The Spring Winds Tighter on Gold

The Spring Winds Tighter on Gold  

What a difference a week makes. A few days ago, the stock market bulls were confidently expecting new all-time highs after one of the strongest rallies in recent years. Now the mood has changed as polls show that Britain may vote to leave the European Union on June 23. It was a pillar of conventional wisdom that Brexit could not happen...ordinary people would be too frightened of the uncertain consequences. Now it seems more than possible. And if Britain is willing to leave, who is next?

George Soros among others has said in the past few days that a vote for Brexit could have a major impact on the stock market and drive gold higher. Soros has noted that the markets have priced in a vote to remain. It is surprising that the swing in the polls has not already had more of an impact on gold. The issue to us seems to be one of countervailing forces. Gold has been struggling to correct an overbought condition as we have noted previously, and the correction to date has been short of what is typical historically.  Perhaps a short-term decline in gold is still possible but the larger picture could not be much more positive.

Financial assets and gold tend to trade inversely to each other; one is a risk asset while the other is not. For equities, Brexit could well be the straw that breaks the camel's back. The charge higher in stocks and high-yield credit since February 11 has been one of the fastest and broadest rallies in history and for stocks it stopped just short of new highs. Will this turn out to be a failing rally just before the bottom falls out...a repeat of 2008? This is not a period of rising economic growth and sound finance in which markets could be expected to shrug off Brexit and move on. The world economy is slowing down and debt levels are now much higher than they were in 2008. In our opinion, the risks are already high without a Brexit event.

If Britains vote for Brexit, what then? The most likely outcome is that central banks will do more of what isn't working...monetary stimulus. Brexit is a risk-off event that will reduce system liquidity, sending money to the sidelines. The central banks will try to reverse this flow, pushing money back into risk assets and trying to increase lending to generate more liquidity and economic growth. Listen to the central bankers. They are saying they can and will do more if necessary. They don't know anything else. We believe the fact that these policies to date have not generated growth will be used by the central bankers to argue that they have not been aggressive enough.

Therefore, expect more currency instability and market volatility, falling confidence and growing risk aversion until the central bankers finally lose control of the credit markets. For investors, the logical answer to these developments is gold.

Meanwhile, the stimulus measures implemented to date are already crushing the commercial banks by narrowing their margins. Ironically, the commercial banks are the most important transmission mechanism for monetary stimulus to enter the real economy.

As we have noted before, gold especially trades inversely to bank stocks. Once again, bank stocks are underperforming broader equities, as they tend to do when gold begins to strengthen. Note how the bank stocks (represented by the ETF KBW) underperformed the S&Ps at the beginning of this year when gold reversed higher: