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Today was a remarkable day in more ways than just the ongoing triple-digit sigma rout in oil: today was perhaps the first day in years when Marko Kolanovic issued one of his traditionally super-bullish reports on a major market downtick, as opposed to its usual dissemination day: when the market was soaring.

So what did the JPM quant who now moonlights as JPM’s in-house virologist (just don’t tell MW Kim who actually is one) had to say to cheer up the bulls and lift the spirits of all those who followed to his July 2019 “once in a decade opportunity” trade reco to buy value stocks and sell low vol/defensive stocks which as shown below did not quite work out as expected?

Nothing really that exciting: just his latest iteration of buy stuff and watch it go up because the Fed’s got your back, which is not only boring at this point but if Marko keeps repeating that all that matters is the Fed’s backstop of stock prices, he will talk himself right out of a job because who needs strategists and quant experts in a centrally-planned world where stocks go up and down by decree?

For those who want to hear the same old story retold yet again, this is what Kolanovic had to say:

After the Fed introduced the first wave of monetary easing, we expressed our view that the S&P 500 will reach its previous highs in the second half of 2021. This was based on our analysis of the pandemic and market structure (flows, positioning, and liquidity).

… what he really meant is that this was based on his analysis of the tsunami of liquidity, which amounts to an annualized $23.4 trillion and which was unleashed by central banks as shown in the chart below…

… but back to Marko, who apparently thinks that somehow the Fed announcing it would buy IG and junk bonds wasn’t a clear message to investors.

Following the second wave of monetary measures, which included a backstop for certain credit assets, we shifted our forecast that the previous highs are likely to happen in the first half of 2021.

At this point, just like Goldman and Morgan Stanley, Kolanovic found himself scrambling to explain how stocks will soar in the next 8 months even with earnings expected to plunge by 30% or more. Here things get funny: unlike Morgan Stanley and Goldman which both rely on that “other” valuation methodology of the Equity Risk Premium – since neither can use forward PE multiples to justify their bullishness – Kolanovic decided to go full first year corp fin analysts and… DCF the entire market!

We will now model the valuation of the S&P 500 via a discounted earnings model. To arrive at a valuation, we look at the various scenarios for the earnings decline and recovery due to the pandemic, and then quantify the impact of the central bank reduction of interest rates and credit spreads – i.e., the earnings discounting rate.

We will show that for the S&P 500, the combined suppression of the risk free rate and credit spreads by the Fed likely has a bigger positive impact on equity valuation, compared with the negative impact of the temporary earnings loss. The reason is that by reducing the discounting rate, present value is increased by ‘adding more’ (i.e., discounting less) of future earnings relative to near-term earnings loss. This would not be true in a high interest rate environment or for companies with high credit spreads (as the ‘back end’ of earnings are already heavily discounted relative to nearterm earnings). It would also not be true in countries that cannot effectively reduce sovereign risk or credit spreads (e.g., non-reserve currency, or high external deficits). For this reason, we believe this model applies only to US, investment-grade companies.

Once again, Kolanovic has outdone himself: instead of using the ERP which at least has some credibility, the quant has decided to stake his entire credibility on a model that even first year ibanking associates mock at every opportunity for the simple reason that a DCF is nothing more than any attempt to demonstrate just how familiar one is with the goalseek function in excel. Undaunted by the glaringly obvious desire to desperately achieve a specific “valuation” outcome, the Croat continues:

Next we calculated the present value of earnings by using the applicable discounting rate after two waves of Fed monetary actions. Currently, the discounting rate has been suppressed by 100bps, which is a result of the combined reduction of risk free rates and reduction of credit spreads via credit asset purchases. This has reduced the discounting rate from ~225bps to ~125bps in our model. Given the massive suppression of the discounting rate, the present value of future earnings in all 3 earnings impact scenarios is above the pre-crisis level. This indicates that the S&P 500 should attain previous all-time highs if the monetary measures are sustained.

There is a whole lot more words in there, but the bottom line is that “the combined suppression of the risk free rate and credit spreads by the Fed likely has a bigger positive impact on equity valuation, compared with the negative impact of the temporary earnings loss. Given the massive suppression of the discounting rate, the present value of future earnings in all three earnings impact scenarios is above the pre-crisis level. This indicates that the S&P 500 should attain previous all-time highs if the monetary measures are sustained.”

