Only gold profits from panic in stock and bond markets

It was a last minute compromise that saved the US from failing to meet its obligations. Normally, such an event leads to a relief rally in stock markets. This was also the case on Monday August 1, but it did not last very long. While Asian stock markets closed with gains, European markets opened with an upside gap, but pared gains. A negative harbinger for what followed at stock markets during the rest of the week.

Many stock market indices lost more than 10% over the week. Three factors contributed to the massive sell-off in major stock markets. Gold was the only metal, which could profit from this turmoil and ended the week higher. Silver and the PGMs posted losses. Also the base metals plunged with the LME metals index dropping by 9% over the week. Whether gold will profit further and other metals will remain under pressure depends on the developments of the three factors contributing to the plunge of stock markets and on the reaction of investors and traders.

The first factor was the uncertainty among investors about the reaction of the rating agencies on the last minute compromise. Moody’s and Fitch confirmed the triple A rating of US government paper by the middle of the week. However, Standard & Poor’s was the most critical about the political process. Last Friday, four hours after the US markets closed, S&P reduced the rating of US Treasury notes and bonds by one notch to AA+ with outlook negative. Two reasons were given by the agency, the political wrestling for a solution, which was in danger by the fundamental opposition of the Tea Party fraction within the Republicans, and that the savings agreed remained below the demand of S&P. From our point of view, S&P is only partly right. It is part of the political negotiations that compromises in difficult situations are made in the 11^th hour. Financial markets sometimes lack this understanding as traders and investors could make decisions rather quickly and implement them immediately. And with different majorities in the House and Senate, compromises have to be found between the two parties. If some members insist on their positions and are not willing to find a solution, the political business in the Congress is more complicated. However, the second argument creates the impression of blackmailing the members of the Congress. Investors should also keep in mind, that it was S&P who was the most aggressive in rating bonds backed by junk sub-prime mortgages as triple A. This agency acts like an arsonist who attacks now the fire brigade for extinguishing the fire.

The crucial question is now, how will the financial markets react on what has already been discounted. Already on Friday, rumors were spread around that S&P would downgrade US Treasuries. If financial markets react according the rule of buying the rumor and selling the fact, then stock markets would rebound from the plunge last week. This does not necessarily imply that all losses would be pared quickly, but equity markets would recover considerably in this case. A recovery of stock markets would also lift the metals with an industrial use and gold might give back some of the gains. However, if markets remain in panic mode, then the downgrade by S&P could lead to further falling stock markets and industrial metals.

Except some of the usual doomsday prophets like Dr. Rubini, many economists expect that the US economy would continue to grow in the second half of 2011 and in 2012. Also many equity strategists are still optimistic for stock markets. Nevertheless, among many traders, the economic sentiment is bearish. They were shocked by the downward revision of US GDP history since 2007. This revision also had an impact on Q1 GDP growth. Furthermore, the ISM manufacturing PMI came in far lower than expected. But the service sector PMI was stronger than expected and this sector is more important for US GDP growth than the manufacturing sector. In addition, the labor market report for July surprised to the upside. The number of new jobs created came in at 117K, far above consensus. Also the non-farm payroll figure for the two preceding months was revised up. The pessimists pointed to the number of persons leaving the work force. However, for GDP growth, the number of new jobs created is more important. History shows that people leaving the work force because jobs are hard to get return to the labor market once jobs are again easier to get. How quickly economic sentiment improves among traders and investors will depend on further economic data. However, also the Fed could contribute by considering some further monetary stimulus.

The third factor is the European debt crisis, which develops into a never ending saga of political failures to calm the markets. As the markets fear a contagion of Spain and Italy, the CDS and yields on bonds of these two countries rose further. The market is fully aware that the decisions made at the recent EU summit are not sufficient to shield Italy. Mr, Barroso was right in pointing out that the volume of the EFSF would have to be increased further to convince the markets. Making this letter public is the first mistake of politicians. But even worse is the reaction from the German finance ministry rejecting this proposal. This was an invitation for speculators to attack Italy further. However, the more Italy and Spain are in the line of fire from speculators, the more the European stock markets came under pressure. The German magazine “Der Spiegel” reported today that the economic advisors of Mrs. Merkel oppose any help for Italy. Fools never die. The more Germany is refusing a quick and convincing solution, the higher will be the costs for the tax payer.

The ECB also missed a good opportunity to teach the markets a lesson not to attack the eurozone. During the ECB press conference, the ECB started to buy again bonds of peripheral member countries after pausing for several months. Initially, this had a positive impact also in Spanish and Italian government bonds. However, as soon as the market got aware that the ECB did only buy bonds of countries already obtaining funds from the EFSF, the market reversed direction. The bund future rose to a new high and spreads of Spanish and Italian bonds widened again. This would have been a good opportunity the buy those bonds too in a second round of market intervention. Speculators and traders would have been caught wrong twice and normally get less aggressive in selling peripheral bonds short.

On Friday, after markets in Europe were closed, Reuters quoted an ECB official saying that the ECB would be ready to buy Italian bonds. The Italian government announced also on Friday evening that it would balance the budget already in 2013 instead of 2014 as scheduled in the package pushed through in early July. The ECB will hold a council meeting by telephone conference later this Sunday. If the ECB decides to buy also Spanish and Italian government bonds to prevent a contagion and shows strong bids for bonds of these two countries when the markets open on Monday, they might be successful in calming strained nerves of jittery investors. This would also contribute to stabilizing stock markets.  

At the start of the new week, there is no major economic data release scheduled. The FOMC meeting will take place on Tuesday. If the FOMC finds the right words in the statement, it could also contribute in stabilizing the markets. Despite the downgrade by S&P of US Treasury paper, there is still a chance that stock markets stabilize and rebound. This would also be positive for industrial metals. Gold might be less attractive as a safe haven in this case. However, a stronger euro versus the US dollar in the case the ECB decides to buy also Spanish and Italian government bonds could provide support to gold.