Market Update: COVID-19 Shuts Down the Economy

Hello everybody and welcome back to Breaking the Dollar. I'm your host, Everett Millman. We are finally returning from a little hiatus here, as you can probably imagine. The kind of economic shutdown from the coronavirus has affected everybody, ourselves included. So that is going to be the topic for today's episode. I'm going to discuss what has happened so far to the financial markets as a result of this pandemic outbreak. And then specifically we'll take a look at some of the really strange and unpredictable things that have gone on in the gold market.

So first and foremost, the biggest effect that we've seen has been a nearly unprecedented jump in volatility. The most frequently cited measure of volatility is the CBOE Volatility Index. Many of you may recognize it by the abbreviation VIX and this gauge is generally called the VIX. If you've flipped on the cable news at all, you probably have seen that the stock market really tanked these past several weeks. But volatility isn't merely about markets going down. In fact, it's simply a measure of the rate of change. And one of the reasons that volatility has been so high is all of the uncertainty generated by the coronavirus. People don't know when they're going to be back to work. Businesses may have to remain closed for an extended period of time and in general, people are not moving around. They're not traveling. They're not going out and shopping like normal. All of that has made it very difficult for investors to make any kind of judgment about where the markets are going, what the economy is going to be doing because these are just very, very unusual times.

As a result, the VIX jumped to its highest levels in at least a decade, probably the highest since about 2008 during the financial crisis. To illustrate how volatile trading has been, there has not been a single trading session in the month of March in which the stock markets moved less than 1%. When you see the broader markets move more than 1% or 2% in a single day, that is a very big move. And we've seen this pattern repeat over and over. A few times we've even seen markets go down by 10%. And then rather quickly back up by 10%. So that is the real definition of volatility is that not only are these big movements, but they are quickly shifting direction as well. Now, the way the precious metals have played into all of this is that a lot of large funds like hedge funds have really been forced to liquidate their positions in gold in order to raise cash and cover their losses in the stock market and to meet margin calls.

For that reason, we have seen on more than one occasion the gold price plummet, somewhat mirroring what we've seen in the stock markets. But since then in the last week of March, we did see quite a rebound in the gold price and across the rest of the precious metals as more people are turning towards safe havens during such uncertain times. Now that is the demand side of the equation, that after the prices for the precious metals fell a couple of weeks ago, there was an explosion in retail buying demand. Now, as I've mentioned many times on this show, the main buyers for gold of late have been central banks and large institutions. Now central banks aren't selling off any of their gold during this crisis. In fact, the Russian central bank quietly added about 12 tons of gold in February, so that trend is still intact. But hedge funds and banks have been forced to sell their gold. And now finally the general public, moms and pops, and John Q Public are finally buying precious metals again.

The only problem with this is the fact that the physical supply of gold and silver are really hitting a bottleneck because of all the shutdowns due to the coronavirus. So for instance, most government mints have halted production. A lot of the big mining companies have had to send workers home, at least cut down their operations and how much output they're seeing. And perhaps most importantly, the three biggest gold refineries in Switzerland have all been on a temporary lockdown. They've sent everyone home. They're not refining metals right now. What all of that means for the precious metals industry is dealers like Gainesville Coins and basically everybody in the industry is experiencing a huge backlog in their inventory. There were so many orders that basically the system got overwhelmed.

Now what this bottleneck has caused is not a direct shortage of supply. Don't get me wrong, there is still plenty of gold available above ground. Much of it is sitting in vaults in London and elsewhere. But it is not in the form that most people want to buy. It's generally held in 400 ounce Good Delivery bars. So these are 400 troy ounce gold bars. That is a lot more gold than most people are buying. Unfortunately with somebody refiners shut down, it's pretty difficult logistically to get that gold melted down and made into smaller sizes and forms that are generally seen on the retail market. For instance, gold kilo bars or 10 ounce and one ounce gold bars. That means there are very long delays in getting some of the popular bullion products to market right now. And in response, most sellers have been forced to raise their premiums extremely high. Under normal circumstances, you usually see a dealer premium of less than 5% on silver and 1% or less on gold. In both cases, these have exploded to nearly 10 times their normal rates. If you look at one ounce of silver, it's very difficult to find for less than a 50% markup. As I said, that's about 10 times bigger in magnitude than the normal.

