Sprott Precious Metals Watch, April 2017 – Trey Reik

Trey Reik, Senior Portfolio Manager

At Sprott, our investment thesis for gold is significantly long-term in scope. We believe gold’s methodical advance since 2000 has had more to do with the growing disconnect between productive output (GDP) and ever-inflating claims on that output (debt and equity valuations), than with short-term fluctuations in variables such as CPI-type inflation or interest rates. Because we view gold as a highly productive, portfolio-diversifying asset until such time as these gaping imbalances are finally resolved (through default or debasement or both), we are generally loath to focus on short-term projections for gold markets. However, the current alignment of fundamental, technical and quantitative factors underpinning gold markets has become so asymmetrical to the upside, we have developed high confidence for an imminent and potentially significant rally in precious-metal valuations.
Post-election advances in market-sentiment measures are now clashing head-on with intransigent U.S. realities of excessive debt, dismal productivity, structural under-employment and chronic economic stratification. In short, the Trump-induced reflation trade is dying a quick death amid epic (mis)positioning. In this report we provide a short precis of our updated reasoning for an allocation to gold, followed by a visual tour of our “top-ten” list of technical and quantitative factors we see powering gold’s developing advance.
In our 2017 Investment Outlook, we made the case that excessive U.S. debt levels all but preclude significant Fed tightening. We suggested that, with total U.S. credit-market debt of $66 trillion atop U.S. GDP of only $18.8 trillion, any sustained increase in fed funds target rates would catalyze immediate upticks in a wide array of financial-stress measures, as well as surging default rates in sketchier components of the U.S. debt pyramid. To us, the greatest shortcoming of consensus economic analysis has been failure to recognize the cumulative and corrosive damage which eight years of ZIRP and QE have inflicted on the market dynamics of nearly every global industry. By artificially depressing interest rates for so long, global central banks have destroyed time preferences, inflated sales by borrowing from the future, and completely distorted legacy sales practices and consumer buying habits. The U.S. has evolved into a “zero-down, zero-percent” society, for everything from cars to leaf-blowers, to jewelry to big-screen TV’s. Manufacturing supply chains have expanded across the globe, enabled by the reduced cost-of-time in a ZIRP world. The day of reckoning for trillions-of-dollars-worth of uncompetitive U.S. businesses (and credits) has been postponed by the palliative of illusory (ZIRP) financial conditions. As the Fed attempts to migrate from the zero bound, these profound economic changes will not be reversed without significant pain and dislocation.

 

 

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No industry has been more disfigured by the Fed’s easy-money policies than the U.S. automobile industry. During the past eight years, cheap Fed credit has engrained zero-percent financing gimmicks at the very heart of U.S. automobile consumption. Contemporary auto-financing terms have evolved towards borderline ridiculous (record average principal balances, ever-lengthening loan periods, rising prevalence of negative-equity trade-ins). Lured by skinny “cost of money” calculations, lease penetration-rates roughly doubled in the five years through 2016. Even used-car pricing has remained remarkably buoyant amid such ample cheap credit.
Many will view as coincidence that key metrics in the U.S. auto industry have suddenly frayed amid the Fed’s December/March (FOMC) two-step. March U.S. vehicle sales slumped to 16.53 million SAAR (versus 17.3 million estimate), despite a 15% year-over-year increase in new-car incentives, to a record $3,768 per car, or 10.4% of average suggested retail (JD Powers). The all-important NADA used-car price index fell 3.8% in February, its sharpest decline since November 2008. Lease volumes have quickly reversed, coincident with accelerating rates of lease turn-ins, exacerbating the used-car pricing picture. Morgan Stanley (3/31/17) estimates the confluence of reinforcing factors now afoot in auto markets could lead to a 50% collapse in used-car pricing during the next five years.

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Figure 1: Cumulative % Net Losses by Subprime ABS Vintage (2006,7,8,15,16Q1,16Q2) [S&P, UBS]
As in the retail sector, the unfolding reversal of fortune in the auto industry cannot be blamed exclusively on the Fed’s recent tightening moves. However, eight years of ZIRP fostered huge imbalances between true economic demand and artificially inflated consumption which will now plague auto manufacturers, creditors and financiers for years to come. Once again, every FOMC rate hike will only exacerbate the downturn. Given the fact that 2016-vintage subprime auto ABS structures are already underperforming 2007/2008 vintage securitizations (Figure 1, above), we view probabilities for two additional Fed hikes this year (and three more in 2018) as significantly below consensus.
Despite downticks in commercial bank lending and tightening of commercial banking standards during Q1 2017, U.S. equity markets continued to set new all-time highs. Consensus attributes buoyant equity markets to post-election upticks in sentiment measures and strengthening “soft” economic statistics. A popular theory suggests hard economic data will soon follow suit. We disagree strongly with this analysis.
Importantly, we believe U.S. asset markets were given enormous support during the first quarter from an important source of liquidity which has garnered almost no attention in financial media.

