Fiscal Instability Rattles Markets

Market uncertainty has spread across financial markets. Investors are concerned about Congress' inability to raise the debt ceiling in a timely manner to avert the risk of default. Failure to meet U.S. debt obligations could dampen GDP growth, prompt sovereign credit-rating downgrades, and trigger a slowdown or reversal in global equity markets. Investors have flowed into cheap gold and gold-backed securities such as SPDRGold Shares ETF to protect their portfolios from near-term market risk. The Fed could delay stimulus tapering into next year if fiscal instability grows.

Slowing economic growth
The U.S Treasury Department warned Congress of economic consequences if they exhaust its borrowing authority. Congress needs to raise the $16.7 trillion debt limit no later than Oct. 17 to avoid bankruptcy for the first time.

A default would further deteriorate S&P 500 earnings, shareholder value, and growth. Analysts forecast Q3 corporate earnings to grow 4.5%, down from 9.84%, which analysts projected at the beginning of the year. Earnings growth fell because of rising commodity prices, disappointing second quarter GDP growth, and fiscal concerns clouding Washington.

The S&P 500 Index recorded net inflows of $6.5 billion during the third quarter, compared to net inflows of $9 billion in the same period last year.

Goldman Sachs estimates a fiscal pullback would cut 4.2% from annual GDP growth. "The effect on quarterly growth rates (rather than levels) could be even greater. If this were allowed to occur, it could lead to a rapid downturn in economic activity if not reversed very quickly," the bank said in a research note.

Such risk events fill global markets with panic, but Morgan Stanley believes the probability of default is zero percent. A default is less likely because the Federal Reserve can print money to cover accrued debt in any given period. With an increase in money supply, the value of the dollar erodes over the long-term -- strengthening gold as a traditional inflation hedge.

Source: Macrotrends.

This chart compares the U.S. dollar and gold using standard deviation. As the monetary base increases, the dollar depreciates and gold jumps in value. 

Buying gold at a bargain
Investors are pulling cash out from stocks into gold and gold-backed securities to protect their portfolios from volatile market fluctuations. Investors run to gold because precious metals hold intrinsic value and cannot undergo devaluations like the currency market.

Some investors flowed into gold-backed ETFs such as SPDR Gold Shares as a cost-efficient alternative to enter the gold market. Falling gold prices have negatively affected gold miners and gold-backed securities, but the pullback to $1,300/oz offered money managers a buying opportunity to gain exposure to gold.

With the Federal Reserve signaling a scaling back of economic stimulus, gold prices could bottom again and prompt further buying from money managers and central banks to protect their reserves. Gold miners have fallen to undervalued, attractive prices amid persistent weak gold prices. The gold sector presents an opportunity to purchase fundamentally sound companies at low valuations.

Large-caps are safer bets at uncertain times
The gold mining sector has struggled to handle falling gold prices and rising mining costs. Gold miners are operating in an inflationary environment where raw import prices for fuel, steel and rubber have substantially climbed over the past 10 years. High all-in sustaining costs, or AISC, which is the cost to produce an ounce of gold, have thinned company margins, profits, and cash flows.

The industry average to produce gold is $1,200/oz to $1,300/oz, which nears the current market price of gold. Junior Gold Miners ETF holds the highest risk if gold prices dip below $1,300/oz. Small miners, unlike large gold producers, do not have the resources or capabilities to generate positive free cash flows and profits in a weak gold environment. If AISC is high, margins will disappear and juniors will incur heavy losses. Some could potentially shut down or divest.

Source: Bloomberg. This chart depicts GDX outperforming GDXJ over the past year.  

Gold miners have initiated cost cutting and dividend payout programs to preserve cash and improve balance sheet liquidity. Market Vectors Gold Miners ETF is under less short-selling pressure because of its focus on large-cap senior gold producers. Large-caps have the flexibility to downsize and optimize their mining operations without reducing production output like junior miners. GDX has year-to-date net inflows of $2.26 billion, compared to GDXJ with net inflows of $231.4 million.

Bottom line 
The fight on Capitol Hill has increased the volatility and uncertainty in global equity markets. Investors have rushed to gold securities to protect their portfolios from the instability of the dollar. If the monetary base continues to grow, the value of the dollar could weaken and boost gold investment. Investors should invest in undervalued gold miners that can operate profitably in a low gold price and high cost environment. These undervalued companies are better prepared to rebound when gold prices recover because of their cost cutting initiatives.  

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