And there you go: all you need to kickstart your valuations to pre-corona crisis levels when your cash flows crater to half their normal level (or less) is to use a discount rate that is drastically below normal levels, and – boom magic, you justify (i.e., goalseek) the value you were looking for all along… just like every “intro to corp fin” class will teach you. Marko even put in a (neatly color-coded for those confused) chart summarizing all the goalseeked scenarios:

But what happens if the crisis escalates and profits/cash flows plunge further, or turn outright negative? Fear not, as Marko will have a solution for that too – it’s called a negative discount rate.

And that’s how you cover every base.

Just three problems.

• First, stocks are now below where they closed 2017. In that period of almost two and a half years, Kolanovic has been bullish the entire time, and yet unlike his employer which has the biggest balance sheet of any bank in the US, the dramatic drawdowns that individual investors suffered during the Q4 2018 crash and then again in March, would have stopped out virtually anyone who listened to Kolanovic (especially on that whole value vs low vol disaster), who is always ready to point out how bullish he was in the past when stocks are rising, yet has never once told his clients to get out stocks, not before the Q4 2018 bear market and certainly not before the March crash which was more violent than the 2008 financial crisis and led to widespread liquidations across the board, especially among JPM clients. Oh yes, one will also never hear Marko discuss his “once in a decade” trade reco (see above) that left anyone who put it on devastated.
• Second, while we marvel at Marko’s perpetual bullishness, Wall Street strategists gain more respect by occasionally reversing their outlook – and ideally timing the market in the process – something Marko’s colleague at Morgan Stanley, has been far more successful at doing, and in fact just yesterday, Wilson turned bearish again after going long at the end of March, saying “stocks are now overbought” and warning that a “correction will begin soon.”  Maybe Wilson just needs to “DCF” the S&P with a lower discount rate and he will turn bullish again?
• Third, the shtick of pretending one is doing “analysis” when one is merely giving lip service to Powell and hoping the Fed will bail markets out again is getting tiresome, and not just for ideological reasons, or even “analyzing” oneself out of a job as there is no need for strategists in a centrally-planned market, but because as SocGen’s Andrew Lapthorne explained on Monday, “time and time again, investors have demonstrated their willingness to buy equities in the knowledge/hope that central banks, and the FED specifically, had their back.” Just like Marko. And yet, as Lapthorne warns “there is zero evidence historically that markets can go up on a sustained basis whilst profits continue to slump. Equity markets may have bounced but investors still seem to be positioning themselves for a drop.”

We realize that all of the above is moot: having been promoted from “mere” quant, if one of the most influential on the street, to a far more prominent, client-facing role one where it is his duty to inspire confidence a la Abby Joseph Cohen (and to have a buyer when JPM itself is selling) what Marko says now has far less practical significance for actual trading than what he used to say just 3 or 4 years ago, when his calls actually moved markets. Now it’s all part of just helping mold the bullish narrative.

No, if we wanted to know what will happen to the market, we would go to someone who not only has skin in the game but also decades of reputation at risk behind his every statement. Someone like billionaire investor and Elliott Management founder, Paul Singer, who in his latest letter to clients has a distinctly different view on what happens next than Kolanovic: in his latter, instead of begging the Fed to bail him out after foolishly having called for more upside, or DCFing non-existant cash flows (at a negative discount rate?), Singer instead approaches the biggest question of our generation from the perspective of a truly impartial outsider who warns that far from new all time highs in 2021, the real crash has yet to happen, to wit:

there is no way of telling whether the minus 36% stock market waterfall decline is “enough,” [ZH: what, not even if you DCS the stock market?] and whether the subsequent sharp rally signals “fini” to the crash (the decline was sharp enough, with several days comparable to the 1929 crash, to justify the “crash” label). Since the actual economic downturn is exceeding in depth and impact – and probably will exceed in length – the 2008 experience, our gut tells us that a 50% or deeper decline from the February top might be the ultimate path of global stock markets.

Demonstrating just why he manages over $30 billion, the next part in Singer’s letter explains precisely why he doesn’t bother with DCFs, or trying to convince someone he is correct, but merely with prudent risk management in a time when everything is falling apart:

… public policy has been marshalled with all its strength to do battle with a resumption of the market decline. Our job, and style, is not to pick tops and bottoms with precision (actually, not to pick them at all), but to have a portfolio that can make some money in normal times and keep it when the music stops for any reason, the timing of which is always a surprise even if you keep a sharp eye on the disc jockey.

And here is something else that makes for a brilliant investor: honesty.

