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Podcasts from Confluence Investment Management LLC, featuring the periodic Confluence of Ideas series, as well as two bi-weekly series: the Asset Allocation Bi-Weekly and the Bi-Weekly Geopolitical Report (new episodes posted on alternating Mondays).
Welcome to the Confluence Investment Management Bi-Weekly Asset Allocation Report for July 15, 2024. I'm Phil Adler. A traditional formula to predict gold prices no longer seems to work. Confluence Investment Management Advisory Director Bill O'Grady joins us today to discuss why investors should take notice. Bill, when did you begin suspecting the formula for gold prices that you relied on in the past was faulty?
Bill O'Grady:Well, for the past several months, the model's fair value estimate, what the output of the model indicates the price of gold should be, has been dramatically underestimating the current price. Now this happens with models. Such an outcome can be caused by any number of factors. One is that there is a temporary issue that's affecting the market. When that ends, a return to normal would be expected.
Bill O'Grady:Unusual weather events can trigger divergences in some price relationships, so can political and geopolitical events. At other times, the divergence is simply inexplicable. That situation may suggest a return to normal will eventually come and would signal to an investor that a market is temporarily over undervalued. Such conditions often indicate a market opportunity.
Phil Adler:So many times, things do even out in the long run. Now in this case, is there hope for the old formula, or or do we need an entirely new way of calculating future gold prices?
Bill O'Grady:Well, that comes down to correctly identifying why the discrepancy is occurring. If it's a factor that won't continue indefinitely, then, yes, things will even out. In fact, there's a term we use to describe this situation known as mean reversion. In the long run, markets tend to mean revert, meaning that fading extreme divergences is a reliable market position.
Phil Adler:Let's dive into this particular situation. Explain your process as you began trying to pinpoint the discrepancy between your model's estimates and the way gold prices actually performed?
Bill O'Grady:Well, the key point is to look around and say, what's different this time? Now there's an old saying in markets that the most dangerous words in the English language are, it's different this time. I've never been terribly comfortable with this comment. It all goes back to a philosophical argument between 2 Greek philosophers, Heraclitus and Plato. Heraclitus argued that the only constant is change.
Bill O'Grady:Thus, it's always somewhat different this time. Plato was horrified by Heraclitus' position because it suggested that all of our knowledge outside of logic is probabilistic. There are lots of unaware Neoplatonists out there in markets. There are some factors that are thought to have stood the test of time. Valuations can expand forever.
Bill O'Grady:Fear and greed are evident in most market moves. But where investors get into trouble is when they become convinced that nothing ever changes. Conditions do change. And when they do, it's important to recognize the change and the impact it will carry. And so what I did was ask the question, what's different?
Phil Adler:And what's your conclusion?
Bill O'Grady:What's different now is that the actions of the US in particular and the g 7 in general took in response to Russia's invasion of Ukraine with regards to the global reserve asset were aggressive and would tend to undermine confidence in that asset. Since Nixon removed the United States from the gold standard, the world has operated on a dollar treasury standard. Most foreign trade is denominated in dollars, and when nations hold more dollars because of running a trade surplus, they tend to hold US treasuries in reserve. What the g 7 did was raise fears among foreign reserve managers. If their nation ran afoul of US foreign policy goals, the US could render those treasuries nearly worthless.
Bill O'Grady:Essentially, a nation in this condition would have no reserve assets.
Phil Adler:Now, Bill, Confluence has consistently warned that US freezing of Russian foreign reserves constituted a a dramatic break from past practice and that countries across the globe would take notice. Has that worked out exactly the way you predicted?
Bill O'Grady:Mostly it has. Foreign trade with Russia and Iran, who also came under a similar sanctions regime earlier, has moved to either a form of barter or settlement in gold. For example, India, who shifted its oil purchases to Russia, paid for that oil in its own currency, the rupee. Russian reserve managers quickly found they were accepting payment in something akin to them at least, to confetti. Indian capital controls limited Russia's ability to invest the rupees back into Indian Thus, the rupees kept piling up.
Bill O'Grady:We could see at some point that Russia will Thus, the rupees kept piling up. We could see at some point that Russia will want India to pay in gold. In anticipation that this practice could expand, foreign central banks have been aggressively buying gold to create optionality.