When we talk about the precious metals being rather liquid, meaning they are easy to sell at the price that you want, it's a pretty good illustration of how the gold market is rather efficient, meaning that price discovery happens when buyers and sellers reach an equilibrium price that everyone can agree on. Through that process, there are normally very thin spreads on gold. So what I mean is the price that a dealer is willing to pay you when you sell it is very close to the price that they then turn around and sell it for is usually a 1% to 2% spread. However, we have seen that spread become basically disconnected from the normal operations of the gold trade. There is a big gap right now between the price of gold futures, which are trade in London and New York. This is generally what we consider the paper price of gold. In normal circumstances, it should be very close to the spot price, the price that you actually pay at a given place in time. The disruption from the coronavirus, however, has really dislodged the normal operating of this market. Not only do you have these supply side disruptions that I spoke about with the refineries and the mines and the mints, but when you couple that with the explosion in physical demand, people wanting to buy metals, the result is a lot of confusion and distrust.

There was a report recently that the local gold price in London was about a $100 difference per ounce than the price in New York. So investors and traders literally could not trust the prices that they were looking at on their computer screens. When you add in the factor that a lot of countries are closing their borders, they're not allowing international travel or they're quarantining their citizens, all of that means that this disruption in the gold market probably will not correct itself for several more weeks, maybe even months depending on how long this pandemic becomes an issue. None of these bottlenecks in the supply chain for the physical metals can be resolved until the economy is operating at some level of normalcy. Given all the uncertainty right now surrounding the virus and how the economy will respond, it is really difficult to say when any of this will start to improve. In the meantime, I would expect that we continue to see really high volatility across all markets and that means the precious metals included. This pattern of large institutional investors liquidating some of their gold in order to raise cash is likely to continue until the crisis is over.

Although all of the fundamentals are pointing toward higher gold and silver prices, I think we are going to have to wait until that rally comes to fruition and we can realize those gains. But there are two interesting things about gold that I want to point out. One of which is that even though there have been some of these sell-offs and a lot of volatility, the price of gold has held up much better relative to other assets. So at the time that I am recording this, gold is actually positive for the year about 8% and those gains are actually even more impressive when you take into account how far the prices of other assets have fallen. So on a relative level, the value of gold has actually improved quite a bit compared to other assets. In some sense, you could say that the value of gold has gained market share over other financial assets.

Moreover, it is fascinating that in order to respond to some of these disruptions with the normal flow of the gold market, the CME in Chicago is introducing a new gold futures contract that is supposed to be more flexible than its predecessor because rather than forcing investors to only buy 100 ounces of gold at a time, the contract is for a 400 ounce gold bar. The new gold futures contract should allow investors to choose from a couple of different options. So as I mentioned before in London, the standard is for all gold bars to be 400 ounces. But meanwhile, in Shanghai, their gold is all in the form of kilobars, which are 32.15 troy ounces. So the hope is by adding these flexible options for physical delivery that gold will be encouraged to flow between different exchanges from Shanghai to London to New York more seamlessly without having to be delayed or stopped from flowing to where it needs to go just based on the form or size of the gold in the contract.

Now aside from what's gone on with the precious metals, I also think it's interesting to talk about how the government and financial institutions have responded thus far to the virus pandemic. Virtually all of the central banks in the world have engaged in some sort of stimulus to try and lessen the blow of all of the businesses closing, people stuck home, essentially the economy being frozen and so on. They are mainly cushioning that blow by slashing interest rates and buying up assets in order to grow their balance sheets. For the most part, this really only helps corporations and businesses. But again, that's not necessarily a bad thing if it keeps people working, prevents people from losing their jobs. As of now, we're still waiting on lawmakers to approve some sort of fiscal response as well, the idea being that if you mail people checks, they will spend that money. I do think that that is the right response right now.