… currently, despite the massive stimulus moves around the world and the unimaginably large new rounds of money printing, there is substantial uncertainty about the future viability of a large range of businesses. Which businesses will eventually emerge stronger than ever, which will come back more or less as they were, and which will require very substantial changes to their business model in order to maintain some profitability (or even to survive)? It is very difficult to make a careful and realistic assessment of the timing and shape of the restoration of the global economy, the future financial condition of the companies whose securities appear to be bargains and the possible further downside of those securities. We are currently in the process of sorting through it.

Nope. No DCFs here, or amateur epidemiological attempts to justify a 400 point S&P surge by “analyzing” that sunshine in the summer is bullish as it will kill the virus and so stocks will soar. Instead what we get is the kind of incisive criticism of the party responsible for everything that is wrong in modern capital markets, that we have grown to admire from Singer. We have included the must read conclusion from Singer’s letter below, although we urge readers to find the full thing and read it – it’s truly inspirational and will quickly answer the question posed by the title of this article.

Should it be a surprise that stocks go straight up and then crash straight down? Which part of “record prices, record valuations, record leverage, record derivatives trading and record complexity” should investors be excused from understanding? Any outright long investor who is not waking up in the middle of the night sweating and worrying whether there will be a next leg of the bear market (despite the desperate and gigantic policy moves) is either Cool Hand Luke or oblivious.

We are not in the business of calling market turns. Why did most managers, economists, strategists and policymakers miss it? Certainly as the virus was getting underway, advisors should have been incorporating it into their thinking. Certainly as the global economy started shutting down, advisors should not have been upgrading their recession probability forecasts “from 20% to 25%” and modestly downgrading their Chinese growth forecasts “from 6.1% to 5.6%.” Maybe investors DIDN’T miss it. Maybe they actually thought that no matter what happens, the authorities want stocks to go up, and that is all you need to know.

The central bankers, particularly at the Fed, should be ashamed of themselves for fostering that belief, and for allowing the policy mix to be so skewed toward free and (overly) plentiful money. The solution is now pouring unlimited money into the boiling cauldron. MMT has come along just in time to justify everything. Not in productive ways, not in the building of useful infrastructure, not doing a better job of educating our workforce so we can grow like crazy, but just to save the screwed-up system that we have, just to hold things together. Helicopter money has made the job of active investing harder, and the suppression of interest rates by central bankers lowers the forward rates of return for everyone. You might say, “But it has enhanced the to-date rate of return.” We would retort, “That is true, but despite the artificially enhanced to-date rates of return in bonds and stocks, net debt has skyrocketed, pension plans are universally underfunded and developed world infrastructure is oriented toward political pet projects and is inadequate to support needed economic growth going forward.”

Authored by Michael Snyder via TheMostImportantNews.com,

This economic downturn is turning out to be far deeper and far more severe than most experts were originally anticipating.  More than 22 million Americans have filed claims for unemployment benefits, and economists are telling us that the U.S. economy is contracting at the fastest rate that we have seen since the Second World War. 

We are already starting to see some high profile companies move toward bankruptcy, but the real story is what is happening to thousands upon thousands of small and mid-size businesses because of the lockdowns.  Many of them were barely surviving even before this pandemic, and now these lockdowns have delivered a death blow.

The restaurant industry is a perfect example.  Prior to the pandemic, there were more than a million restaurants in the United States, and about half of them were independent.  Those independent restaurants employed approximately 11 million workers, and now the vast majority of those workers have been laid off.

Once the lockdowns are over, it would be wonderful if all of those independent restaurants would spring back to life, but the results of a recent survey suggest that simply is not going to happen.  In fact, that survey found that 28 percent of all independent restaurants are probably not going to survive if the lockdowns last for another month…

A survey released Thursday by the James Beard Association found independent restaurants laid off 91% of their hourly employees and nearly 70% of salaried employees as of April 13 – double-digit increases in both categories since March. The poll of 1,400 small and independent restaurants found 38% of have closed temporarily or permanently, and 77% have seen their sales drop in half or worse.

Perhaps most troubling: 28% of restaurants said they don’t believe they can survive another month of closure, and only 1 out of 5 are certain they can sustain their businesses until normal operations can resume.

28 percent of 500,000 is 140,000, and so if these lockdowns are not lifted soon we could be facing a scenario is which tens of thousands of independent restaurants are lost forever.

Of course a lot of restaurants that do reopen will face a really tough struggle because fear of the coronavirus is going to keep customers away for the foreseeable future.  So even if all of the lockdowns were lifted tomorrow, the restaurant industry would still not fully recover.

