By Chris Puplava
Chief Investment Officer, Financial Sense® Wealth Management
July 25, 2022
As mentioned in the first part of our quarterly newsletter (Recession Realities & Portfolio Strategy), we wanted to delve deeper into the details regarding our asset allocation decisions given the heightened probability of a US and global recession. In our prior letter, we mentioned why we built a sizable position in longer maturity US Treasuries (USTs) and that we planned to hold onto our precious metals position. Today, we will show how gold, USTs, and stocks perform during the twelve months leading up to a recession and twelve months after the onset of recession.
The title to our newsletter comes from a quote attributed to Mark Twain. Like the quote, market cycles don’t repeat in that every cycle has differences relative to the cycles before it, but there are also many similarities or patterns that make market cycles rhyme. What separates cycles are typically severe economic downturns that ultimately lead to a recession. This is why our firm performs so much analysis around studying the prospects of a recession so that we can make the correct asset class call (weight towards stocks, bonds, commodities, cash, etc). As we mentioned in the last letter, there is growing evidence that we are either already in a recession or will be staring one in the face before the end of the year.
In just the last week, we have been treated to more disappointing economic data from housing, which has severely come in below consensus, as well as disappointing labor market and business cycle indicators. For example, in the most recent June reading for the Conference Board’s Leading Economic Indicator (LEI), it posted its 13th monthly decline in the last 14 months. At its current decline rate, the LEI’s annual growth rate will be in negative territory this month and will fall below a -1% annual growth rate by August.
A decline below the -1% threshold would be a significant development since it typically acts as a major demarcation line for recession. To put it more precisely, the U.S. economy has NEVER skirted a recession (going back to 1960) once the LEI’s growth rate slips below -1%. Looking at prior lead times to recession, the median over the last 7 recessions (not including 2020) was 3 months (two had no lead time and one had 1 month). So, should we fall below -1% in August, we could be looking at the start date of a recession occurring between August to November 2022.
Gold’s Performance Around Recessions
Given there is a real possibility that the economy is or will slip into a recession over the next year, let’s take a look at how gold and long-term USTs perform during the twelve months leading up to a recession and the twelve months after the onset of recession. Ever since Nixon took the US off the gold standard in 1971, the US has fallen into 7 recessions. Looking at the performance 12 months before through 12 months after the onset of a recession, gold showed positive gains in 5 of the last 7 recessions for an average gain of 50.43%. For the 5 recessions it had gains for, the average return was 79.33% and the average loss for the two recessions it lost value in was -21.81%. The worst trade came during the 1981 recession where in the 12 months before and after the onset of the recession, gold fell 40% as the US dollar (USD) staged a 42% rally over the period as it was in the process of beginning its most explosive run ever from the early to mid-1980s. Typically, the ideal exit for gold would be 6 months into a recession where the average gain for the winning trade was 81.62%, meaning gold starts to lose its luster often before the recession ends.
Given gold often trades conversely to the USD, it’s important to also see how the USD Index fares in recessions. Looking at the past 7 recessions, the USD Index rose in only 3 of them for an average gain of 4.89%, which was significantly impacted by the historically unique and quite extraordinary 42% USD rally in 1981. Absent that explosive move, the USD Index typically shows flat to negative performance. The twin deficits (trade & budget deficits) are likely the two best predictors for the USD Index’s future performance. They typically lead turns in the USD by 18 months and thus serve as useful guides to determine the USD’s likely direction.
When we look at the lagged impact of the runaway fiscal spending due to COVID and record deficits (as US consumers purchased record amounts of goods from abroad), we saw the twin deficits hit levels never seen before at -20%, almost double the prior extreme of -12% coming out of the Great Financial Crisis (GFC). This argues a decline is in the offing, particularly if the US slips into a recession, forcing a U-turn in monetary policy and a return of stimulus measures.