Phil Adler:Is there any going back?
Bill O'Grady:Well, yes. But it would require some sort of binding agreement that the US would restrain its financial sanctions. Given how useful these sanctions are to American policymakers, it doesn't seem likely. And, of course, there is the issue of how the US would be bound. Superpowers have a history of agreeing to something and then violating that agreement if the restriction becomes onerous.
Bill O'Grady:The best example, of course, is Nixon's unilateral move to abandon gold.
Phil Adler:Bill, let's focus now on the role China plays in all this. Is there any way to prove, without actual data from China, that Chinese purchases of gold are a major reason gold prices are soaring, and why Shanghai gold prices have consistently surpassed the New York price.
Bill O'Grady:As we noted in the earlier question, we have seen that gold purchases have been rising among central banks. The World Gold Council has been monitoring this buying, but the data are made with rather long lags. So we need a variable we can monitor for real time information. Now we settled on the gold price difference between Shanghai and New York. For the past several months, the gold price in China has been well above that of New York, reflecting purchases of the People's Bank of China.
Bill O'Grady:This situation doesn't persist in history for good reason. It's creating an arbitrage opportunity. A gold holder in New York can sell to a Chinese buyer for a riskless profit. Still, it has persisted. And so if you observe the spread and compare it to the model's deviation, it fits rather well.
Phil Adler:Are there other factors that might explain gold's recent performance?
Bill O'Grady:Well, private buyers could be buying gold for other reasons that may only be obliquely tied to the financial sanctions issue. The most notable news is the advent of the gold vending machines at Costco. The company reports brisk sales of the metal from this venue. Now by itself, this isn't enough to move prices, but it may be signaling stronger retail interest. On the other hand, sales of gold coins have been normal.
Bill O'Grady:Coins tend to be a good reflection of retail interest. Now we've also heard numerous reports of Chinese capital flight. China restricts their citizens' ability to move funds overseas legally, forcing wealthy Chinese to use all sorts of methods to move money out of the country. Gold has often played a role, but actually being able to acquire data to measure this, as you'd expect, is nearly impossible.
Phil Adler:Do you foresee a situation where gold prices might rise sharply even from present elevated levels?
Bill O'Grady:I do. Currently, conditions that weigh on gold prices, high real interest rates, dollar strength, falling central bank balance sheets are all in place. This is why our model is diverging from the actual price. Now if these conditions were to change, if the Fed starts lowering interest rates, if real interest rates fall, if the central bank stop contracting your balance sheets, then the usual factors will be additive new sources of buying. And, of course, if the US expands its sanctions regime, especially against China, gold prices could move much higher.
Phil Adler:Bill, what's the impact of this on US treasuries? After all, if the Chinese are buying more gold, it stands to reason that there is less interest in US treasuries. Would you have to adjust the way you predict prices for treasuries as well?
Bill O'Grady:Well, on its face, it should reduce demand and lead to higher interest rates. At the same time, it's become evident that it's hard to improve the efficiency of the dollar treasury system. Russia's travails to try to trade outside that system show that there will always be some level of foreign demand for treasuries. It's also critical to remember that the interest rate on treasuries has a political element as well. The fed and the treasury can work together to prevent interest rates from rising above a certain level.
Bill O'Grady:In some respects, this feature is more important to modeling interest rates. How is Confluence Investment Management folding this new way of approaching gold prices into its investment model recommendations? Well, we are maintaining our gold allocation in the face of factors that would lead us usually to reduce or remove gold from the allocation. It can be difficult to make such allocations when you lack clear data to prove a change has occurred. However, as an investor, if you wait till all the data become clear, usually by that time, there's no longer an investment opportunity.
Bill O'Grady:All investing is probabilistic. It really comes down to this issue. When market prices diverge from what you think is normal, you have to determine if the current situation is rational or not. Sometimes you figure out the why, but still think this condition can't last. Then we get into Cain's famous observation that markets can stay irrational longer than you can stay solvent.
Bill O'Grady:But sometimes the world really does change, and that's where I believe we are now.
Phil Adler:Thank you, Bill. Our discussion today is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security. Our audio engineer is Dane Stoll.
Phil Adler:I'm Phil Adler.