The Gold Bull Powers Ahead

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There’s a fair bit happening on the domestic front this week.

The Reserve Bank meets tomorrow to decide on interest rates. On the same day, the government will announce its pre-election budget.

But, as far as the market is concerned, none of this is really important. The Reserve Bank will keep rates on hold, making their meeting a non-event. And there won’t be much in the budget to move the market, so thankfully I can ignore much of this politically nauseating period of the year, focussing instead on what really matters for Australia: China.

I’ve focussed on China a lot lately. That’s because it’s in the midst of another epic credit expansion…one that will have momentous effects on Australia over the next few years.

But the Australian financial media turns a blind eye to the disturbing reality of China’s desperate monetary moves. Instead, it paints a picture of China being in control of its economy, successfully transitioning to a new, more sustainable growth model.

While China is in control, it’s only just managing to keep it together. The transitioning bit went out the window at the beginning of the year. That’s because the pressures on the yuan, and the resultant global market volatility, were too much for the Communists. To relieve the pressure, they decided to open the credit spigots again.

That gave global stock markets some respite. But there is a fair bit of concern that this latest effort by China’s central planners is a step too far. Last week, I wrote about the pressures emerging in China’s corporate bond market. That’s unusual (or should be) for a country in the midst of a credit boom.

But it’s not. Defaults continue to rise, according to a report from DailyFX:

The increasing default rate in corporate bonds has lifted companies’ costs of borrowing of recent [sic]. As of April 27th, Chinese firms have delayed or cancelled at least 103 bonds with a total value of 100.9 billion yuan, approximately 3.4 times the amount from 2015.

Credit risks have been rising and extended from private-owned companies to state-owned enterprises. As of today, 11 Chinese entities have defaulted on 22 bonds, and this likely isn’t the end of that theme. For instance, the probability of Xining Special Steel, a major steel producer, defaulting over the next 12 months is 5.7%.

This is even higher than the 5.61% probability of Dongbei Special Steel, which has already defaulted.

Let’s ignore the fact that a company with a 5.61% default probability actually defaulted! The real issue is the rising cost of debt, which goes against the backdrop of easy credit conditions.

The problem is that the credit surge has been very inefficient. It takes a lot of debt to produce not much economic growth. On the weekend, you saw more evidence of this lack of impetus (from the Financial Times):

Growth in China’s factory activity eased in March, an official survey showed on Sunday, reinforcing signs of a tepid economic recovery but raising questions about the efficacy of recent stimulus measures.

The government’s Purchasing Mangers’ Index for the manufacturing sector was 50.1 in April, still above the 50-point level that separates contraction from expansion, but down from 50.2 in March. Economists had forecast the index at 50.4, according to a Reuters poll. The services PMI also eased to 53.5 from 53.8 in March.

Now, to be fair, I’m not sure how much China’s factory activity correlates to its domestic economy. Although the services sector slowed too, which is a better measure of domestic activity. The factory slowdown probably says as much about tepid global growth as it does about the unsustainability of China’s recovery.

Which might be the reason behind gold’s rise to a 15-month high in Friday’s trading session in the US. It closed the session at US$1,294.25 an ounce, the highest close since January 2015.

The chart below shows the gold price over the past few years. The recent move to new highs is a bullish move. I think it’s only a matter of time before gold takes out the high from January 2015, which is US$1,306.


Source: Market Analyst

[click to open in new window]

If I’m right, the bottom is in for gold. I said as much to subscribers of Crisis and Opportunity last month. It’s why I added four more gold stocks to the portfolio in early April. One of them, a calculated speculation, is already up around 100%…

Importantly for Aussie gold producers, gold priced in Aussie dollars remains very healthy despite the recent rise in the Australian dollar against the greenback. Gold priced in Aussie dollars jumped around $40 an ounce on Friday, to just over $1,700.

At these prices, a well-run gold producer with a decent orebody will be making very good money.

While the chart paints a very positive picture for gold, the only question mark is whether gold is simply rallying along with the rest of the commodity complex, or whether it’s a reflection of increasing concerns about the world’s monetary system.

The market sometimes views gold as a commodity, other times as a monetary metal…a de facto currency, if you will. Given the biffo going on between the world’s major currencies right now, it’s not surprising that gold is emerging from its long bear market.

But if it’s simply moving with other commodities, it’s susceptible to a China-driven slowdown. I don’t think that’s the case, but it’s worth keeping in mind. I recommend using stop-losses to get you out if the market does take a turn for the worse. But for now, it’s time to run with the bulls.

Cheers,

Greg Canavan,

For The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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