The Macro View on Gold
Featuring Tavi Costa
Published on: April 25th, 2019 • Duration: 18 minutesTavi Costa, global macro analyst at Crescat Capital, makes his Real Vision debut in style — with a bullish trade idea on precious metals. He highlights why it’s finally time for gold to start outperforming, confirms his thesis by examining a variety of macro indicators, and discusses how to play the current setup, in this interview with Jake Merl. Filmed on April 24, 2019.
JAKE MERL: Welcome to Trade Ideas. I'm Jake Merl sitting down with Tavi Costa, Global Macro Analyst at Crescat Capital. Tavi, it's great to have you on the show for your very first Real Vision interview.
TAVI COSTA: Thank you, Jake. I appreciate it. Looking forward.
JAKE MERL: So before we get into your actual trade idea for today, can you please go over your background, who you are, and what you do at Crescat Capital?
TAVI COSTA: Sure, I've been working for Crescat for about six years. And I usually focus more on the global macro research and help Kevin Smith, our CIO, on the portfolio-management part. And Crescat's investment process really revolves around building fundamental equity macro models. And essentially, that is how we develop our investment themes.
At any point in time, we have about three investment high-conviction ideas in the portfolio. Today, we have three. So one would be the US stocks. They're historically over value. And the second would be China being the largest credit bubble we've seen in history. And the third one would be the precious metals, which is what I want to talk about today.
Precious metals is what we see as a tremendous value with the turning in the business cycle, which we think is going to happen anytime soon. So we'd like to elaborate further on this.
JAKE MERL: So what are you looking at specifically that's shown you it's a good time to be bullish on precious metals?
TAVI COSTA: Sure. So today, it's more of a big macro picture. We put out this chart looking at historical imbalances in total debt to GDP of the last largest credit bubbles we've had in the last 30 years, all the way going back to the 1990s with Japan, 1997 with the Asian crisis, and US housing bubble in '07, '08, and that European debt crisis in 2011 and 2010.
And what you find there is that if you calculate the average of those imbalances at the peak of those bubbles, it was somewhere around the 245% of total debt to GDP. And if you looked at the top largest total debt-to-GDP ratios today-- or 2018 because that's the most recent data you can get-- you get somewhere close to an average of 270%.
So you look at that imbalance. It's not a macro indicator for timing. However, when you put that together, usually, when you have excessive amounts of that, it tends to cause destruction of value of global fiat currencies. And when you put that together with the monetary base-- the size of monetary base today and money supply globally, relative to above-ground gold, and then you kind of line up with all the macro indicators that we have today, which I'm going to be talking about soon, that makes us really believe that gold and precious metals essentially look very attractive as a long here, in any portfolio, really, as a hedge.
The second part of it, which I think it's quite interesting, is we put out the stats looking at the percentage of companies are losing money on a free-cash-flow basis globally. So it's across countries. And what you find there is that no financial stocks for Canada, for instance, are losing-- about 82% of those companies in Canada are losing money on a free-cash-flow basis. And Australia is about 71%. And then you have the US, Hong Kong, and China, and Singapore right about 60% of those companies are losing money.
It makes you think about this whole market that's been propped up by central banks with the ultra-low interest-rate environment. And it's kind of an impossible scenario. If you had sort of a normalized cost-of-capital situation with more normalized rates, you would never be able to survive in a situation like that. So enabling companies, Zone B companies to be alive, it's quite of a distortion, really.
And really, if you think about it, there's another way that the central banks have kind of propped up markets in the credit markets, essentially, which is the 30-year yields. When you look at 30-year yields, essentially, compared to Fed funds rate, which is overnight rate, what's interesting about that is that it inverted in 14 economies. So 14 economies have their 30-year yields lower than Fed funds rate.
When you see that throughout history, we put out this chart looking at throughout history, every time this spread reaches an extreme on the negative side, we're at the peak of a cycle. So we had that in the tech bubble, we had that in the housing bubble, and we're now having this issue today. But what's unique about it is that we're having this problem in 14 economies. It's really, a precedent amount of countries having this issue.
And there's really three takeaways from this chart. Number one, it's global-yield-curve inversion, which we think is negative for stocks. Number two, is it makes you think about US rates being relatively high when compared to other global rates in general. So one example would be the US treasuries versus German bunds. We think that those rates are likely to converge, or at least the narrowing of the spread is likely to happen as we reach this bear-market case that we think it's likely to unfold.
And the third one would be the dollar. You know, if you're a believer that we're likely to see some inflows towards more of safe-haven assets, like treasuries, really, across the entire curve-- because the two-year yields are also very attractive all the way to the 30-year yields relative to global rates-- then you would think that that would cause an inflow to the dollar.
So I'm here giving you a case for gold, but at the same time, I'm actually very bullish on the dollar, which we can get into in another conversation. But it's a dollar versus places like China, or Hong Kong, or some places in Europe. We think that gold in yuan terms, or renminbi terms, or Hong Kong dollar terms-- they all look very interesting as well, not just against the dollar. So that's just a little bit different takeaway.