Sadly, the same could be said for the fitness industry.  In fact, we just learned that one of the biggest fitness chains in the nation is getting ready to file for bankruptcy…

Gym chain 24 Hour Fitness is working with advisors at investment bank Lazard and law firm Weil, Gotshal & Manges to weigh options including a bankruptcy that could come as soon as the next few months, people familiar with the matter tell CNBC.

The chain is grappling with a heavy debt load, deteriorating performance and a coronavirus pandemic that forced it to shut its more than 400 clubs.

Yes, a certain segment of the population is quite eager to resume all of their normal pre-pandemic activities, but even a 20 or 30 percent drop off in revenue will be fatal for many gyms.

And the truth is that a lot of people are simply not going to be in the mood to share exercise equipment with others for a long time to come.

The entertainment, tourism and retail industries have also been hit extremely hard by this pandemic.  The other day I was quite stunned when I learned that Neiman Marcus “is reportedly ready to file bankruptcy”…

Neiman Marcus Group, one of the largest retailers in the United States, is reportedly ready to file bankruptcy amid the COVD-19 pandemic after defaulting millions in bond payments last week and furloughing 14,000 employees.

Neiman Marcus would become the first major US department store to crumble amidst the economic set backs from the coronavirus outbreak.

No, things are definitely not going to be returning to “normal” in America, and there will be a lot more big corporate names among the victims in the days to come.

At this point, even some of the most prominent corporations in the entire country are “indefinitely” sidelining their workers…

Indefinite furloughs began this weekend for more than 100,000 Disney, Best Buy and CarMax workers as businesses make cuts to survive the coronavirus pandemic and subsequent mandatory closures.

But most Americans are not in any position to handle “indefinite furloughs”.

In fact, one survey discovered that a whopping 50 percent of all Americans will run through their savings “by the end of April”…

One of the largest concerns on most homeowners minds right now is how they are going to pay bills — specifically their monthly mortgage payments. 50% of Americans reported their savings will run out by the end of April. Prior to the COVID-19 outbreak, 30% of homeowners had less than $1,000 in an emergency fund, with 22% reporting they didn’t have enough in savings to cover their mortgage payment for one month.

Just like during the last recession, countless numbers of Americans will go from living a comfortable middle class lifestyle to being desperately needy in just a matter of weeks.

I have been writing a lot about the absolutely massive lines that we have been seeing at food banks all over the nation, and we just witnessed another example in Miami.  In one of the wealthiest areas of the entire city, vehicles were lined up for a mile as people waited patiently to receive handouts from a local food bank…

Talk about a Norman Rockwell painting idea come to life — a parade of cars filled with hungry people in Miami … smack dab in the middle of two of the city’s ritziest hotels.

Check out this surreal scene down in Miami Beach, where a MILE-long line of cars were arranged in a giant U-curve in between the W Hotel and Setai Hotel — two of MB’s most high-end go-to spots for celebrity out-of-towners … like Kim K, Justin Bieber and more.

You can see photos from that event right here, and if you look closely you will see that some of those vehicles are quite nice.

As I have warned so many times over the years, if you don’t have any sort of a financial cushion you can “suddenly” find yourself in a whole lot of trouble when disaster finally strikes.

Unfortunately, we have now entered a time when there will be one crisis after another, and every new crisis will significantly escalate our woes.

For a very long time, there have been very loud warnings that our debt-fueled economic bubble would burst, and now it has happened.

The road ahead is going to be filled with immense pain, and most Americans are not going to be able to handle it.

Months ago, as the novel coronavirus was still barrelling across China during the early days of the outbreak, we reported on rumors about an outbreak inside North Korea. The regime has gone to great lengths to suppress any and all information about how quickly the virus is spreading within NK’s borders. Only a handful of stories – including a horrifying rumor about the country executing a quarantine violator with an anti-aircraft gun – based on little more than rumor managed to trickle out.

At the time, we joked that we probably wouldn’t hear much more out of North Korea unless KJU managed to catch the virus. Of course, in this time when truth is stranger than fiction (who ever thought producers would effectively be paying buyers to take delivery of West Texas crude) the notion that this joke has now become a reality is hardly a surprise. So, when we saw the headlines last night about KJU potentially being on his death bed, we were inclined to take them seriously.

When South Korea’s Yonhap reported that it had seen no evidence to support the story, we suspected this wouldn’t be the end of it. Crucially, Yonhap didn’t deny the claims, it merely reported that South Korean Intelligence had nothing to back them up. One would think if there truly was something seriously wrong with Kim, that his neighbors to the South would be among the first to know.

