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The Second Wave
The U.S. economy remains mired in the pandemic. July’s release of Q2 U.S. GDP confirmed that that the fallout from COVID-19 resulted in the worst-ever quarter-on-quarter contraction: -9.5%, translating to an astounding -32.9% annualized. Daily COVID-19 new case count reached a peak of 77,255 on July 17, more than double the April peak of 36,261. The states grappling with rising cases include California, Texas, and Florida, respectively the largest, second-largest, and fourth-largest state economies. Close attention will be paid to the July jobs report, scheduled to be released on August 7, and whether it will show a reversal of the positive hiring trends from May and June.
Source. Johns Hopkins (CSSE)
Despite the worsening virus situation, U.S. equity markets posted a robust +5.64% gain in July, on the heels of a healthy June gain of +1.99%. One off-the-cuff explanation is that the markets have become desensitized to pandemic news. We believe that examining the relative performance of the S&P 500 versus gold reveals a more fundamental phenomenon: the greatly increased money supply resulting from the Fed’s unprecedented quantitative easing policies in late spring continues to drive the performance of all financial assets. The chart below plots the growth in money supply as measured by M2.
Source. Orthogonal, Federal Reserve Bank of St. Louis
As we explained previously, there is strong theoretical and empirical evidence that the price of gold accurately reflects changes in money supply in the long run (see May commentary), and that adjusting equity market performance by the performance of gold is one way to control for the impact of increased money supply (see June commentary) on financial markets. The chart below sets out the performance S&P 500 as adjusted by the price of gold.
Source. Orthogonal, Reuters.
The S&P 500 underperformed gold by -4.77% and -0.87% in July and June, respectively. If measured from June 9, 2020 (the trough in the 5-day moving average of new COVID-19 cases prior to the second wave), the S&P 500’s performance has lagged gold by -10.76%, a steep decline as compared to its unadjusted headline return of +2.73%. This is strong evidence that the Fed and its unprecedented monetary policies continue to drive the upwards performance of financial assets, including gold and stocks, despite the deteriorating COVID-19 situation.
The question remains of how far the impulse of the Fed’s flood of liquidity to date can go in the face of growing economic headwinds. One framework suggests there may still be some room to go. In our May commentary, we analyzed the fair value of gold as determined by M2 money supply. We’ve updated that analysis based on current M2 ($18.32 trillion):
This formula suggests a price target of $2,406/oz for gold, which leaves another 20%+ upside from its current price as of writing. The takeaway is that if the price of gold correctly indicates that the increase in money supply has yet to fully work its way into the financial markets, there may yet remain fuel for powering asset prices.
Nevertheless, there is reason for caution. The economic headwinds posed by COVID-19 are growing again and may overwhelm the liquidity-fueled inflation in asset prices. In the real economy, weekly initial claims are back on the rise. Last week saw a second consecutive increase in initial jobless claims and a substantial rise in continuing claims, suggesting that the initial impulse from re-opening on employment is beginning to taper. Moreover, it is unclear how well small and medium enterprises will weather the winter as the temperature cools, stimulus checks run out, and people return indoors. The world is highly uncertain.