JAKE MERL: So it sounds like from a macro perspective, we're getting close to the time where gold should really start skyrocketing higher. But what models or what timing tools are you looking at that's helping you determine now is the time to get in?
TAVI COSTA: Yeah. So gold-- we like as, really, a safe-haven aspect of gold is really attractive to us. So we always go back to reviews, and macro views in the US, and globally. But we built this model called the "Crescat macro model."
And the idea here is to acknowledge first that there's not one single factor that works perfectly throughout history, but by combining economic indicators, equity fundamental factors with a few technical indicators, you can kind of-- they all have some sort of high statistical correlation to the changes in the market. It can help you at least to find or figure out where we are in this business cycle. What stage are we in?
So we built this model. Right now, we're about two percentage points from record overvalued levels. And what's interesting about this model-- it goes back all the way to 1987. And it perfectly timed the peak of the two last housing-- the housing and the tech bubble as well, and the bottoms as well.
And today, it actually reached the overvalue stage in September of 2015, which was a time when we had emerging markets blowing up, as you remember. Oil prices were dropping significantly. And at the same time, you had US stocks in December-- the sell-off, which was a correction that we had. What saved the markets, really, was that the Federal Reserve paused its rate-hike cycle, and then that kind of extended the business cycle.
And it's kind of interesting. When you really research credit markets today, it's really telling you a very different story from what we think is likely to happen in this scenario. So a lot of investors are kind of oblivious, believing that we're going to see another 2016 soft-landing scenario, when I think it's actually going to be very different.
JAKE MERL: So Tavi, you're saying we're at the end of the business cycle. Is that right?
TAVI COSTA: That's right. And one way to look at that is credit markets because they tend to serve as a bellwether for stocks, historically, at least. Most people have been looking at a three-month versus 10-year yields and some other spreads that kind of got inverted recently-- and rightly so. It's very important. But we build a much more comprehensive way of looking at credit markets in general. And we're looking into all possible 44 spreads in the US yield curve and calculating how many of those are actually inverted.
Today, about 50% of those spreads are actually inverted, which is just as high as it was at the housing and the tech bubble as well. And what's interesting about that is when you link back to the 2016 environment, in 2016, the number of the percentage of yield curve inversions was actually below 20. So right now, being close to 50-- and that number kind of changes on a daily basis-- but about 50%, it's a pretty alarming situation. We think credit markets are pricing in-- perhaps a recession in the near term, which is likely to develop as a bear market first. So most times, it develops with the bear market first.
What's important about inversions is at first, they tend to be great times for you. When you have inversions, it tends to be a great time for you to buy gold, precious metals in general. And most importantly, it's gold to S&P 500 ratio that tends to rise in moments when you have inversion.
One way to look at that is looking at the five-year yield versus Fed funds rate and the three-year yield versus Fed funds rate. When they invert, first, you were at the peak of the cycle. But also, most importantly, it tends to be great times for you to buy gold relative to US stocks. And we've seen this twice.
And the interesting thing about Gold to S&P 500 ratio, is that it's actually forming a pattern that resembles a global financial crisis of '08 and '07. And it kind of broke off from this multi-year resistance line recently and broke up with authority in December with a sell-off in stocks in the fourth quarter, kind of madness that we had globally.
And then it kind of, with this bounce since this 2019 year, it kind of bounced back to the resistance line. And it's been kind of retesting that line, which is very similar to what happened in '06. '06-- the ratio of also broke out from a multi-year resistance line, and then retested back to that line. And that was an interesting time because the retest was in '07, right at the beginning of the housing crisis that began to unfold.
And that was an interesting time because also, it marked the increasing volatility period for equities. And you can see that by looking at the VIX. The VIX was forming higher lows until all the way to the end of the crisis. We think that we just entered a very similar pattern today.
JAKE MERL: And so how does the Fed affect your thesis?
TAVI COSTA: Yeah. We looked at this. I think it's a must-watch. You should be in everyone's must-watch list and their monitors if you're an investor is the two-year yields. And the two-year yields-- it's a very simple-- and it has a perfect track record of looking back and predicting recessions and severe bear markets.
So if you put out in the chart the two-year yields all the way back to the '70s and '80s, and then you kind of connect at the tops and create this resistance line as well, if you will, and then every time the two-year yields touch the resistance lines and fall significantly, you're at the peak of a cycle. It happened in a double-dip recession in the early '80s, the tech bubble, and the housing bubble again. And it's happening today.
JAKE MERL: So basically, you're saying that the Fed pausing or cutting rates isn't necessarily bullish for stocks.
TAVI COSTA: Absolutely. That's correct. I don't think it's bullish at all. And one way we think that-- be wary or concerned every time the credit markets are starting to price in, that the Fed is going to start to cut rates or ease anytime soon, especially at late stages of the cycle. That has never been a bullish sign. It's actually been a very bearish sign historically.
JAKE MERL: And so gold correlates pretty highly with real yields. What are you looking at there?
TAVI COSTA: Yeah. So that's a good point. So if we think that nominal rates are going to be falling significantly, like I showed before, real yields are likely to fall as well. And the interesting part about real yields is that if you invert the real yields and put that with gold prices, they track each other really closely. And that's not a surprise for a lot of people.