Whatever the reason for Yonhap’s denial, we received more clarity from President Trump last night: During a Q&A with reporters, the president said he “doesn’t know” whether Kim is ill, but nevertheless, wished him luck in dealing with any ailment.

“We don’t know,” Trump said at the briefing. “I can only say this, I wish him well,” adding that he and the Communist Dictator had gotten along well while working together. However, Trump added that he “wouldn’t place much credence” in the report.

Still, as US Intelligence ponders the question ‘where in the world is KJU’, the Nikkei Asian Review has offered a quick guide to a subject that is rarely discussed in the west: the North Korean line of succession.

The Kim family dynasty is known as the “Mt. Paektu bloodline.” Here’s more from NAR:

The Kim family asserts the legitimacy of its rule by citing family lineage – the Mount Paektu bloodline – that goes back to Kim Il Sung, the country’s founding father. Since then, the country’s leadership has been passed down to his son Kim Jong Il and later his grandson Kim Jong Un.

The Kim family asserts the legitimacy of its rule by citing family lineage – the Mount Paektu bloodline – that goes back to Kim Il Sung, the country’s founding father. Since then, the country’s leadership has been passed down to his son Kim Jong Il and later his grandson Kim Jong Un.

Given the importance of this family lineage, Kim Jong Un’s sister, Kim Yo Jong, could be handed over power in the event of an emergency. Kim Yo Jong, 31, vice director of the Propaganda and Agitation Department of the Workers’ Party of Korea, was reinstated as an alternate Politburo member of the party on April 11, solidifying her position as the de facto No. 2.

Kim also has an older brother, Kim Jong Chul, who was passed over for the leadership. The father, Kim Jong Il, considered Kim Jong Chul “girlish” and not fit to lead the country, the family’s former Japanese sushi chef Kenji Fujimoto wrote in an autobiography. 

CNN reported Monday that Kim was in critical condition, eliciting a flood of ‘fake news’ accusations to pile on top of CNN’s coverage of Chris Cuomo emerging from quarantine ‘for the first time in weeks’. Yonhap cited a senior SK official saying Kim was likely recovering from a heart procedure in a remote village after visiting a hospital used only by the Kim family. But others, including intelligence officials from the Japanese government, have pushed back on this, saying nobody knows what’s going on, and the situation is being closely monitored, with another SK official relaying reports that Pyongyang was put on lockdown on Friday, for a reason that wasn’t immediately made clear.

Kim is thought to be staying in a provincial region together with close aides, Yonhap News reported, citing a senior South Korean official.

Meanwhile, Yoon Sang-hyun, chairman of the South Korean National Assembly’s foreign affairs committee, told reporters that North Korea’s secret police completely locked down Pyongyang several days ago. He said there are signs of an abnormal situation involving Kim Jong Un.

“I know about the reports,” said Japanese Chief Cabinet Secretary Yoshihide Suga of the news about Kim’s health. “We will gather and analyze information while working closely with the U.S. and others.”

This isn’t the first KJU death rumor, as Nikkei reports.

Since Kim Jong Un became supreme leader in 2012, he has gained weight, and there has been frequent speculation about his poor health. In September 2014, reports of his activities were suspended and rumors that he was brain dead emerged. South Korea’s National Intelligence Service eventually said a cyst was surgically removed from his left ankle.

Kim’s last activity to be reported by North Korean media was his attendance of meeting of the Politburo of the Worker’s Party on April 11. On April 15, Kim Il Sung’s birthday, rumors about Kim Jong Un’s ill health became rampant after there was no report of him attending a ceremony at Kumsusan Palace of the Sun in Pyongyang, where his grandfather’s body lies in state. Kim Jong Un had not missed the ceremony there before.

Daily NK, a South Korean online news outlet focused on the North, reported Monday that Kim received a cardiovascular procedure on April 12 at a special hospital exclusively used by the Kim family located north of Pyongyang. Kim is recovering, with his medical team returning to the capital, Daily NK reported.

“No unusual signs have been identified inside North Korea,” South Korean presidential spokesman Kang Min-seok said Tuesday. “There is nothing we can confirm with regard to Chairman Kim’s alleged health problem.”

So, is KJU still alive? Probably, but nobody outside NK can say for sure.

Back in April 2011, just before gold exploded to a record above $1,900 following the US credit rating downgrade, we first said – and Kyle Bass echoed – that the main reason behind our long-running, bullish view on gold is that the Fed can’t print gold , unlike every other asset.

