Orlando's Outlook: All that glitters is not gold
Bottom Line In the aftermath of the failed “Grand Bargain” budget negotiations between President Obama and House Speaker Boehner nearly two years ago, stocks have recovered nicely, with the S&P 500 soaring by more than 50% from August 2011 through last month’s all-time record high. But investors have left commodities in the dust, as crude oil has drifted sideways over the past two years, while gold has plunged in a seeming free fall by nearly 40%. The reason for this, in our view, is that the normal fundamental drivers of higher commodity prices—rising inflation, weak currencies, strong economic growth and geopolitical risk—have all been largely absent. As we look across the proverbial valley, however, we’re growing increasingly concerned about developments in the Middle East, and specifically the troubling interrelationship among Iran, Syria, Hezbollah, Russia, Israel and the United States. To be sure, we are certainly not forecasting a regional nuclear holocaust. But we are becoming worried that changes at the margin in Middle East dynamics could amp up geopolitical-risk concerns among investors, and with it, the demand for gold and oil as possible haven hedges.
Commodity fundamentals in check:
- Inflation remains benign Core inflation on a year-over-year basis is running at well-behaved levels of 1.7% for both the wholesale Producer Price Index (PPI) and the retail Consumer Price Index (CPI) through May. The core Personal Consumption Expenditure (PCE) index, the Federal Reserve’s preferred measure of inflation, is running at a very benign 1.1% year-over-year through May, which is near the low end of the Fed’s 1.0% to 2.0% target range and well below its 2.5% inflation trigger to reverse its current Zero Interest-Rate Policy (ZIRP).
- Dollar strength Over the past two years, the U.S. dollar has strengthened by about 13% versus the euro (from 1.50 in May 2011 to 1.30 now), while the dollar has strengthened by about 30% versus the Japanese yen (from 75 in October2011 to 100 now).
- Weak global economic growth Since the U.S. exited the Great Recession four years ago, Gross Domestic Product (GDP) growth has approximated 2%, which is moderately below trend-line economic growth of 3% and well below the 4% to 5% GDP at which we should be performing at this point in the economic cycle. Globally, the European Union remains mired in recession, Japan is taking promising first steps toward exiting their two economic lost decades thanks to “Abenomics,” and investors fear an emerging-market hard landing in key economies such as China and Brazil.
Geopolitical risks growing in the Middle East
Upset in Iranian election The Obama Administration no doubt breathed a sigh of relief at the conclusion of the recent Iranian presidential election, as the moderate candidate, Hasan Rowhani, won a decisive victory over his much more conservative rivals. As head of the Iranian nuclear program from 2003 to 2005, Rowhani had (at the time) agreed to suspend Iran’s uranium enrichment program. While Rowhani served for more than two decades on Supreme Leader Ali Khamenei’s policy team, creating a strong influential relationship between the two, it is unclear whether Rowhani will be the difference maker under Khamenei, who retains power over Iranian national security and its nuclear program. Harsh economic sanctions—which include restrictions on financial transactions and crude oil exports—imposed by Western nations have punished Iran for its aggressive nuclear program, resulting in recession and high unemployment and inflation. Although Rowhani wishes to ease economic tensions between Iran and the West to reduce sanctions on Iran and improve its economic conditions, Iran’s nuclear program has strong domestic support. Rowhani takes office in August, and the U.S. will certainly attempt to engage Iran diplomatically in an effort to resolve this nuclear standoff.
Conflict in Syria After two years of waiting, during which time 100,000 Syrians were killed due to the ongoing civil war there, President Obama recently decided to aid the Sunni Muslim rebels, because the Basher al-Assad regime crossed the so-called red line of using chemical weapons against his own people. The U.S., Britain and France will implement a no-fly zone in Syria, which allows a layer of protection to carry out arms supply and rebel training operations. On the other side of this conflict, Russia, Lebanon’s Shiite militia Hezbollah and Iran are actively aligned with Assad.
Russian involvement During the recent Group of Eight (G8) meetings in Northern Ireland, Russian President Putin dismissed allegations by the U.S., U.K., and France that Assad had used chemical weapons, and declared that Russia’s supply of weapons to Syria is within international law. Russia also expanded its naval presence in the Mediterranean Sea.
Hezbollah militants Hezbollah, the Iranian-backed Lebanese militant group, is fighting with Assad’s forces against the rebel Sunni Muslims, providing critical resources and guerrilla fighters whose combat skills are superior to those of Syria's conventional forces. Hezbollah led the recapture of the strategic border town of Al-Qusayr, and they are now preparing for an offensive in the northern city of Aleppo, a strategic city in northern Syria located just 20 miles from the border of Turkey.
Israel’s security threatened Israel is our one true ally in the Middle East, and Israeli Prime Minister Benjamin Netanyahu has expressed legitimate concern over the prospect of a terrorist organization getting hold of Syria’s chemical weapons and of Iran launching a nuclear strike. These concerns may cause Israel to take pre-emptive military action against Iran at some point in time, if it feels that its sovereign security is threatened, which could ultimately draw both the U.S. and Russia into an ugly global conflict.
What might happen with commodity prices?
Crude oil prices stable West Texas Intermediate (WTI) prices have been relatively stable over the past year, trending between $80 and $95 per 42-gallon barrel of oil, largely due to tepid global economic growth. But over the past three months, as the escalating conflict in Syria has increased concern that oil supplies from the Middle East may be disrupted in upcoming months if the violence spreads, crude oil prices have risen by nearly 16%, from $86 to almost $99 per barrel. Although Syria is not a key global oil supplier, investors may worry that a broadening civil war could lead to spreading instability in oil-producing nations in the Middle East, which yield more than a third of the world's oil. U.S. oil production has been up 43% since 2008—chiefly driven by shale-oil production—and U.S. crude stockpiles remain near their highest level in more than 30 years. While oil prices are projected to increase marginally over time due to an improvement in underlying supply-and-demand fundamentals, an expansion of Middle East violence represents a potential supply risk for OPEC producers, which could at least temporarily spike crude oil prices to recent peaks—such as to the $110 level achieved last year, $115 in 2011 or $147 in 2008—which would have a deleterious impact on U.S. and global economic growth.
Gold prices plummeting Due to the aforementioned absence of underlying fundamental support at present—no inflation, a strong dollar and mediocre economic growth—gold prices have been in free fall, plunging by 39% from $1,920 per troy ounce in September 2011 to a three-year low of $1,179 today. That’s a stunning reversal from the gold bug’s heyday, in which investors enjoyed a compound annual growth rate of 21% over the 10-year period from $255 in February 2001 to $1,921 in September 2011. Where’s the bottom? Fundamentally speaking, we’re at the mercy of global fiscal and monetary policy and resultant changes in economic growth, which are, of course, uncertain. Technically speaking, a full 50% retracement of that huge decade-long run might find support at about $1,088, which is still about $90 and 8% below current levels. Even though it is not our forecast, if conventional or nuclear fighting should suddenly escalate in and around the Middle East, gold could quickly resume its status as a haven asset, a store of value, and a hedge against geopolitical risk.
Research support provided by Federated Investors intern Matthew Flanagan.