Gold remains underweight as economy falters

Published: December 11, 2019 2:25:25 AM

There has been no meaningful pickup in earnings upgrades despite the massive corporate tax cut. Earnings revisions have been minimal in large-caps as well as mid-caps. One reason could be that high growth is already factored into analysts’ one year forward estimates.

Gold, economy, Gold price, Gold price today, economy newsThe tick up in inflation also played a key role in RBI’s decision to not cut rates despite a slowing economy.

By Sunil Sharma

GDP at 4.5% is at the lowest level since 2013. The GDP data is in a strong downtrend since January 2018, making it the worst two-year performance in the past decade. Last quarter’s growth data showed a contraction in manufacturing and subdued investments. It was only government spending that bolstered the economy, with private consumption remaining subdued. High-frequency indicators suggest the slowdown has extended into October and November.

There has been no meaningful pickup in earnings upgrades despite the massive corporate tax cut. Earnings revisions have been minimal in large-caps as well as mid-caps. One reason could be that high growth is already factored into analysts’ one year forward estimates.

A narrative of higher valuations, global liquidity, financialisation, limited alternatives for investment and strong performance by a few leading companies has driven markets to new highs. The model continues to favour a positive tilt to equities, driven by strong flows and diminishing attractiveness of bond yields, and valuations supported by low interest rates.

Improving earnings and the sharp price correction in mid-caps over the past couple of years have compressed mid-cap valuation multiples and brought them in line with large-caps. However, earnings revisions data remains dismal for mid-caps. The technical momentum does not indicate a switch to mid-caps. The large-cap to mid-cap asset pair model moves to neutral from a slight tilt towards mid caps in the prior quarter.

Spreads between AAA corporate bonds and G-Secs have expanded to 114 basis points (bps) as of November, above the 10 year average of 93 bps. The spread has remained broadly stable over the past year. The credit upgrade/downgrade ratio continues to be under pressure with Q3 CY19 downgrades at eight-year high. The 10-year G-Sec repo spread widened during the IL&FS crisis late last year and has continued to hold on to the premium versus repo, on concerns related to fiscal deficit, elevated spending, corporate tax cuts and slowdown in tax and GST collections.

Bonds – short vs. long
The one-year to 10-year spread has widened to a multi-year high, favouring the long end. The five-year to 10-year spread has also widened to multi year highs. Gross borrowings of over Rs 7 trillion and large issuances from state governments are likely to add pressure at the long-end of the curve, as most government borrowings are for 10 years and above.

The tick up in inflation also played a key role in RBI’s decision to not cut rates despite a slowing economy. This will be a negative for long term bonds. However, the story on corporates comes with attendant risks as well, as the corporate downgrades ratio has accelerated higher.

Underweight gold
The gold-oil ratio remains over-valued, with the long-term average relationship implying a gold price of $894 per troy ounce versus gold’s current price of $1,475. Separately, volatility in global markets has declined over last few months, prompting asset flows from “safe-haven” assets like gold to “riskier” assets such as equities.

Exchange traded fund (ETF) gold holdings have continued falling in the last few months, while at the same time speculative net contracts in the yellow metal have risen offsetting some of the holdings losses. Net-net, this remains an overhang for the precious metal. The Gold Cash asset pair has moved to a moderately bearish view on gold, from a neutral view in the prior quarter, indicating a declining preference for gold.

The writer is chief investment officer & ED, Sanctum Wealth Management. Edited extracts from Investment Strategy.

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