As the Fed collects interest on the enormous portfolio of Treasuries and MBS securities on its balance sheet, this cash is actually passed on to the U.S. Treasury.  Logistically, the Fed credits interest payments (as they are received) to the Treasury’s “general account,” where they appear as a liability on the Fed’s weekly balance sheet (H.4.1).  In essence, the Treasury’s Fed balances serve as a giant piggy bank which can be drawn upon whenever Treasury has short-term liquidity needs (or faces a looming debt ceiling such as is currently the case).  As shown in Figure 2, below, the Treasury’s Fed balances have oscillated during the QE era, but have been in a sustained uptrend since late-2015.

For reasons that may never be entirely clear, the Treasury chose to draw down its Fed balances at a frenzied pace during the first quarter.  Between 10/26/16 and 3/15/17, the Treasury’s general account balance at the Fed declined from $429 billion to $38 billion.  Coupled with pro-rata earned-interest credits accruing to the Treasury’s account during the span ($150 billion annual run-rate), Treasury withdrawals from its Fed account totaled roughly $450 billion in little over a four-month period.  Unlike excess commercial bank reserves held at the Fed, Treasury balances are essentially a dormant deposit, so when they are drawn down they amount to a direct liquidity injection into the U.S. financial system.  As the Treasury drew down its Fed balances during the past four months, an amount of liquidity was injected into the commercial banking system equal to roughly 7% of GDP, or significantly greater than the rate of stimulus from QE3!  Andy Lees (MacroStrategy Partnership) informs us that there is simply no historical precedent for such a concentrated drawdown of Fed balances by Treasury, the next closest having been drawdown of an amount half as large over a period twice as long, just prior to the market dislocation of August 2015.  Over the next several months, we expect U.S. asset markets to feel a pronounced pinch from extinguishment of this unprecedented liquidity source.

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Figure 2: U.S. Treasury Deposits on Federal Reserve Balance Sheet (2005-3/15/17) [Federal Reserve, MacroStrategy Partnership]
In recent weeks, whether due to investor recalibration of Trump’s prospects in effecting lasting economic change, or simply due to growing recognition that even successfully implemented policies will take years to address legacy imbalances, market euphoria has clearly tempered. Simultaneously, we believe, cumulative effects of the Fed’s three rate hikes have set in motion a cycle of long-overdue debt rationalization. Complicating matters, the Atlanta Fed announced (4/14/17) that its GDPNow forecast for Q1 2017 has shrunk all the way to 0.5% (from 3.4% on 2/1/17), which would mark the weakest GDP growth during a quarter in which the Fed has hiked rates since Chairman Volcker did so in February 1980. Finally, as shown in Figure 3, on the following page, the U.S. Treasury reported 4/12/17 that trailing-twelve-month federal tax receipts posted in March their fourth straight month of year-over-year percentage declines (-1.3%), with corporate tax receipts (-16.7%) measuring their steepest collapse since September 2008. Perhaps tanking tax receipts shed a bit of light on the Treasury’s recent rundown of its Fed deposits!

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Figure 3: Trailing 12-mos. Percentage Change Total Federal Tax Receipts (1972-March 2017) [U.S. Treasury, Meridian Macro]
We expect the second quarter of 2017 to witness reversal of what we perceive to be unsustainable year-to-date trends in many asset, currency and interest-rate markets. By way of example, as shown in Figure 4, below, eroding expectations for GDP and S&P 500 earnings have yet to be reflected in valuations for the S&P 500 Index itself. Something has to give, and reigning equity valuations appear substantially vulnerable.

 

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Figure 4: S&P 500 Index, Consensus Estimates S&P 500 2017 EPS, Atlanta Fed Q1 2017 GDPNow (1/1/17-4/13/17) [Bloomberg, Atlanta Fed, Zero Hedge]
With respect to precious metals, we have rarely observed such a confluence of gold-supportive technical and quantitative variables across such a wide spectrum of relevant asset classes. While we are the first to admit no one can predict the future path of the gold price, we are intrigued by the degree to which these traditional valuation tools are aligning in gold’s favor. In the next section of this report, we present a largely visual review of the ten most compelling variables supporting our contention that gold prices are poised for a potentially significant advance. Given dominant institutional positioning and proximity to important support levels for each of these variables, the slope of the gold advance we envision may prove surprisingly steep.