Today, with a 9 year delay, Bank of America has caught up with where we were at the start of the decade, and repeating virtually everything we have said – consistently each day for over 11 years – says that while “the size of major central bank balance sheets has been stable at 21 to 28% of GDP in the past decade just like the gold price” things are changing rapidly and “as central banks & governments double their balance sheets & fiscal deficits we up our 18m gold target from $2000 to $3000/oz.” And while it’s not all smooth sailing, with the bank warning that “a strong USD backdrop, falling equity market volatility, and weak jewelry demand in India & China may remain headwinds”, it is now clear that even Wall Street’s agenda is aligned with that of all those who have been calling that the biggest beneficiary of central bank lunacy will be the “barbarous relic”, one which according to the most clueless person of the 21st century only had value because it was “tradition.” And yet here we are, when one of the biggest US banks just said that gold is the “ultimate store of value.“

Who to believe: a pathological liar (i.e., a central banker) or someone who finally sees the light?

Incidentally, the name of the BofA report was “The Fed can’t print gold”, which was a delightful flashback to what we said some nine years ago.

Here are the key highlights from the report:

Gold prices have performed well in the recent period

As the ultimate store of value, gold prices have performed well during the past 15 months, posting a rally of over 10% since the Federal Reserve did a monetary policy U-turn in January 2019. Gold has also delivered a strong performance against other asset classes YTD. Of course, it has not been a straight line up, and gold did sell off hard for a brief period in March. The swing in gold prices mirrored the down and then up move in real interest rates. Now our CTA models suggest gold positioning is light, likely because of the spike in volatility and the mechanical drop in the gold Sharpe ratio. But this constraint could change as volatility keeps falling quickly across financial markets.

Now, significant monetary, fiscal easing around the world…

Due to the Covid-19 lockdowns, US GDP could go down by 30% YoY in 2Q20, the steepest drop in modern history. Other countries like Japan will likely experience a 21.8% decline in output in 2Q20, while China just reported a contraction of 6.8% in 1Q20. As central banks rush to expand their balance sheets and backstop asset values and consumer prices, a lot of risks could end up being socialized. The size of major central bank balance sheets has been stable at around 25% of GDP for the last decade or so, just like the gold price. As economic output contracts sharply, fiscal outlays surge, and central bank balance sheets double, fiat currencies could come under pressure. And investors will aim for gold. Hence, we mark-to-market our forecasts and now project an average gold price of $1,695/oz in 2020 and $2,063/oz in 2021.

…lifts our 18m gold target from $2000/oz to $3000/oz

True, a strong USD backdrop, reduced financial market volatility, and lower jewelry demand in India and China could remain headwinds for gold. But beyond traditional gold supply and demand fundamentals, financial repression is back on an extraordinary scale. Rates in the US and most G-10 economies will likely be at or below zero for a very long period of time as central banks attempt to push inflation back above their targets. Beyond real rates, variables such as nominal GDP, central bank balance sheets, or official gold reserves will remain the key determinants of gold prices, in our view. As central banks and governments double their balance sheets and fiscal deficits respectively, we have also decided to up our 18m gold target from $2,000 to $3,000/oz.

And with that let’s dig deeper into “The Fed can’t print gold” and why BofA thinks that gold will have a 3-handle in 18 months time:

Gold prices have performed well during the recent period…

As the ultimate store of value, gold prices have performed well during the past 15 months, posting a rally of 12% since the Federal Reserve did a monetary policy U-turn in January 2019 (Chart 1). More recently, gold prices have continued to post a robust run, with returns broadly outpacing other major asset classes year-to-date (Chart 2). Only long duration bonds and high quality tech stocks have delivered comparable performance, with 30 year Treasury yields posting 16.9% and the S&P Tech Sector delivering flat returns YTD.

…except over a brief window where liquidation occurred

Of course, it has not been a straight line up for the yellow metal. In fact, gold prices sold off very hard with close to 5 million futures trading volume during the March 9th to March 19th window (Chart 3) on the back of a major liquidity crunch. The move was not unique to the gold market, with fixed income assets also experiencing a big spike in volatility around that time (Chart 4). The pre-March 19 peak to trough decline for gold was 12% compared to an 8% drop in the US Treasury Inflation Protected Securities (TIPS) ETF or a 22% decline in investment grade ETF values such as LQD.

The sell-off in gold prices mirrored the move in real rates

It is worth noting too that the drop in gold prices mirrored the move in real interest rates during the past two months (Chart 5). As investors feared the extension of the China lockdown to the US and the rest of the world economy, asset values and consumer price expectations collapsed faster than nominal interest rates, triggering fears of an economic depression. Having learned the lessons of the Global Financial Crisis (GFC), the Federal Reserve raced to expand its balance sheet to increase fixed income liquidity and reflate US asset values, ultimately supporting a sharp recovery in gold prices (Chart 6).

