A Very Interesting Set-Up
This week the S&P 500 closed at its lowest level since November 5th. The slide lower in the S&P has now given back all of the index’s post-election rally. Importantly, the S&P is also decisively breaking below its rising trading channel off the August 5th low, and simultaneously breaking several significant internal support trend lines. Furthermore, on Friday’s sell-off, the S&P 500’s advance/decline ratio demonstrated strong negative breadth with 87% of the stocks comprising the index closing the day lower for the fifth strongest downside day of the past seven months. In other words, with the dollar and Treasury yields continuing to rise, the selling in stocks is beginning to pick up.
As HAI noted last week, we enter 2025 with tightening financial conditions (dollar up, yields up), a trapped Fed, a potential illiquidity problem, a very fragile AI narrative, and a Buffet valuation indicator at record highs. Still, the stock market is priced for more than just perfection, and the bubble is now incredibly vulnerable—with no room for error. All told, the current circumstances offer a very interesting set-up for further downside in financial assets and major market indexes.
Meanwhile, gold has been in a mild correction since the presidential election, working off overbought conditions. But even as prices across the gold sector have backed off, the fundamentals underpinning both gold and gold stocks remain firmly bullish. Over two months into a cleansing correction, gold miners enter a very interesting set-up of their own ahead of Q4 reporting season in February.
For many producers, Q4 is likely to have seen the strongest quarterly production of 2024. That strong production came on an average quarterly gold price that ended $180 dollars higher than Q3. Furthermore, the Q4 gold-to-oil ratio (a good gauge for what on average amounts to between 15%-20% of all-in sustaining costs for producers) notched the third strongest quarter of the bull market dating back to 2015. Importantly, these stacked positive fundamentals for producers in the Q4 reporting season all come amid what’s been a significant correction in both sector sentiment and the price of most gold miners across the board. In HAI’s view, this potent mix of ingredients could foretell the makings of a delicious dish come February. An intriguing set-up for a reinvigorated rally in the gold producers could now be coming together nicely.
Now, in commodity related sectors, the real-time performance of the underlying commodity dictates all. If the price of physical gold moves further to the downside over the next several months, then all bets are off. But, if the price of gold stabilizes or resumes its rally and we do see blow-out earnings, Q4 reporting season could catalyze an impressive rally in the gold stocks.
This week, legendary natural resource investor Rick Rule highlighted the potential opportunity in the gold producer sector. According to Rule, the valuation disconnect between “the enterprise value of the best gold producers and the gold price is at historic lows. If the gold price continues to do what I think it will do, which is to say go up, the gold producers will enjoy a catch-up. So, investors need to be in the space.” He added, “I think relative to the gold price on an enterprise value to net asset value basis, which is the right way to view it, or on a price-to-earnings or price-to-EBIT [Earnings Before Interest and Taxes] basis, that the gold stocks relative to current prices are the cheapest I’ve ever seen.” He continued, pointing out that “investment quality gold stocks,” specifically, “are historically cheap.” Rick Rule’s conclusion? “If I’m right about the gold price, I’m really, really, really right about [buying] the senior producers.” HAI is in complete agreement and couldn’t say it better.
A final factor of particular intrigue to HAI ahead of Q4 reporting is the possibility that the all-important Western investor may now be a more receptive audience to any blowout earnings from gold miners relative to the recent past.
In HAI’s view, gold is best understood as the ultimate form of financial insurance, and nothing stokes Western investor interest in financial insurance more than concerns over the health and stability of the U.S. bond market and questions as to the solvency of the U.S. government.
We now have a whopping $36.2 trillion in government debt. In fiscal year 2024, the U.S. ran a $1.8 trillion deficit, an 8% increase from 2023. So far, in fiscal year 2025 starting in October, we are already running a $624.2 billion deficit. That’s up 64% from the $381 billion deficit for the same period last year. In other words, we have a massive debt and deficit problem, and things continue to spiral in the wrong direction.
Now, despite post-election enthusiasm that the DOGE will significantly cut government spending once the new administration takes the reins, the reality is far more complicated. The only government spending line items big enough to meaningfully shrink the deficit are entitlements, defense spending, and interest expense.
No one in the old administration, the new administration, or anyone else in Washington for that matter is even talking about talking about entitlement cuts. Until that changes, we can assume cuts to entitlement spending are DOA—full stop. As for cuts to defense spending, earlier this month Congress passed and the President signed into law the National Defense Authorization Act for fiscal year 2025. It authorizes an increase in defense spending to $895 billion from $886 billion last year. So if there are only three line items that matter, and entitlements aren’t in the discussion and defense spending is increasing, then the only hope for deficit reduction comes from Jay Powell’s monetary policy toolkit—specifically, rate cuts to lower the interest expense on the national debt.