But what's interesting about real yields, if you looked at US five-year real yields inverted-- it just broke off from, also, a multi-year resistance line-- if that continuation of that plot pattern is likely to happen and continue, we think that gold prices could rise much further and follow the same pattern.
JAKE MERL: And so Tavi, before, you mentioned gold priced in Chinese yuan. Can you please talk a little bit more about that and why you think it's important?
TAVI COSTA: Sure, absolutely. So we think, as I said, China is the largest credit bubble we've seen in history. It's about $40 trillion on balance-sheet assets that they have. And off balance sheet, they put out this stability report-- financial stability report-- every December of every year. They admitted to another $45 trillion off balance-sheet assets.
So we put that together. And actually in a conservative way, it's been a growth of about 400% since the global financial crisis, in normalized terms on balance-sheet banking assets. What you find there is that we think that the consequential damage of all this debt build-up in the Chinese economic model, really, will have a problem with the Chinese currency. One way you can see that is actually on the current account problem.
So first, we've seen the current account declining in China. But if you plot that with several countries all the way back to the global financial crisis-- so if you look, you know, just a change in current account from where the global financial crisis levels were to today, you have Argentina. They shrink their current accounts significantly. And then at the same time, they lost close to 90% of the value of their currency.
And today, China is actually the only currency in the world-- the Chinese renminbi is the only currency in the world that actually appreciated since the global financial crisis at the same time as its current account balance actually shrank significantly. If you put that on a quadrant, other countries are very close to debt. Like the Hong Kong dollar and Saudi Arabia-- they're all pegged currencies.
But we just think that this is kind of unsustainable now. You have this in-data growth model for many years, and now the current account is turning negative. If that's going to continue to happen, we're likely to see a devaluation of the yuan.
So what we like about it is if you study back in history, how credit markets or credit busts tend to develop themselves throughout history, especially in emerging markets, what you find is sometimes, you have a credit bust. The equity market actually rises in the local-currency terms, but the currency itself depreciates significantly against the dollar.
Now what you find-- there is one pattern that tends to happen in credit busts in emerging markets is that gold tends to rise in local currency terms. So we think that one of the best rates out there is gold. In yuan terms is likely to rise significantly. And it's being kind of pegged, as a lot of people have been kind of talking about this, with a very high correlation between gold and USD/CNY. But we think that the correlation is unsustainable. What's essentially going to happen is they're going to break out on gold in local currency terms as the whole crisis in China unfolds.
JAKE MERL: And so your trade idea for today is going long gold in dollars, not Chinese yuan.
TAVI COSTA: Yes.
JAKE MERL: Aren't you a little bit nervous about the potential for the dollar to scream higher?
TAVI COSTA: We actually don't disagree with this bullish thesis on the dollar. We actually like the dollar quite a lot relative to other currencies, especially the Chinese yuan, Hong Kong dollar, European countries as well. But what's interesting about that is that the other thing that-- we've been doing this whole bullish thesis on gold-- didn't information inflation. Inflation hasn't even been part of it because it's solely due to this idea that we think that the global markets are kind of this negative outlook for global markets in general and kind of overdue for a recession in a bear market.
So we really like the safe-haven aspect of gold mostly. If this thesis-- this bear case is going to really unfold, we think gold is in a very, very good situation. What we've seen in history is that central banks tend to resort back to money printing and excessive monetary policies to really prop up markets to continue to go up. And we think that that's just going to be very beneficial for gold and precious metals in general.
One way you can look at that is Russell 3,000, for instance, relative to silver. Russell 3,000 is more of your broad US stocks kind of index. And' it's a very interesting ratio because when you looked at that relative to silver, it kind of formed this almost perfect double top, kind of recasting that really high valuations, crazy valuations we had in the tech-bubble period. And then it's now been kind of coming down a little bit.
And we think that, essentially, silver-- you could think of silver as a high-beta version of gold. Silver is historically depressed prices, really, especially relative to broad market in general for equities in the US. So we think US equities are most likely going to fall and at the same time as silver prices. This is not just a bullish thesis on gold itself, but also, on silver.
JAKE MERL: So break it all down for us, Tavi. You know, what vehicle would you use? What's your target? What's your stop loss? And over what time horizon do you expect this thesis to play out?
TAVI COSTA: So we've seen kind of global imbalances all over, and also, this record valuations for asset prices at the same time as kind of this nonsense reliance on central banks will be able to continue to prop up markets, which, in our view, is really a recipe for a hard-landing scenario. At least that's what we've seen in history. So we think that gold and precious metals will really benefit from that.
For your average investor, it would be maybe GLD, the ETF. We think GLD will reach their 145 level in one year from now. And our stop loss is at 111.
JAKE MERL: Tavi, that was great. Thanks so much for joining us.
TAVI COSTA: Thank you, Jake. I appreciate it.
JAKE MERL: So Tavi is bullish on gold. Specifically, he suggests buying the SPDR Gold shares ETF, ticker symbol GLD at $120, with a stop loss at $111, and a target price of $145 over the next 12 months.
That was Tavi Costa of Crescat Capital. And for Real Vision, I'm Jake Merl.