But one of the possibilities that we all need to be aware of, particularly in the aftermath of the global financial crisis in 2008 when all of the banks were bailed out, is that these types of emergencies that call for corporate welfare are often used as a power grab or a way for special interest to get the best bailout package. Like I said, I do think that stimulus measures are needed and are warranted, but it is undeniable that these kinds of situations are usually an opportunity for bailouts, corporate welfare, to take precedence over the rest of the public and their financial well-being. One interesting report that I saw from Reuters comparing the current situation to the response of the financial crisis in 2008 and 2009 is that instances of insider trading spiked during the financial crisis, or at least the aftermath. We often don't bring that up anymore because it is so long ago in the rearview mirror, but basically the risk that this emergency situation will be taken advantage of for financial gain by certain influential institutions or entities is absolutely something we should be vigilant about. Otherwise those types of bailouts are going to continue to go to the wrong places. That type of, for lack of a better term, graft is really what people are worried about when they say that the cure for this coronavirus pandemic, all of the central banks and governments pumping stimulus into the economy, that could actually have worse effects economically than the disease itself.

And now I know given the circumstances and the stark reality of people being sick and vulnerable, it doesn't sound good for anyone to suggest that the cure could be worse than the disease. But the two things are not mutually exclusive. We can be sensitive to how bad the situation actually is while not allowing corporations to hijack the moment for their own enrichment. We have already seen that just the mention and plan of these stimulus packages has already had a positive effect on investor sentiment. So after falling roughly 30% deeply into a bear market, the Dow Jones Industrials have now bounced back to technically speaking a bull market. The Dow is now more than 20% above its lows, which some people are prematurely citing as a reason to believe that stocks are poised to make their next bull run. I don't know if that is actually going to be the case.

We may not have hit the bottom in the equity markets, but that brings me to maybe my most important insight about the whole coronavirus situation. The damage to the economy that we're seeing right now as a result of the shutdowns and the basic freeze in economic activity is only the catalyst for how bad things have gotten. The outbreak of the coronavirus is the proximate cause of all of this economic damage, but the massive buildup of debt and leverage is why the pain is going to be so acute. The entire world economy, not just the United States, would have been so much better positioned to deal with this if there was not so much debt sloshing around the system. Moreover, more companies would be able to remain solvent and not need government bailouts if they hadn't been so leveraged before this entire situation even began.

I think I did mention this in our first episode covering the coronavirus back in January, I believe, but the pandemic is also exacerbating some of the existing tensions we had in terms of the trade war. Lest we forget, neither China nor the US has really relaxed any of their punitive measures on each other. They have not pulled back tariffs even with COVID-19 spreading basically everyone in the world. So I think it's important to keep in mind that a lot of existing problems and existing risks for the financial system are being made worse or brought to light because of the temporary panic over the coronavirus.

And finally, one more thing that I would like to caution all of you listening not to get caught up in is hype about how soon or how long the virus will remain an issue. I think the main point here is that this is a novel coronavirus, meaning it is new. There is so much that we don't know about it. Coming up with models for how it will spread or how long it will take is really subject to so much uncertainty right now that the models are only so useful. I've seen very wide ranging estimates about how soon or how long this could take that I think is difficult for anyone, even the medical experts, to declare how long this is going to last.

With that being said, it's probably best to think about this probabilistically. There's a worst case scenario, a best case scenario, and then the range of probabilities in between, and so you should be prepared as best you can for all of those potentialities. And of course, no matter how difficult it may seem, I think we do all need to remain positive and optimistic during this whole situation because that will make it easier to get through. And in fact, it's also been shown to increase your immune system response when you're not stressed and you're not fearful. So keep all that in mind as we go forward and just understand that nobody is going to have all the answers. There is no silver bullet for this. It is simply the reality we are dealing with.

So on that note, I will turn to this week's question from the listeners. I've got one here from Benjamin, does not list where he's from, and Benjamin asks, is now the time to sell my gold? That is a fascinating question, and unfortunately the answer is a bit of: well, it depends. In general, if you can avoid it, if you don't have to, it is always better to hold on to your gold for the long term, we're talking at least 5-7 years, and more than likely, generationally. However, there is no shame in having to sell some of your gold, or perhaps all of it, depending on how much you have, if you need to raise cash. That's what it is there for. That's what we mean when we say gold is a safe haven during times of turmoil, that it is a highly liquid asset. All of that is just another way of saying that when you need to sell your gold, that's what it's there for.

As always, I want to thank everybody out there for listening. We really appreciate you guys tuning in, supporting the show. Amid all of this disruption and crazy work schedules, we have not come up with a topic for next episode, so unfortunately I don't have anything to tease you with right now, but be sure to tune in and check out the next episode of Breaking the Dollar to find out.