Unfortunately, Jay Powell and the hoped-for rate cuts have two enormous problems. The first problem is that Powell would be cutting rates into what increasingly looks like bottoming inflation. Just this week, The ISM Services PMI “prices paid” component jumped from an already hot 58.2 up to a boiling 64.4. That’s a 22-month high in that all-important Services sector inflation gauge. Meanwhile, on Friday, University of Michigan’s 5-year/10-year inflation expectations measure spiked up to 3.3% from 3% to the highest level since 2008. If Powell and the Fed want to help the deficit, they will be cutting into still-elevated inflation that looks to be bottoming and potentially re-accelerating. In HAI’s view, that’s a likely recipe for a further re-acceleration of inflation, and ultimately a crisis of confidence with far ranging negative consequences.
The second problem now facing rate cuts is that, at least for the last couple of months, the Fed has lost control of the long end of the yield curve. Despite 100 basis points of Fed cuts already delivered, the yield on 10-year U.S. Treasurys has actually rallied over 100 basis-points since the Fed started cutting. In fact, 10-year U.S. Treasurys are down 5.9% (yields up) since the Fed began rate cuts in September. That’s the worst performance this far into an easing cycle since 1966.
The sell-off in Treasurys (rise in long-end yields) since the Fed started efforts to loosen policy appears to be the manifestation of a market beginning to recognize that the Fed is trapped—an expected eventuality long discussed in HAI. It now appears we have entered a new paradigm in which 10-year U.S. Treasury yields rise regardless of whether the Fed is tightening or loosening policy.
If the Fed tightens policy to fight inflation, the U.S. dollar will get too strong and trigger aggressive foreign selling of U.S. Treasurys in order to raise the U.S. dollars necessary to service $13 trillion in foreign-held U.S. dollar-denominated debt. Furthermore, the rise in yields will cause the “bond vigilantes” (a term describing bond traders who protest massive deficits by selling off bonds to push yields higher) to sell Treasurys as the increasing interest expenses will continue to blow-out the deficit and entrench debt-spiral dynamics in the U.S.
If, on the other hand, the Fed loosens policy into still-elevated inflation to ease the deficit through lowered interest expenses, Treasurys will sell-off (yields will rise) as inflation expectations rise. Furthermore, just as in the case of the Fed tightening described above, the rise in yields will cause the bond vigilantes to sell Treasurys as the increasing interest expenses will continue to blow out the deficit and entrench debt-spiral dynamics in the U.S. So, yes, Houston, it seems we have a problem.
If the Fed has lost control over the long end of the curve, that’s very bad news for both consumers and companies counting on lower rates. It’s also incredibly bad news for U.S. deficits and, by extension, the developing U.S. fiscal crisis.
Crucially, we are now getting evidence that the bond vigilantes are engaging in the dynamics of a trapped Fed described above. In HAI’s view, mega U.S. institutional bond buyer PIMCO fired a shot across the bow of the bond market in mid-December, and unofficially announced the return of the bond vigilantes. In a note to clients, the world’s largest active bond fund manager referenced bond vigilantes and said, “we are already making incremental adjustments in response to rising U.S. deficits. Specifically, we’re less inclined to lend to the U.S. government at the long end of the yield curve, favoring opportunities elsewhere.” PIMCO is as good a proxy for the Western investor as any. If PIMCO is now closely watching deficits and beginning to shun the long end of the yield curve, so, too, is the Western institutional investor—and that’s incredibly bullish for gold.
Furthermore, as previously stated, if the Western investor is now backing away from bonds and warming to gold, then gold miners that post impressive earnings in Q4 may be greeted by a much more receptive audience than many expect. As always, the gold price will determine the near-term fate of the sector, but if the gold price cooperates over the next month or so, Q4 reporting season for the miners could be a very interesting set-up.
Weekly performance: The S&P 500 was down 1.94%. Gold was up 2.27%, silver was up 4.15%, platinum was up 5.04%, and palladium was up 4.98%. The HUI gold miners index gained 3.10%. The IFRA iShares US Infrastructure ETF was off 2.79%. Energy commodities were volatile and higher on the week. WTI crude oil was up 3.53%, while natural gas surged 18.93%. The CRB Commodity Index was up 3.10%. Copper was up 5.66%. The Dow Jones US Specialty Real Estate Investment Trust Index was off 4.15%. The Vanguard Utilities ETF was down 2.00%. The dollar index was up 0.63% to close the week at 109.49. The yield on the 10-yr U.S. Treasury was up 17 bps to close at 4.77%.
Have a wonderful weekend!
Best Regards,
Morgan Lewis
Investment Strategist & Co-Portfolio Manager
MWM LLC
