and bullion banks represent central banks and gold mining
companies (with theoretically unlimited access to inventory). It is therefore significant that in recent weeks,
commercial participants have reduced their net short positions to the lowest levels in 14 years. Figure 20, below,
highlights weekly CFTC positioning in gold markets since 2014 (light purple specs, dark purple commercials).
Figure 21, below, depicts net commercial short positioning since 1999. Suffice it to say, when jewelry
manufacturers and agents for central banks perceive limited downside, gold prices are generally set to rally.
Figure 20: Current Positioning in Gold Futures (12/30/14-12/2915) [CFTC, Software North]
Figure 21: Weekly Net COMEX Gold Commercial Short Positioning (1999-Present) [CFTC, Lewis Capital]
This report is intended solely for the use of Sprott Institutional Gold & Precious Metals Strategy investors
and interested parties. Investments and commentary of the Sprott Institutional Gold & Precious Metals
Strategy are unique to this strategy and may not be reflective of investments and commentary in other
strategies managed by Sprott Asset Management USA, Inc., Sprott Asset Management LP, Sprott Inc., or any
other Sprott entity or affiliate. Opinions expressed in this report are those of the Portfolio Manager of the
Sprott Institutional Gold & Precious Metal Strategy and may vary widely from opinions of other Sprott
affiliated Portfolio Managers.
This information is for information purposes only and is not intended to be an offer or solicitation for the
sale of any financial product or service or a recommendation or determination that any investment strategy is
suitable for a specific investor. Investors should seek financial advice regarding the suitability of any
investment strategy based on the objectives of the investor, financial situation, investment horizon, and their
particular needs. This information is not intended to provide financial, tax, legal, accounting or other
professional advice since such advice always requires consideration of individual circumstances. The
investments discussed herein are not insured by the FDIC or any other governmental agency, are subject to
risks, including a possible loss of the principal amount invested.
Generally, natural resources investments are more volatile on a daily basis and have higher headline risk than
other sectors as they tend to be more sensitive to economic data, political and regulatory events as well as
underlying commodity prices. Natural resource investments are influenced by the price of underlying
commodities like oil, gas, metals, coal, etc.; several of which trade on various exchanges and have price
fluctuations based on short-term dynamics partly driven by demand/supply and also by investment flows.
Natural resource investments tend to react more sensitively to global events and economic data than other
sectors, whether it is a natural disaster like an earthquake, political upheaval in the Middle East or release of
employment data in the U.S. Past performance is no guarantee of future returns. Sprott Asset Management
USA Inc., affiliates, family, friends, employees, associates, and others may hold positions in the securities it
recommends to clients, and may sell the same at any time.
All figures in this report are expressed in U.S. dollars unless otherwise noted.