Gold’s Relative Performance Around Recessions
When looking at gold on a stand-alone basis around recessions, it has a high hit rate (71% positive returns) and a strong average return (+50%). When we compare gold versus stocks, we see that it is a superior investment around recessions where gold beat the S&P 500 in 4 out of the last 7 recessions. While gold’s hit rate of outperformance was only 57%, it won big when it beat and its underperformance was much smaller when it lost. During the 4 recessions where gold beat the S&P 500, it did so on average by 104% with its best return during the 1973 recession when it beat the S&P 500 by 229.59%. When gold underperformed in 3 of the last 7 recessions, it did so on average by 17.5%, with its worst performance coming during the 1981 recession in which the USD Index rallied 42% and it underperformed the S&P 500 by 37%. Absent the 1981 performance, the other two negative performances were mostly flat with only moderate underperformance relative to stocks.
Relative to the bond benchmark (the US Bloomberg Barclays Agg), gold beat in 5 of the last 7 recessions for an average outperformance of 31.69%, 57% in years it beat and by -45% in the two years it underperformed. The large negative performance was skewed by the 1981 recession in which gold fell more than 40% while the USD Index and bonds rallied over 30%. Gold’s relative outperformance to bonds peaked 3 months into a recession as gold’s gains moderated and on a stand-alone basis often peak 6 months into a recession while long-term USTs performance typically accelerates.
Long-Term US Treasury Performance Around Recessions
When we look at bonds, we see that in the last 6 recessions long-term (LT) USTs of 20yr+ maturity were up 5 times for an average gain of 23.43% overall and an average gain of 29.8% during the 5 positive performances. Its one losing performance was for a loss of -8.54% around the 1980 recession. While I do not have performance stats for the 1973-1974 recession as the index began in 1976, the Bloomberg 10yr+ UST Index began on 01/1973 and for the 10 months prior to and 12 months after the onset of the recession it posted a gain of 5.96%, so I think it’s safe to say that in the last 7 recessions that LT USTs posted gains for 6 of them.
In light of the above high success rates for gold and bond performance around recessions, we have allocated client capital to both where permitted. Further, we maintain an elevated cash position and a significantly reduced exposure to the stock market.
Stock Performance Heading Into Recessions
Looking at how the S&P 500 Index performed heading into the last 7 recessions showed on average it fell -3.83% where it was down 4 out of the last 7 recession in the 12 months prior. The data is skewed by the S&P 500’s performance before the COVID-induced 2020 recession as the Fed launched another round of QE in 2019. Removing the 2020 recession shows the S&P 500 was down 4 out of the last 6 times in the twelve months prior to recession for an overall average loss of -9.28% and the two times it showed positive performance, the average gain was a meager 2.01%. Looking at how the S&P 500 Index performed around recessions, it often traded flat from 12 months to two months prior to a recession and its losses picked up steam in the final two months leading into a recession.
Given the above data, we have maintained our precious metals exposure despite the disappointing performance this year and, more recently, made a sizable allocation to long-term USTs. Moreover, we continue to have elevated cash as well as below-average levels of exposure to stocks. We may be wrong in our recession call and the Fed could make an aggressive U-turn in their tightening policy stance, which is why we will continue to track conditions as they evolve in the financial markets and the economy. As well, we will promptly update our clients to any change in our investment philosophy. While we feel the risk of a recession is high and calls for a defensive posture, we do not want market mispricing to turn into missed opportunities, and we are likely witnessing one right now in the energy patch.
The Disconnect Between Physical and Paper Markets for Energy
The Biden administration has dropped the US Strategic Petroleum Reserves (SPR) to its lowest levels since 1985. This is adding fuel to the recessionary fire concerns that is leading to a sharp selloff in commodities, particularly energy.
As shocking as it may be to hear that we have lost a quarter of our emergency reserves during the Biden presidency, that isn’t the most troubling development. Despite the biggest decline EVER in the SPR, total US oil inventories excluding the SPR have barely budged off their lows this year. Let me repeat that…the biggest release of oil EVER in the US has barely budged overall private oil inventory levels!
When we look at total US crude oil inventories (private sector inventories plus U.S. Government SPR inventories) we see that overall total U.S. crude oil inventory levels are at their lowest level since 2004.