Gold is a function on real rates, USD, commodities and risk…

As explained above, the selloff and subsequent recovery in gold prices during March was somewhat mechanical in nature. As the ultimate store of value, gold is a reflection of market movements across all major financial and physical assets. In the past we have argued that gold volatility is a function of real interest rates, USD, commodities and risk (Chart 7). Swings in these four variables alone can help explain up to 80% of variation in weekly gold price changes (Chart 8), providing an important template to understand the direction of future gold prices.

…and gold volatility tends to follow moves in other markets

Another factor to think about in precious metals is volatility. Specifically, gold volatility increased with market turbulence, but it has broadly lagged the spike in other asset classes like equities or oil (Chart 9). On our estimates, gold volatility more or less tracked G10 currency vol in the past two months, particularly mirroring perceived safe haven currencies like JPY and CHF. Unlike other commodity markets, the term structure of gold volatility is more aligned with that of paper assets (Chart 10). In contrast to oil or natural gas, gold is not constrained by storage dynamics and its price is not necessarily mean-reverting to the marginal cost of production over the long run.

Covid-19 has also triggered physical market dislocations…

Still, the physical settlement of paper contracts means that gold has unique features compared to other perceived safe havens. In normal times, when the CME delivery mechanism functions smoothly, differences between gold futures and the physical gold market are usually quite small. Yet the margin between futures and physical prices has blown out as of late (Chart 11). In part, there have been concerns over disruptions of shipments to the US over recent travel restrictions, as the London market typically provides liquidity to New York. While futures contracts are relatively rarely held to expiry, Chart 12 shows that inventory levels in CME warehouses are well below open interest.

…leading to the launch of a new CME gold futures contract

Also, the CME contract trades in 100koz, while a London Good Delivery Bar is 400koz. This matters because around one-third of global refining capacity has been shuttered over Covid-19, which made the conversion of bars into shapes suitable for delivery into the CME challenging.  Tackling these issues, CME has since launched new futures, which also accept 400oz bars. This should ultimately help alleviate liquidity concerns, although it may take some time for open interest to switch to the new contract. Beyond that, and perhaps more importantly, the Swiss refineries have been resuming operations again, while insurers now also accept charter flights to ship gold to New York, rather than just commercial connections. Not surprisingly, the differential between futures and physical gold has been narrowing.

Gold interacts with all financial markets in different ways

Beyond the volatility, physical and price change drivers discussed above, gold interacts with various financial markets in different ways. For instance, we recently noted that the correlation between gold and equities has recently turned positive (Chart 13). The positive equity/gold correlations are a possible sign that equity markets may not have fully bottomed (Chart 14) and that the gold market has further room to run, in our view. The trigger here could be an extension of lockdown restrictions over the next few weeks.

Despite the rally, gold positioning has been surprisingly weak

Another reason to be particularly constructive on gold is that our CTA gold positioning signal suggests that momentum players are only slightly long gold (Chart 15). Having peaked at 56% of their maximum length in the month of January, our models suggest that momentum players are currently holding 5.7% of their maximum allocations, well below the historical 99th percentile in history of 48%. While gold momentum is in full force following a brief collapse mid-March (Chart 16), our CTA model has only slowly crept into a long position due to the prevailing high volatility regime, a feature that is also likely prevalent in the broader class of vol targeting funds.

Fundamentally, EM gold demand should continue to be soft…

Also, jewelry demand usually declines when prices rally (Chart 21), as buyers in emerging markets like India often purchase on a budget. With jewelry often referencing spot market prices, this means that fewer ounces can be bought as gold rallies. Indeed, gold imports from India have been quite low (Chart 22), although this has also been influenced by low foot traffic in stores due to the recent lockdown over Covid-19.

…as purchasing power in India and China is suffering

Similarly, sales of jewelry in China, the second largest physical market, have been subdued for a while, as Chart 23 suggests, on persistent headwinds to growth which have been exacerbated by the health emergency in the first quarter. Meanwhile, the scrap market correlates positively with gold quotations, with owners of old metal often incentivized to monetize the gold as prices increase (Chart 24). Of course, the dynamic in the jewelry and scrap markets highlight the importance of investors: as the yellow metal rallies, non-commercial market participants need to pick up more ounces just to keep further price upside intact.