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Trey Reik

Senior Portfolio Manager

Mr. Reik has dedicated the past fourteen years to comprehensive analysis of publicly traded gold-mining companies, developing significant perspective on their intrinsic values under a wide range of market conditions.  Additionally, Mr. Reik is a commentator on gold markets and monetary policy, including policies and actions of global central banks, global conditions for money and credit, and factors affecting supply/demand conditions for gold bullion.

Mr. Reik joined Sprott USA in March 2015 as lead portfolio manager of the Sprott Institutional Gold & Precious Metal Strategy.  The Sprott Institutional strategy is composed of separately managed accounts and involves transparent investment in publicly-traded equities with no lock-up provisions of any kind.  Sprott Institutional portfolios hold no illiquid or hard-to-value securities, no private placements and no derivatives or options of any sort.

For the six years prior to joining Sprott, Mr. Reik served as Managing Member of Bristol Investment Partners LLC, a registered investment advisor managing separate accounts composed exclusively of gold equities.  Mr. Reik served as Chief Investment Officer and Portfolio Manager to all Bristol customer accounts.  From January 2006 through November 2008, Mr. Reik served as Strategist to Apogee Gold Fund, LLC and Apogee International Gold Fund, Ltd.  Before joining Apogee, Mr. Reik was Founder and Portfolio Manager of Clapboard Hill Partners, L.P., a long/short equity partnership focused primarily on precious metal equities and financials.  Clapboard Hill Partners launched during February of 2002 and merged into Apogee Gold Fund during the first quarter of 2006.

Mr. Reik served as Senior Managing Director of Carret Securities, LLC (2000-2006) and held investment positions at Prudential Securities (1996-2000), Smith Barney, Inc. (1993-1996), William D. Witter, Inc. (1991-1993), Mitchell Hutchins Asset Management, Inc. (1984-1991), and Security Pacific National Bank (1982-1984).

Mr. Reik has 34 years of investment experience.  Mr. Reik graduated from Pomona College in 1982 with a B.A. in Economics.

 

Sprott U.S. Media, Inc. is a wholly owned subsidiary of Sprott Inc., which is a public company listed on the Toronto Stock Exchange and operates through its wholly-owned direct and indirect subsidiaries: Sprott Asset Management LP, an adviser registered with the Ontario Securities Commission; Sprott Private Wealth LP, an investment dealer and member of the Investment Industry Regulatory Organization of Canada; Sprott Global Resource Investments Ltd., a US full service broker-dealer and member FINRA/SIPC; Sprott Asset Management USA Inc., an SEC Registered Investment Advisor; and Resource Capital Investment Corp., also an SEC Registered Investment Advisor. We refer to the above entities collectively as “Sprott”.

The information contained herein does not constitute an offer or solicitation by anyone in any jurisdiction in which such an offer or solicitation is not authorized or to any person to whom it is unlawful to make such an offer or solicitation.

Forward-Looking Statement

This report contains forward-looking statements which reflect the current expectations of management regarding future growth, results of operations, performance and business prospects and opportunities. Wherever possible, words such as “may”, “would”, “could”, “will”, “anticipate”, “believe”, “plan”, “expect”, “intend”, “estimate”, and similar expressions have been used to identify these forward-looking statements. These statements reflect management’s current beliefs with respect to future events and are based on information currently available to management. Forward-looking statements involve significant known and unknown risks, uncertainties and assumptions. Many factors could cause actual results, performance or achievements to be materially different from any future results, performance or achievements that may be expressed or implied by such forward-looking statements. Should one or more of these risks or uncertainties materialize, or should assumptions underlying the forward-looking statements prove incorrect, actual results, performance or achievements could vary materially from those expressed or implied by the forward-looking statements contained in this document. These factors should be considered carefully and undue reliance should not be placed on these forward-looking statements. Although the forward-looking statements contained in this document are based upon what management currently believes to be reasonable assumptions, there is no assurance that actual results, performance or achievements will be consistent with these forward-looking statements. These forward-looking statements are made as of the date of this presentation and Sprott does not assume any obligation to update or revise.

Views expressed regarding a particular company, security, industry or market sector should not be considered an indication of trading intent of any fund or account managed by Sprott. Any reference to a particular company is for illustrative purposes only and should not to be considered as investment advice or a recommendation to buy or sell nor should it be considered as an indication of how the portfolio of any fund or account managed by Sprott will be invested.

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