When we look at the 10-year seasonal pattern for total US oil inventories, we are well below the 10-year extreme low and seasonally inventories decline into late September. Can you imagine where prices would be had the Biden administration not released the SPR? While this is a temporary and unsustainable solution, there is nothing being done to increase supplies domestically but instead our efforts are spent trying to force OPEC to produce more, which it has limited capacity to do.
This is not just a US problem but a WORLD problem of a lack of supply. The data comes out with a big lag but, as of March, total OECD oil inventories (OECD countries make up 63% of total world GDP) have fallen dramatically to the lowest levels since 2005. Once we get the recent data, I am sure we will be at the lowest levels in a quarter century.
We bailed out banks, auto companies and insurance giants in 2008 and airlines in 2020 but it would be political suicide to bail out energy companies, which is exactly what was needed two years ago. Given most in the US shunned the energy industry to focus on green energy, we failed to support necessary infrastructure in the US to secure our supplies as so many refineries went under during the COVID-induced lockdowns never to open their doors again. So, as US demand for gasoline returned once the US economy reopened, we did so with less, not more refinery capacity, which fell to the lowest level in 8 years by the end of 2021.
It often takes a crisis to get politicians to respond given their lack of foresight or will to prevent catastrophes. Sadly, there is a good chance we are heading into an energy crisis that could last years. The seeds were sown years ago, which we highlighted in a client letter last fall to support our bullish view on commodity prices before the dramatic rise in energy prices. The data below is a key portion from that client letter that I want to reshare:
Since 2007, according to BP’s Statistical Review of World Energy, the U.S. has cut its coal production by 55%, Germany by 56%, and the U.K. by 90%. We’ve even seen a reduction on the reliance of clean nuclear energy since the 2011 Japanese Fukushima nuclear meltdown. Japan has cut its nuclear energy consumption by 82% since 2011, while Germany has cut its consumption by 46%. Nuclear consumption here in the U.S. and the U.K. has remained steady while China’s nuclear consumption has grown by 298% as part of a concerted effort to shift away from coal and reduce air pollution. In terms of natural gas, since 2007, China has grown its production by 229%, the U.S. by 82%, while Germany has cut its natural gas production by 73% and the U.K. by 53%.
Considering dramatic cuts to production and consumption of nuclear, coal, and natural gas, Europe and the U.K. are leaving themselves at the mercy of Russia and the U.S. to help meet their needs and both regions better pray for a mild winter this year or the recent price spikes in energy could get a lot worse.
We are likely to see much higher oil prices in the years ahead and many will suffer for it as they already have. Businesses in the UK and Europe are closing left and right due to the skyrocketing electricity prices and many can’t even buy necessities as their discretionary spending is getting squeezed. The most recent casualty is Germany’s largest utility as highlighted in the following article.
Uniper Starts Using Winter Gas with Urgent Bailout Needed
Germany’s Uniper SE has started using gas it was storing for the winter after Russia cut deliveries to Europe, increasing pressure on Berlin as the German energy giant needs to be rescued “in a few days.”
The country’s top buyer of Russian gas started withdrawing fuel from storage sites to supply its customers, the company said in a statement to Bloomberg on Friday. The drawdowns, which began on Monday, will also help the company to save some cash as it has been forced to pay up for gas in the spot market. Uniper needs urgent help, risking insolvency within days, said Harald Seegatz, chairman of the Uniper Works Council and deputy chairman of the supervisory board.
Given we are witnessing unprecedented declines in our oil reserves with no improvement in sight, the recent decline in energy prices (including natural gas) appears unwarranted in our view and spells an opportunity. We will be monitoring energy closely as a likely area for us to deploy cash raised earlier in the year. The risk of a recession here in the U.S. and in Europe remains high and typically recessions reduce energy demand and energy prices often fall. We have to balance the risk that traders push oil prices lower on recession fears vs inventory realities with the incredibly tight inventory situation that should be supportive for higher prices. Should we feel it time to begin building back up our energy position that we lightened up back in April we will keep our clients appraised.
Advisory services offered through Financial Sense® Advisors, Inc., a registered investment adviser. Securities offered through Financial Sense® Securities, Inc., Member FINRA/SIPC. DBA Financial Sense® Wealth Management.
Copyright © 2022 Chris Puplava