Gold’s weird rally

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Good morning. This week’s data releases, culminating with jobs day on Friday, will be closely scrutinised for hints of US economic slowing. The Atlanta Fed’s GDPNow fourth-quarter growth tracker, which will incorporate all this data as it comes in, now stands at a middling 1.2 per cent. As an over-under bet, where will GDPNow end the week? We’ll take the over, but the margin could be slim. All thoughts welcome: [email protected] and [email protected].

Why gold is at a record high

Gold prices closed at all-time highs on Friday, which seems a bit weird. The most important variable for gold prices, historically, is real rates, the opportunity cost for holding a yield-free metal. Exact measurements vary, but however you cut it, we’re around the highest level of real rates since at least the financial crisis. Why is gold gaining?

Part of the answer lies in levels versus rates of change. Real rates, using yields on 10-year inflation-linked bonds (Tips) as a proxy, are indeed high but have fallen nearly 50bp since the peak in October. That seems to have cleared the runway for gold prices:

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Recent moves in Tips yields elude easy explanation. Economic resilience was a widely cited reason for real rates’ rise in September and October, so creeping signs of slowdown may have spurred a reversal. Better inflation news also might have curbed fears of more future inflation volatility, another reason why real rates could be higher. Whatever the reason, it’s good news for gold.

A second tailwind is coming from a weaker US dollar. Gold is largely priced in dollars, meaning that USD weakness gives non-US gold buyers more purchasing power. The US dollar index fell 3.5 per cent in November, a reaction to growing expectations for US rate cuts and historically an omen of gold rallies:

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These two explanations, a falling dollar and lower real rates, don’t feel fully satisfying, however. They held true at various points earlier this year, including the flight to safety after Silicon Valley Bank’s collapse, and no gold price breakout followed. Something else is going on.

Gold is considered a geopolitical risk hedge, making the Israel-Gaza war a reasonable guess. In the week immediately after the Hamas attacks of October 7, gold prices leapt 6 per cent. But this, too, is not dispositive. More recently, the tail risks of the conflict — namely the risk of a wider regional war that would slam global markets — appear to have waned. Iran, a key actor, has sought to prevent escalation, to give just one example. The World Gold Council’s model of gold returns had an abnormally large “residual” term in October, suggesting that a big, unmodelled shock (such as a war) had hit gold prices. The residual disappeared in November.

A final explanation is a structural change in central bank demand for gold. Ukraine-related sanctions encouraged EM reserve managers to nudge their portfolios away from US dollar assets (largely Treasuries) towards gold. Unhedged is sceptical that this spells the end of dollar hegemony, but even incremental changes in the dollar’s standing among central banks can matter to gold prices. As the chart below from Absolute Strategy Research shows, central bank gold reserves in the Brics+ bloc were already rising before the Ukraine war. Central bank gold buying hit record levels in 2022, and is on track for a fresh record this year. Gold mining activity, also on track for a 2023 all-time high, is responding to higher demand.

Put together, these four factors pointing in the same direction feels like a more complete story. At the same time, though, we struggle to see the makings of an explosive gold rally. The metal has tried and failed for three years to break its ceiling of $2,050 or so. And the forces now boosting it may not have enough kick to keep prices rising. Higher central bank demand is well telegraphed, geopolitical risk has waned and it’s unclear how much further real rates have to fall. Still, if you’ve a bull case to tout, or if we’ve missed something horribly obvious, let us know. (Ethan Wu)

Private equity’s insurance subsidiaries

Last week, private equity house KKR announced that it was buying the third of Global Atlantic it did not already own, for $2.7bn. The FT story on the deal quoted KKR co-CEO Scott Nuttall saying the following: 

“We are not doing this because we have to, we are doing it because we want to and this has been a home-run investment,” said Nuttall. He pointed to synergies KKR could garner with full ownership, such as selling private equity funds it had designed for wealthy individuals to Global Atlantic’s existing clients. 

This comment struck me as slightly off. Not the bit about GA being a home-run investment, which is true to date; the bit about selling PE funds to insurance clients. Big private equity-cum-asset managers buy insurance companies (see also: Apollo/Athene, Brookfield/American Equity) not to cross-sell, but to gain a source of stable capital. 

The PE insurance company subsidiaries sell annuities, that is, contracts by which individuals exchange a lump sum for a certain level of income over a certain period of time, sometimes the rest of the individual’s life. The PE shop then tries to earn more from the money than they have to pay for it. It’s a spread business, like banking, although annuity withdrawals are, in theory, rarer than deposit withdrawals. For the annuity buyers, the crucial point is that there are tax advantages to buying an investment product classified, for vestigial reasons, as insurance. For the PE shop, the crucial thing is that an insurance subsidiary gives them direct access to retail investors’ capital, which normally they are only allowed to access indirectly, through big pension funds. 

As with any big structural shift in the way investment assets are held, invested and distributed, we should ask whether the change decreases or increases risk in the system. The private credit industry often points out that they are safer owners of credit assets than banks, because they use less leverage and because they do not take deposits, which can run. “Every dollar that moves out of the banking system reduces systemic risk,” Nuttall said recently. There is a good deal of truth in this.

But while annuity premiums may be more stable than deposits under normal circumstances, they can run. Customers can pull their premiums, at a penalty, and if they become convinced that their annuity company isn’t stable, that is what they will do. This is what happened to Executive Life, then the largest insurer in California, in the early 1990s: policyholders withdrew $4bn after the company announced losses from junk bond investments, and the company collapsed. Annuity capital is not permanent capital. PE firms raising capital by selling annuities have to worry about maturity mismatches. 

One appeal of the annuity business for the big PE firms is that the capital raised can be put to work in credit assets that banks are trying to get rid of anyway, in an era of high and rising capital requirements. These might include leveraged loans, franchise finance or aircraft leasing. But — as Steven Kelly of the Yale Program on Financial Stability pointed out to me — as those assets leave the banking system, regulators lose visibility on them. “Suppose we have a crisis, what can the regulators see? Who does the Fed lend money to?” Kelly asks. And regulators may not see the crisis coming as quickly as they would were the assets held in banks, with their regular marking of assets. 

As Sonali Basak pointed out on Bloomberg last week, if the assets are held within insurance-company subsidiaries, insurance regulators will have visibility, and there will be some required disclosures. This should help offset this risk. 

A more remote risk that Kelly points out is that individual banks may become overexposed to the private asset industry on the deposit side of their balance sheets, the way Silicon Valley Bank was overexposed to the venture capital industry. Annuity-holder runs against PE firms’ insurance subsidiaries could lead to sudden and heavy withdrawals from banks.

All of these risks are remote right now, and might not crop up even in a bad default cycle. But as retail capital flows to private asset managers, and those managers pull risky credit assets out of banks, systemic risk will remain in the financial system, even if it takes new forms.

One good read

Is South Korea disappearing?

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