…although we expect central banks to buy some gold bars

So physical demand in traditional gold markets like jewelry looks soft and could be a drag on precious metals prices. However, central banks across major emerging markets have been avid buyers of gold for their reserve portfolio (Chart 25). As central banks in developed markets have expanded their balance sheets to support domestic asset and consumer prices (Chart 26), some EM central banks have become more proactive buyers of precious metals. In particular, Russia, China and India have opted to increase gold holdings in the past 5 years to diversify away from G-10 sovereign bond positions.

Gold may take comfort on rising inflation expectations…

We have previously argued that inflation expectations embedded in US TIPS collapsed and then rose again as the Fed acted to backstop fixed income asset values (Chart 29) and consumer prices. Now, with the Fed committing to do whatever it takes to prevent widespread bankruptcies across the US, Congress injecting a $2tn fiscal stimulus plan, and economic growth on standstill until there is a cure or a vaccine, inflation could rise even if GDP does not. This backdrop should prove very positive for gold, in our view. Similarly, the sharp increase in the ECB balance sheet in recent years, coupled with the likely massive expansion ahead, should provide strong support to gold (Chart 30).

…driven by massive monetary easing plans around the world…

One of the most intriguing developments ahead is that US GDP could drop by 30% YoY in 2Q20, the steepest collapse ever in modern history. Other countries like Japan will likely experience a 21.8% decline in output, while China just reported a contraction of 6.8% in 1Q20. As central banks rush to expand their balance sheets and backstop the economy, a lot of risks could effectively be socialized, boosting the appeal of gold. In aggregate, major central bank balance sheets have been stable at around 25% of GDP for the last decade or so (Chart 31). But clearly Covid-19 has started a race to increase balance sheets and save domestic asset values (Chart 32).

…and also by unprecedented fiscal deficits and government borrowing

Another important point to remember is that, just as central banks are socializing risk in financial markets, governments are increasing their spending like never before during peacetime. Fiscal spending plans across developed economies are nothing short of breathtaking whether we look at them in dollar terms (Chart 34) or as a percentage of each nation’s GDP (Chart 33). Of course, emerging economies do not have the domestic savings base to attempt such an extraordinary feat, but their central banks may opt to reduce DM sovereign bonds in favor of gold.

Cross-asset portfolios should increase exposure to gold…

Our Dynamically Diversified Momentum portfolio allocation tool uses a combination of clustering and Sharpe ratio momentum indicators to either add or reduce exposure to a broad range of asset classes (Chart 35). This allocation technique is representative of what some systematic cross-asset portfolios would use. In DDM, gold has generally been classified in the haven cluster, but has recently switched to the equity cluster and our tool has held a long gold position since mid-March. Also, traditional equal risk contribution portfolios, whether balanced or fixed income geared, should keep adding exposure to the yellow metal over the coming months to increase efficiency (Chart 36).

…and on our estimates investors are still underweight gold

Investment demand has correlated strongly with gold prices in recent years, and we expect precisely this group of buyers to drive gold prices higher (Chart 37). In other words, different levels of non-commercial demand are required to sustain different average price levels. Indeed, for gold to average $2,000/oz next year, purchases need to rise by 73% YoY (Chart 38). Given the current macro-economic backdrop, we believe this figure is likely to be exceeded.

We increase our average gold price forecasts from 2020 on…

We have been long-term gold bulls, maintaining our constructive forecast even through the recent volatility. That said, gold has now hit our average 4Q20 price forecast at $1,700/oz, Hence, we are marking-to-market expectations, while at the same time anticipating further upside, largely because central banks underwrite fiscal stimulus and financial markets through money printing, with fundamentals justifying a rally to $2,250/oz in 2021. Still, strong USD backdrop, reduced market volatility, and lower jewelry demand will likely remain headwinds to gold.

…and we also up our 18m gold target from $2000/oz to $3000/oz

Beyond the supply/demand fundamentals, financial repression is back at an extraordinary scale. Rates in the US and most G-10 economies will likely end up at or below zero for a very long period of time, just as central banks attempt to push inflation back above their targets. Beyond flow variables such as real rates, the USD or market risk, variables such as nominal GDP, central bank balance sheets, or official gold reserves will remain key determinants of gold prices. If central banks double their balance sheet as GDP contracts, gold prices will push higher (Chart 39). Thus, we increase our 18m gold target from $2,000 to $3,000/oz. When will gold start to catch steam? Our work shows that Google trends (Chart 40) could be an early real-time indicator that broader interest is picking up.